April 17, 2014

Diamonds Are A Perfect Example of the Inability to Calculate Financial Intrinsic Value

Following the 25-year case study of Tiffany & Company, I have been thinking a lot about diamonds.  From the economic pricing model to the cartel that controls diamond prices, not a day has gone by since that post when I have not studied gemstones, or the jewelry business, in some capacity, often for several hours at a time.  I picked up several new books, including The Heartless Stone, a look into the world of conflict diamonds and the diamond supply chain, to photographic reference guides such as Gemstones of the World.  

Lately, I’ve been looking for some very specific gifts for reasons I’d rather not get into at the moment.  Diamonds make fantastic gifts.  They turn an ordinary piece of jewelry into art.  Witness the new use of diamonds in the tops of Montblanc fountain pens.  It’s a small touch but it makes a big difference.  I love diamonds.  Everyone I know loves diamonds.  This is true even though the economist in me understands the pricing of the diamond industry is … complicated.

The Diamond Industry Is Controlled By a Cartel That Influences Prices Far More Than Is The Case In Other Commodities

People don’t understand the diamond industry.  For every 100 diamonds mined, 80 of them end up being used in an industrial capacity, either to drill, polish, cut, or grind other materials.  Even more interesting, diamonds are not particularly rare since supply actually exceeds demand but, as all economic students worth their salt know, the market price for diamonds has been influenced by the DeBeers monopoly for centuries.  If you need a short history, stop what you are doing and read this 30-year-old article about the illusion of diamond preciousness from The Atlantic.

The cartel has such power, though weakened of late, that no one actually knows what the free market price of diamonds would be in a pure economy driven by buyers or sellers, such as the markets we have in gold or oil (even with the notable presence of traders and leveraged derivatives).  It is entirely possible that a $10,000 diamond should be selling for $2,000; we just don’t know.  One thing is reasonably certain: The price would not be higher than it is now.  The basic laws of economics tell us that much.

These things, of course, are going through my mind all the time.  Yesterday, I was in Omaha with Aaron, my brother, and my brother’s girlfriend.  We stopped in Borsheim’s, the Berkshire Hathaway jewelry store that I have loved since childhood.  As I browsed the counters looking for something very specific, I was impressed by some of the pieces.  I don’t own much, if any, jewelry other than some cufflinks, but there was a wedding band that caught my eye.  It was phenomenal.  It featured 5.34 carats of diamonds in a platinum eternity setting, with the diamonds rated in the exceptional white colorless range (F on the GIA scale) and a VVS in clarity.

Flawless Diamonds Men's Wedding Band

A 5.34 carats diamond wedding band in a platinum eternity setting, with the diamonds rated in the exceptional white colorless range (F on the GIA scale) and a VVS in clarity … Copyright Joshua Kennon, All Rights Reserved. Reproduction or Linking to Image Strictly Forbidden.


I would be lying if I didn’t say I ran the compounding math in my head.  Ten or twelve times.  If I were to buy two identical copies, even at the Berkshire Hathaway discount price (which the sales associate was kind enough to ballpark for me and is substantial – at minimum 30% off retail, probably more) at an average rate of compounding, by the time I was Warren Buffett’s age, it would cost me $5 to $10 million in foregone wealth.  That is my opportunity cost.  What about financial intrinsic value?  

You Cannot Calculate the Financial Intrinsic Value of a Diamond 

The question in the back of my mind is: “What is this ring really worth?  What is the financial intrinsic value?”.  I can tell you the spot price of platinum and calculate the premium going to the jewelry store for the overhead, inventory carry costs, et cetera.  I can look at a gallon of gasoline and tell you if the truck stop is treating its customers fairly.  I cannot, however, tell you what that ring is “worth”.  Sure, I can tell you that it retails for nearly $27,000 plus sales tax, so let’s call it an even $30,000.  If DeBeers loses its grasp on the diamond market, though, would it sell for $20,000 at retail?  How about $15,000?  Maybe even $5,000?  I have no idea.  No one does.

That is the insane part of the diamond industry.  I cannot tell you the financial intrinsic value of that ring.  It is impossible.  Factor in the existence of diamonds in space and you have a real problem.  In 2004, Travis Metcalfe’s team at the Harvard-Smithsonian Center for Astrophysics found a star made of diamonds estimated at 10 billion trillion trillion carats.  If mankind could ever mine space, diamonds would be practically worthless; as common as dirt.  It isn’t unreasonable to think that several centuries hence that would be a possibility.  After all, it took barely more than a single century to go from a horse and buggy to space travel.  Once knowledge expands, it tends to have a habit of exploding.

Oh, and one other problem: It is estimated that the public holds half a billion carats of diamonds.  If even a decent minority of households sold them, the price of diamonds would fall so far, so fast, they would become cheap.  As a result, the diamond cartel hired marketing agents and psychologists to find ways to convince people that rings are “heirlooms” that never leave the family.  Instead, you take grandma’s wedding jewelry and have it reset; conveniently keeping it out of the public market.

Back to intrinsic value.  We cannot calculate the financial intrinsic value of a diamond.  This problem introduces the concept of emotional intrinsic value.  The question would become, “Is the price I have to give up for this item worth the opportunity cost of the funds and utility provided to me in terms of emotional fulfillment, regardless of the ultimate resale value I might be able to achieve in the event of a necessary liquidation?”

On that measure, the true intrinsic value of that diamond ring is different for every single person reading this post right now.  For some of you, $30,000 after sales tax at retail would be an absolute steal.  For others, it would be the worst possible financial decision you could ever make.  Me?  If I saw something that was really spectacular, I would buy it even if it made no financial sense because the utility it provided me exceeded the cost in terms of the opportunity use of money.

Some Businesses Have the Same Intrinsic Value Problem

Men and women are social creatures.  Certain types of businesses carry social prestige.  Thus, even though the financial intrinsic value may be “X”, the business may sell at a price of “2X” because owning the firm results in all sorts of emotional perks and power.  Since this post mentioned Borsheim’s, we’ll go back to controlling stockholder Warren Buffett, who once mentioned in his shareholder letter that newspapers and sports teams were the types of businesses that benefited from an emotional intrinsic value kicker.  

Intrinsic Value of Diamonds

It is impossible to calculate the intrinsic value of some assets, including certain businesses and commodities, such as diamonds.

Stated in more basic terms, a billionaire who had a single asset consisting of total control of Tiffany & Company, generating $665 million in annual pre-tax profit, would be “richer” than another billionaire with the exact same annual income who derived all of his annual income from sewage treatment plants and funeral homes.  He would be invited to more social events.  He would have access to a wider range of people.  However, $1 in profit from diamonds spends exactly the same as $1 in profit from sewage treatment.  As an investor, you job is to buy the greatest net earnings you can for every dollar invested.  The game is interesting because figuring out whether to pay up, or go for the bargain, is as much art as it is science.

The intersection of economics and behavioral psychology is fascinating.  When all is said and done, people are people.  They are driven by basic desires such as food, shelter, clothing, emotional intimacy, social prestige, and physical comfort.  Everything in civilization is a means to provide those ends.  That is one of the reasons all businesses are not created equal.  Walmart makes far, far more money than Saks, but most people would rather own Saks.  That tells you a lot about humanity.

Footnote: To add layer upon layer, consider the discussion some of us had in the comments section the other day. It is now possible to get synthetic diamonds that are virtually identical on a molecular level to so-called ‘natural’ diamonds. Yet, people want the ‘real’ thing, even though they are identical. History is what they are paying for, yet if they didn’t know the history, it wouldn’t matter in terms of item utility. This is why I am slightly obsessed with the jewelry industry. It is a vortex of intersecting mental models through which you can understand the entire world.  Even I am not immune.  All else equal, I’d rather pay a much higher price for expensive diamonds created in the ground than in a lab.  It makes no sense.

Advanced Footnote: For those of you interested in intrinsic value, even thought you couldn’t calculate the figure for a diamond, if the market were freed from monopoly-like pricing control, you could calculate the production cost per carat mined by quality, or some comparable metric, and become a net buyer whenever the current sale price falls below the cost to mine.  This would be especially attractive in a situation where above-ground inventories were being depleted rapidly.  Such a situation cannot exist forever.  I don’t see that happening any time soon, but on a theoretical basis, the possibility would exist for an interesting operation under such circumstances were one to have access to wholesale diamond inventories and plenty of spare liquidity.

  • Gilvus

    The value of natural gemstones is comparable to the numismatic value of coins. A natural gemstone of exceptional quality is rare, just like a double-struck or limited-edition coin. Remove the scarcity, and suddenly no one’s interested.

    A gem-quality ruby can fetch thousands per carat at auction, but I have a ruby the size of a bottle cap that’s milky red and full of contaminants. Cost me $3.

  • Jack

    There is no such thing as “intrinsic value.” Everything is worth more to the buyer than to the seller. If the seller valued the item more than he was selling it for, he would not sell; and if the buyer valued the item less than he was paying for it, he would not buy it.

    • Joshua Kennon

      While your assertion is accurate (in psychology, you are discussing the so-called “endowment effect” mental model that results in people overestimating the worth of a possession once in their control), your definition of intrinsic value is wrong.

      There are several forms of intrinsic value. On this site, the most discussed is the intrinsic value resulting from the fundamental utility produced by a given asset regardless of the market activity surrounding that assets.

      For example, if you own a manufacturing plant that produces $1 million per year in after-tax income and you try to sell it, but no one wants to buy it, that doesn’t mean the asset lacks intrinsic value. Sure, the market value is $0. However, as you continue to hold ownership, $1 million per year gets deposited into your bank account that you can spend, give to charity, or reinvest. Assuming no growth and current interest rates, the intrinsic value of your asset is between $8 and $12 million regardless of the fact no one wants to buy it and it is worthless in the after-market. That is a rough estimate of the ultimate time-adjusted wealth your ownership will generate for you; the utility it will provide, even in the absence of a willing buyer of that equity.

      Likewise, if you owned a plot of fertile land in the middle of nowhere and you couldn’t get someone to buy it from you at any price, you could still use the soil to produce bushes of apples, orange, grapes, corn, almonds, olives, or soybeans, depending upon the geography. That could keep your family alive or be sold to generate cash. Regardless of the market activity surrounding the asset, there is an intrinsic value inherent in the inextricable production capability of the property itself.

      Another, less stable, form of intrinsic value is the supply-demand curve driven by human desire, as influenced by the cost of production per unit. The more alternative uses of a given asset, the more secure its inherent intrinsic value. Timber has an intrinsic value. It can be used for firewood. It can be used to construct homes. It can be used to build rudimentary roads or bridges. It can be turned into furniture. Whenever you can acquire assets below the cost of production, while being reasonably assured that the consumption will remain steady, you can make a lot of money by arbitraging the difference between temporary market prices and the true, underlying intrinsic value of the asset. A good example would be copper in the 1960′s or 1970′s when above ground inventories were being reduced through consumption but the commodity itself was trading for less than the cost per ton to get it out of the ground.

      If I keep going on, we’re going to get into graduate level investment theory but the bottom line is: No. Intrinsic value does exist independent of the market value placed on a given asset by buyers and sellers of the asset itself, such as in the first couple of examples. A lesser form of intrinsic value can also exist by looking that the production cost of a given commodity relative to the supply-demand outlook. This intrinsic value is influenced by, and rooted in, biology. Humans don’t pay for air because it is abundant and free but the intrinsic value is far higher than all of the treasure on the planet.

      In both intrinsic value tests, diamonds at the prices sold in the retail market, fail miserably. The industrial utility of a diamond does not require a jewelry quality stone and is very inexpensive. The total cost to bring to market absence artificially monopoly cartel control would be far lower than it is currently. In all actuality, a $25,000 diamond ring should probably be $5,000. I don’t know if we’ll see it in our lifetimes, but I think the market will eventually reflect this given the technological advancements made over the past few decades. You can’t eat it. You can’t smoke it. You can’t easily generate heat with it. You can’t easily cool a room with it. It doesn’t throw off any excess value, like a business or farm can. The above-ground stores are not consumed so the total carat weigh held in private hands continues to climb, even adjusted for population growth. Diamonds only have “value” because of a so-called social fact, which is itself built upon the lie that diamonds are scarce. They are not.

      Bottom line: Financially, diamonds are vastly overpriced due to manipulation. They are very pretty and I myself have a diamond watch, diamond fountain pens, etc., all of which I love and paid a lot of money to own. That doesn’t change the reality of the situation. Who knows? I may someday but a $50,000 ring for myself from Harry Winston, despite knowing all of this. Again, that doesn’t change the economic fundamentals.

      • Jack

        Let me rephrase, then… Intrinsic value is impossible to quantify.

        That factory may bring in x dollars per year, and assuming a P/E ratio of y does not make the intrinsic value x*y any more than assuming a P/E/ of z makes the intrinsic value x*z.

        Now, if we were to start computing our net worth by our net income from investments, we might have something useful.

  • http://AJCiti.com/ AJ

    Wow, you definitely sent me down the rabbit hole with this one. I’ve been obsessing over diamonds since I read this article yesterday. I knew a little about the history of diamonds and De Beers, I find it so fascinating how they’ve been able to maintain such control over the entire industry from all aspects and for so long.

    The craziest part is how their ad campaigns have shaped consumer perception and attitude towards diamonds til this day! I also find that whole aspect of diamonds having terrible resale value extremely interesting as well. Diamonds are so expensive and so many people think owning a diamond is equivalent to owning gold in a sense.

    Anyways, after all my reading and video watching I’ve concluded that I will opt to buy moissanite jewellery and lab made diamonds over “real” diamonds. The former 2 are much prettier and less expensive.

    • Joshua Kennon

      The author of The Atlantic article I linked to earlier, Edward Jay Epstein, wrote a book 30 years ago called The Rise and Fall of Diamonds: The Shattering of a Brilliant Illusion. It is now out of print, but you can get used copies for $2 to $3 on Amazon. I bought a copy that is on its way. My research keeps coming across it as the definitive history of diamonds and the industry.

      Moissanite fascinates me. By all available accounts, it is vastly superior to diamonds. It looks prettier. It has more “fire”, in industry speak, due to how it reflects light. It is less expensive.

      Lab made gems – those that are chemically identical to their real-earth counterparts, not a synthetic such as cubic zirconia – also fascinate me. I keep coming across Chatham, a manufacturer of gems that are identical on a physical, chemical, and optical level to those found in the earth, have no impurities, greater color, are more beautiful, and less expensive. They aren’t “fake”. They are absolutely, positively better and superior. Yet, people still seem to prefer the inferior stones created in the Earth rather than in a lab even though they are the same material. Millions of years from now, if aliens landed on the planet and found the stones shattered and in rubble, they wouldn’t know the difference. It’s no different than a cultured pearl versus a natural pearl.

      In short: I find myself arriving at the same conclusion you did. There is no rational reason to buy mined diamonds over lab created diamonds. The latter are less expensive and more beautiful.

      • Gilvus

        On the superiority of moissanite: I have a 10cm-by-10cm piece of silicon carbide (non-gem moissanite) that I use for hardness demonstrations. I slash at it with a big survival knife and all it does is dull the knife.

        • Joshua Kennon

          I am studying moissanite now as a follow up to the diamond industry (in the midst of a sub-research project on electric and water utilities for something I’m working on for the family). It is one of the most fascinating business products I’ve ever encountered.

          You have a gemstone that is literally far rarer than diamonds, only coming from outer space, except that humans figured out how to manufacture it in a lab. Although a little softer than diamonds (not much as your demonstration points out, beautifully), it is nearly twice as “good” as a diamond in appearance, color, refraction, vibrance, etc.

          Moissanite isn’t even a diamond simulant or synthetic. It is an entirely different gemstone, like rubies or emeralds or sapphires. They shouldn’t be compared in some regards. I can come to no other rational conclusion that it is vastly preferable to have moissanite over diamonds.

          When the patent runs out and the gems can be mass manufactured in 2015, it is highly probable that the price will fall off a cliff. This is basic supply and demand. It could, theoretically, become as common as glass. Yet, you will have a huge moissanite 5 carat ring that is more beautiful and more perfect in all conceivable ways trading for a fraction of the price of an inferior diamond. It is going to be an interesting study in psychology to see fools buy the more expensive material (diamond) despite being worse across the board. They are literally buying an idea, not a product. I am only interested in intrinsic value. Screw the idea. I’d rather have the money and buy something that is better. I just want the best, which does not always mean the most expensive.

          I am seriously contemplating having a set of wedding bands manufactured in moissanite, maybe 5 to 10 carat total weight each. If I can find a decent goldsmith, I might even custom order several different colors of the gems and have cufflinks made. Some of these colors would be awesome for my French cuff dress shirts.

    • Joshua Kennon

      P.S. Have you come across Lev Leviev, the billionaire that is single handedly taking down the DeBeers cartel? It is fascinating. Read everything you can about what he is doing. He is going to undo the market. He loves, and is obsessed, with diamonds.

      He also launched his own diamond company that has some of the most beautiful jewelry I have ever seen in my life. It’s like a modern day Harry Winston. You can browse some of their products (I recommend the ‘catalog’ feature) at http://www.leviev.com/

      This particular piece is so amazing to me, structurally, that if I were 70 years old, had no future compounding use for money, and didn’t care about growing my net worth any more, I’d buy it just to display in my office. I wouldn’t want to own a Monet or a Rembrandt. I’d want this: http://leviev.s3.amazonaws.com/catalogue/md/LEVIEV_TextPages-37.jpg

  • Miss Mul

    This is fanscinating! I have been thinking about the uniqueness of diamonds and their valuation since reading this. Can you think of any other goods or industry (luxury or otherwise), that is like that of diamonds? I can’t so far but would love some opinions.

    • Joshua Kennon

      Off the top of my head, the only comparable industry that the average person is in contact with every day that suffers from such a wildly inflated price structure is refined sugar in the United States. As diamonds are controlled by manipulating the supply, the supply of sugar in the United States does not follow a true theoretical free market because it has been influenced heavily by quotas and other laws, regulations, and tariffs the United States Congress used / uses to reward a handful of sugar billionaires. In my personal opinion, it is an unethical form of welfare that transfers money from poor and middle class families to the top 1% for absolutely no rational reason.

      You can read a little bit about the so-called ‘Great Sugar Shaft’ at this link.