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Why Warren Buffett Is Wrong on Gold

Stocks in this article: GLD XOM BRK.A

NEW YORK ( TheStreet ) -- Warren Buffett, legendary investor and head of Berkshire Hathaway (BRK.B), has slammed gold, yet again, saying it doesn't have any use and isn't procreative.

In an adaption of his upcoming shareholder letter published on Fortune's Web site, Buffett rips into the intelligence of owning gold, saying that real demand for gold, defined as industrial and decorative, is incapable of soaking up new production and that the gold you own doesn't "do" anything. At the end of the day, gold is just an ounce of gold worth whatever someone is willing to pay for it.

Buffett does acknowledge that gold's 10-year bull market has been helped by the multiplication of fear in the marketplace, which triggered a flood into the hard asset. But he writes this rally off by saying that "as 'bandwagon' investors join any party, they create their own truth -- for a while."

Buffett uses the Internet and housing bubbles as examples of rising assets that fueled their own fire until those bubbles burst. With all the gold in the world amounting to $9.6 trillion, using $1,750 an ounce as the price, Buffett says he would rather buy all the U.S. cropland, 16 Exxon Mobils (XOM) and still have $1 trillion left over.

Since 2001, gold has rallied 539% while Exxon has climbed only 90%. Now, of course 16 Exxons would have produced a killer return, but why not own both? Most experts recommend that 5% to 10% of one's portfolio be in gold. Those that are more aggressive say 20%.

Although Buffett is one of the best-known investors in the world, here is why he might be missing out on gold investing.

It's not just retail investors or traders that are buying gold and making it a "bubble," but central banks are too. The "official sector" bought 430 tons of gold in 2011 -- the second year central banks were net buyers in more than two decades -- and the majority of these buyers are coming from emerging market countries that need to increase their reserve ratio.

India now holds 6% in gold reserves, which is still considerably lower than the 20% of gold reserves it held in 1994. China holds 1.8% of its reserves in gold. Compare these numbers to the U.S., which holds more than 75% of its reserves in the yellow metal. All of Asia currently only holds 2% of its reserves in gold. Even if the continent were to reallocate their holdings to 3%, it would need to buy 1,000 tons.

Central banks, in general, regard reserve allocation as an ongoing government policy and the more emerging markets rack up trade surpluses with the U.S., the more likely they will be to buy gold. Chinese companies that trade with the U.S. end up with dollars that are exchanged for yuan with the central bank. Then the central bank winds up buying a lot of Treasury bills with that money. The more dollars it accumulates, the more gold the country will have to buy in order to keep its asset ratio consistent.

"Gold holdings are part of a broad set of assets and liabilities of a central bank and are held to ensure against the negative impact of a sudden withdrawal of foreign capital and adverse exchange rate movements," says James Steel, analyst at HSBC. He thinks emerging market central banks will keep adding gold to their portfolio. "We forecast that the official sector could account for 450 tons of net purchases in 2012," this number is more than quadruple mine supply in 2011.

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