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A Very Unusual Market

As you know, precious and even semi-precious metals have been enjoying several years of positive attention from investors. Between rising industrial demand in developing countries and fears about the stability of national currencies, it’s been a pretty good decade for gold, silver, platinum, palladium and even copper. But there’s another commodity,...

As you know, precious and even semi-precious metals have been enjoying several years of positive attention from investors. Between rising industrial demand in developing countries and fears about the stability of national currencies, it’s been a pretty good decade for gold, silver, platinum, palladium and even copper.

But there’s another commodity, also expensive, and also mined from the ground, that has been altogether ignored by investors, despite its equally impressive price performance. In the last 11 years, this commodity has increased in price by approximately 65% (below is a chart of its price since 1960). During the 2008 market crash and recession, this commodity lost a mere 4% of its value. And like gold and silver, this commodity’s value is not dependent on the value of any currency. But unlike gold and silver, tiny quantities of this commodity can be worth millions—easily stored in your home or a lock box, or carried undetected from place to place ... even across borders.

So why aren’t investors flocking to this recession-proof, portable commodity that constantly increases in value?

Because the commodity in question is diamonds.

When considered in the light above, diamonds seem like the perfect investment. Surely Ajediam, the diamond broker that created the graph above, would like you to believe so. On their website, the company touts diamonds as “the most concentrated store of value that exists.” However, the diamond market is one of the world’s strangest free markets. And it’s a terrible place to be an investor.

Edward J. Epstein explores this strange market in his 2011 book, Have You Ever Tried to Sell A Diamond?, based largely on his 1982 article of the same name in The Atlantic.

Diamonds, like other luxury goods, are desirable precisely because they’re expensive. (In economics, this is called a Veblen good.) But keeping diamonds expensive is a lot harder than keeping, say, Louis Vuitton purses expensive. Louis Vuitton makes every single one of its purses, so it can limit production to keep prices high. It also brands every bag with its signature initials, so competitors can’t undercut it.

Diamonds, on the other hand, are mined from the ground. And while productive diamond mines aren’t exactly around every corner, there are far more now than there were back in 1960—when diamonds sold for a 10th of their current price. Nine new mines have opened in the last 10 years alone.

And diamonds can’t be branded—once they’re dug out of the ground and polished, diamonds from a De Beers mine in Botswana are pretty much identical to similar-quality diamonds from a Rio Tinto mine in Australia.

So why are diamonds still so expensive?

Aware that demand for them depends on keeping prices high, the major global producers of diamonds have managed to keep diamonds expensive against all odds. Luckily (for them), there are few enough players in this space that this feat—making a natural resource more expensive every year, even as supply increases—has been improbably possible.

In 1955, for example, a giant new source of diamonds was discovered in Siberia. At the time, almost all of the world’s diamonds came from South Africa, where they were mined and sold exclusively by De Beers. De Beers’ owners knew that if all these new Soviet diamonds were allowed to flood onto the market (a market they had carefully created with an intense, decades-long advertising campaign) the price of diamonds would fall. So when the mine began producing, in 1962, De Beers agreed to buy virtually all of its production. For the next several decades, De Beers dutifully bought almost all of the Soviet production of diamonds, and placed them into a four-story deep vault in London.

This monopolistic tactic served De Beers well for many decades, and the company employed it globally. After the political change of the 1990s caused De Beers to lose some of its production agreements with warlords and other leaders in West and Central Africa, the company had another new source of non-De Beers diamonds to worry about. In a brilliant (if disturbing) marketing coup, the company successfully branded all diamonds coming from small producers in African conflict zones as “blood diamonds.” By the year 2000, the U.N. and many other organizations had condemned or banned the sale of these “undocumented” diamonds from “conflict zones,” unwittingly propping up De Beers’ monopoly.

However, the monopoly isn’t what it once was. The European Union eventually declared its practice of buying and stockpiling Russian diamonds anti-competitive, and ordered De Beers to stop by 2009. De Beers cleverly turned the diamond production over to Alrosa, a state-owned Russian company. Because Alrosa controls 97% of Russia’s diamond production, it’s also in its best interest to keep prices high.

In 2009, after the financial crisis and recession had caused a slight dip in diamond prices, the Russian government bought $1 billion worth of diamonds from Alrosa, to support the industry and keep the supply off the market.

This is how the supply side of the diamond market operates around the world, controlled by barely a handful of large companies manipulating prices in their interest.

But more diamonds are being discovered every year—in Canada, Angola, Brazil and elsewhere—and the monopoly frays more with every new source. What’s to keep a new player from undercutting the cartel?

Another thing about diamonds: they’re practically indestructible.

Almost every single diamond ever set in an engagement ring, tennis bracelet or necklace is still floating around somewhere. As Edward Epstein wrote in a 2009 article, “De Beers executives estimate that the public holds more than 500 million carats of gem diamonds, which is more than 50 times the number of gem diamonds produced by the cartel in any given year. The moment a significant portion of the public begins selling diamonds from this prodigious inventory, the cartel would be unable to sustain the price of diamonds, or maintain the illusion that they are such a rare stone that their value is, as the ad slogan claims, ‘forever.’”

The most likely catalyst for the public to start doing such a thing would be a significant decline in diamond prices. The public has been successfully conditioned to believe that diamonds never lose their value—that they’re “forever.” If that faith was shaken, there would be nothing the cartel could do to stop people from selling their diamonds, “before they lose any more value.” (Sound familiar?)

And that’s why it’s very, very important to diamond producers everywhere to keep prices very, very high.

As for an investment, I think it’s safe to say that buying diamonds is a poor idea. However, I do have two diamond-related stocks that may be appropriate for some investors.

The first is Harry Winston Diamond (HWD). Harry Winston both mines diamonds and sells finished luxury goods like jewelry and watches. Andrew Mickey, editor of Hard Money Millionaire, wrote the stock up on September 26 when he thought it looked like a bargain. It’s still trading at the same level it was then, so HWD could still be a good deal for investors who expect it to rebound:

“Despite the steady rise of diamond prices, shares of diamond producers haven’t held up nearly as well. Harry Winston Diamond Corp. is the diamond stock bellwether. Its shares have fallen at more than twice the rate of major indices in the last few months:

“Granted, this looks bad. And it is for those who rode it down. For those of us biding our time, however, it’s great news. The lackluster performance of Harry Winston has dragged down the few diamond stocks available to invest. But diamonds are in a bull market supported by a tight oligopoly, a class of customers getting steadily wealthier, and have been in demand for thousands of years. So regardless of how bad this leg of the recession will be, the trend in diamonds has been up for 50 years. There’s no reason to expect a change any time soon. Once we see an end in sight to the current selloff, we’ll be moving into one or two diamond stocks. There could be a huge opportunity. After all, in 2008 Harry Winston shares fell to a low of $2.68 while diamond prices held steady. The result was a run from less than $3 to more than $18 in just over two years. This isn’t 2008, but falling diamond share prices and rising prices will create the opportunity for decent gains at some point in the future.”

Obviously, this prediction only holds true as long as diamond prices remain untouchable, which they probably will for quite some time.

The second stock I have for you today is much more tangentially related to the price of diamonds. This is Tiffany & Co. (TIF), the jewelry company. Stephen Leeb, of The Complete Investor, recommended Tiffany on October 10:

“As the rich continue to get richer, luxury items should continue to do very well. Though it’s hardly the largest of the luxury retailers, Tiffany & Co. certainly comes to mind. If there’s any relatively small company that fits the definition of a franchise, it has to be Tiffany. This is reflected by its mention in artifacts of popular culture from Breakfast at Tiffany’s to the lyrics of ‘Diamonds Are a Girl’s Best Friend,’ immortalized by Carol Channing and Marilyn Monroe, respectively, in the Broadway and film versions of Gentlemen Prefer Blondes. Clearly, when one thinks of luxury, the name Tiffany comes to mind. Financially speaking, the company’s fundamentals are strong, and it being in the business of gold and silver does not hurt either.”

I’ve seen Tiffany in several other advisories as well, as a play on the super-rich in the U.S., the growing upper class in China, and the growing realization that we’re not entering another recession. TIF obviously reacted quite a bit to the growing double-dip fears this August and September, but it has recovered beautifully this month (up 27% so far) and I wouldn’t be surprised to see it resume its growth trajectory soon. Plus, the company pays a nice 29-cent-a-month dividend, for a 1.55% yield.

Wishing you success in your investing and beyond,

Chloe Lutts

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.