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Zimnisky: Diamonds lack fungibility to be a major investment product

12 february 2018

paul_zimnisky_xx_excl.jpgPhysical diamonds will never be a viable widespread investment product simply because they inherently lack fungibility, meaning they are all unique, according to Paul Zimnisky, an independent diamond industry analyst and consultant, who is based in New York.

He told Rough & Polished’s Mathew Nyaungwa in a wide-ranging exclusive interview that the lack of fungibility makes diamonds illiquid and consequently very expensive to transact.

Zmnisky also said that diamonds had considerably underperformed global stocks in recent years and this is mostly due to a secular change in American luxury consumption preferences and marriage rates, and the economic slowdown in China a few years back.

However, the Chinese market had since shown signs of recovery and would lead to stronger relative global demand for diamonds in 2018.

He projected demand for polished diamonds in value to increase 3-4 percent this year, driven by a strong global economy while global rough diamond production in value was expected to decrease 1-2 percent.

NB: Zimnisky has a monthly subscription-based diamond industry newsletter called, State of the Diamond Market and a proprietary rough diamond price index available at www.roughdiamondindex.com.

Below are excerpts from the interview.  

Are diamonds an ideal form of investment in terms of wealth management?

I don’t think physical diamonds will ever be a viable widespread investment product simply because they inherently lack fungibility (meaning they are all unique), this makes them especially illiquid and thus very expensive to transact. I would say that if diamonds had a fungible characteristic similar to that of gold, and the total transaction costs were similar to that of gold, diamonds would be a viable investment product, especially given the diversification benefits and the very high value-to-size ratio they offer –but the reality is the lack of fungibility and thus the lack of liquidity is just too high of a cost relative to the benefit diamonds can offer most portfolios.
How are diamonds performing compared with the traditional investments like stock markets and gold?

Generally speaking, diamonds have significantly underperformed global stocks and a lot of commodities, including most precious metals, in recent years. This is mostly attributed to a secular change in American luxury consumption preferences and marriage rates, and the economic slowdown in China a few years back. The Chinese market has since shown signs of recovery, and I think this will lead to stronger relative global demand for diamonds in 2018, however American and developed market demand remains the biggest threat to longer-term sustained demand growth in my opinion. For context, America is the diamond industry’s largest market representing about 50% of end-demand, followed by China which is approaching 20%.

There are three ways of investing in diamonds: buying the actual product, buying an investment fund that buys/sells in the business and buying stocks of mining companies or producers. Of these three, which one do you think is more attractive to high-net-worth clients?

I think it all comes down to the investor’s ultimate goals. Very rare, high-end auction-house-quality diamonds would probably make sense for a high-net worth individual looking to diversify wealth into long-hold physical assets. Again, physical transaction costs tend to be quite high, but if an investor plans on buying a million-dollar diamond and holding it for 10+ years, that cost becomes more manageable. It’s worth noting, in the case of buying physical diamonds, buying quality over quantity has been a better strategy, for example buying the best $1 million stone you can find versus one hundred $10,000 stones. Investing in industry private equity or funds that hold interests in privately held companies in the industry can be a viable strategy, but I would say this is probably the most complicated form of investment you mention, and one really needs to understand not only the industry but the intricacies of investing in private equity. Lastly, publicly traded equity in either miners or diamond retailers is the most accessible form of investment mentioned as far as minimum investment required and liquidity. The diamond miner space for instance, is relatively small, compared to say the energy industry or even gold mining, and thus is relatively underfollowed by banks and institutional investors, which can create an opportunity for those willing to do the work and really familiarise themselves with the space.

Do you see demand for large, unique or color diamonds on the part of the high-net-worth clients?

There is certainly a market for these diamonds, albeit it is small, the number of individuals that can afford to participate is of course quite select. I would note that over the last five years or so, new demand for very high-end diamonds as an investment, has primarily come from high-net worth individuals in China.

Do you consider large, unique or color diamonds to be a good investment?

Perhaps for the wealthiest people in the world, those that have so much wealth that diversifying it all actually poses a challenge. For most everyone else, stocks, bonds and real estate probably make more sense.

What is considered an investment-grade diamond?

This is subjective, but personally I would consider investment grade to be stones at least in the $100,000’s range but ideally those worth $1 million-plus. These can be large high-quality colorless or fancy. A mixture of demand and rarity is of course key.

Do diamonds hold their value when inflation erodes the value of savings?

In theory, a tangible asset that is historically perceived as valuable, such as a diamond, should at least somewhat act as an inflation hedge, but I would argue that in general gold, stocks, bonds or real estate have historically been a better choice for an inflation hedge or “store of wealth.” But as I mentioned [earlier], there are a lot of moving parts and nuances that go into this. 

A Bain Capital report showed that prices for rough diamonds increased 31 percent and polished stones 24 percent in the 2010-11 period. What is the potential investment return on diamonds under the prevailing global economic conditions?

I do think the current supply/demand environment is setting up for a year of upward pressure on diamond prices, but I don’t think it will be anywhere near 20-30 percent, but closer to the low to-mid single digits. Regarding holding physical diamonds, all-in transaction costs can be in the low double-digit percent-range, so even with a 20-30 percent return, more than half of that would be eroded by transaction costs round-trip. Regarding diamond mining equities, there is an intrinsic leverage to rough diamond prices in that if rough prices increase, and the miner’s cost to produce the diamonds remains the same, margin expansion is realized. However, there are a lot of moving parts when it comes to analysing miners, for example, if a South African diamond miner pays its employees in Rand and sells its diamonds in USD, and the rand appreciates versus the dollar, it will have a negative impact on margins. Regarding particular companies, I think Canadian miners, Mountain Province Diamonds and Stornoway Diamonds, offer attractive value at the moment, as both have the potential to produce positive free cash flow for the first time this year and both stocks are trading around multiyear lows. Lucara Diamond, a Canadian-listed company, with an African asset, the Karowe mine, is a well-run company with exposure to larger, higher-quality diamonds. The company is already profitable and pays a dividend that yields about 4 percent.

What is the level of global demand for diamonds by millennials and baby boomers?

This is the million-dollar question. In the U.S., demand from this demographic is certainly lower than it was with previous generations, but I don’t think it’s as low as some would make it seem. In addition, the U.S. is still experiencing net population growth which is supportive of most all consumption, including diamonds, and this somewhat offsets a declining per-capita consumer appetite for diamonds. Further, looking at diamond demand globally, middle class growth in China and India and other emerging markets could further offset some of this loss of per-capita demand in the U.S.

Lastly, what is your projection of the state of the diamond industry this year?

In 2016 a lot of excess rough inventory was transferred from the miners to the mid-stream segment, which since has been consumed as polished diamond jewelry during the recent holiday season. The miners still hold some excess inventory, as does the mid-stream segment, however comparatively speaking, the supply chain is in much better shape than it was at this time last year and in 2016, and especially 2015, which I think makes room for higher diamond prices. I estimate that global rough diamond production in value will decrease 1-2% this year while demand for polished (in value) will increase 3-4%, driven by a strong global economy. I see the biggest risk to this demand forecast being higher interest rates in developed markets via reversing of monetary stimulus, which could lead to a decrease in asset values, and thus impact consumer sentiment and discretionary spending.

Mathew Nyaungwa, Editor in Chief of the African Bureau, Rough&Polished