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.
[mainbodyad]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.
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 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.
[mainbodyad]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.
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.
