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Equity Investment: Do we Have What it Takes?

Equity Investment: Do we Have What it Takes?

There are many ways to examine the diamond industry. If you are a regular reader of my articles, you know that I have broken it down from many angles. In all of them, I looked at the industry from the perspective of an insider. As someone active in the diamond industry, I see it from my perspective, especially in the up- and mid-stream, as well as from the perspective of someone active in the high-end polished diamond investment side. I try to understand my clients, and make sure they get good value for their money, and as such, it makes sense to examine the industry from another perspective – that of an outsider.

Most diamond buyers are regular folks, men and women who buy diamond jewelry, either as an adornment or to signify an important life event – engagement, marriage, childbirth, change in career, or some other important and emotional life event. However, there is another kind of diamond buyer: an investor. The investor usually wants to buy something that looks good when considering an investment in an equity, be it a painting or a vintage car. So, the diamond that such an investor would consider should be pretty. That being said, a diamond that also serves as an equity investment must offer much more than beauty. First and foremost, it should make sound economic sense. The question is: do investment-grade diamonds offer an interesting economic opportunity, and how does the diamond industry viewed from that perspective?

I know you probably feel that an investor would mainly and simply look at past returns to make up their mind. They will likely compare price trends to alternative investments. However, a smart and seasoned equity investor would also want to look forward, and ask a few additional questions: what kind of prospects would such an investment have? Is availability decreasing? Is demand growing? These are important questions, but we in the diamond industry have limited influence on these issues. The past is behind us. Availability is more a matter of historic geological activity than anything else. We have the power to influence demand by investing in marketing, for example, but there is a bigger picture that we have to consider, and it has an enormous impact on how attractive investment grade polished diamonds can be in the eyes of an equity investor – the way we conduct ourselves.

Many may dismiss this notion, but think of how we consider our vendors and even clients: we want to know their purchasing history, there credit worthiness, of course, but also, have they ever been accused of misconduct? Has anyone ever complained about them? Based on these factors, we may or may not do business with them. Even if we do business with them, we may sell them less to mitigate a future problem, only against immediate payment or COD, or ask for better guarantees. The way they did business in the past, even if it is with others, influences how we do business with them in the future. This is true for a one-on-one situation, as well as when we consider entering a new industry. We have to ask how well that particular industry works. If the answer is not well, I’ll go elsewhere, because, as we say in Hebrew – you don’t rest a healthy head in a sick bed.

So let us consider what we are doing, and think about how it may look to an outsider. At the bottom of the diamond pipeline, we see no real growth in demand. According to De Beers’ 2017 Diamond Insight Report, global consumer demand for diamond jewelry grew by just 0.3% year-over-year. Only two countries are responsible for that growth, as small as it is. They are the US, where demand for diamond jewelry rose 4.4% in 2016 vs 2015, and Japan, the third-largest diamond consumer market, where demand increased by 8.1%. Japanese demand, however, increased only due to the appreciation of the yen against the US dollar. From a consumer perspective, the Japanese spent 2.9% less on diamond jewelry. The three other major diamond consumer markets suffered a deep drop in demand: in China demand fell by 4.8%, in India by 13%, and in the Gulf region by 10%. In the rest of the world, demand fell 3.2%. It is a very poor state of affairs if demand for diamond jewelry remained flat only thanks to two countries, especially when in one of them it was by chance.

Even in the US, where business was supposedly good, we know that the number of specialty jewelry stores continues to decrease. The number of stores was down some 6% year-over-year because of tough business conditions and the lack of interest on the part of storeowners’ children to enter the business. Further underscoring the problems of diamonds on the consumer level, the value of diamonds sold in retail, meaning the value of the stones without the jewelry, decreased 0.7% during 2016 on the back of a 2% decline during 2015. Clearly, the prospects for consumer demand are not good. This does not look like a growth market.

Most of you are very familiar with the state of the midstream, which is troubled by a wide range of issues. Banks that finance the industry are closing their diamond departments and ending their funding altogether. The list includes Standard Charter Bank, Bank Leumi, and the closure altogether of Antwerp Diamond Bank. Very quietly and without fanfare, a range of banks in India decided to depart as well. The reason for their departure in all cases was quality of business – banks either lost money or expressed concern with the way the diamond industry did business, and decided that they did not want to be associated with it.

In addition, manufacturers and wholesalers’ margins have been very thin for years. In the last few years, margins have gotten worse, as wholesale prices of polished diamonds have steadily declined over the last three years. At the same time, the cost of borrowing increased, and the cost of manufacturing remained largely unchanged because salaries and energy costs have been steady. The cost of real estate only increased, and the cost of machinery has been fixed or increased too.

Another cost bearing on diamond manufacturers, which is a major issue, is that of rough diamonds. Although prices of rough diamonds declined in 2015 and the first half of 2016, these declines are not catching up with the decline in polished diamond prices. Worse, during the second half of 2016, rough diamond prices increased although polished diamond prices decreased. A business where your revenue is declining, and your expenses are either fixed or rising, is one where profitability erodes to nearly nothing – and then beyond nothing. That is why there are so many businesses closing or going under in the mid-stream of the diamond pipeline. This is an unsustainable business model.

As for the upstream of the diamond pipeline, although things are better there, they are not that rosy. BHP Billiton, the world’s largest miner, decided to exit diamond mining, and sold its assets, because they did not consider diamonds very profitable. Rio Tinto, the world’s second-largest miner, sold a small mine in Zimbabwe, and plans to close its biggest mine, Argyle in Australia, in a couple of years when it depletes its current stage in the mine. They decided not to develop it further. De Beers has sold a number of mines over the years, because they found them to be less profitable, and have recently closed a mine in Canada for the same reason.

All along the diamond pipeline, the industry is resisting the introduction of new tools that could improve business, is shying away from issues of transparency, and is refusing to address pressing issues of public concern such as ethics – even though the industry has nothing to be ashamed about. We are already seeing a price to this: lab-grown diamonds are starting to eat away at natural diamonds’ market share in the US, the sole country where there is still some real growth. What will happen if growth in the US flattens, or worse, declines like in most of the rest of the world?

And so, considering all of the above, would you invest in the diamond industry? What do you think an equity investor would do? If you think they will turn to invest in other areas, then we are in agreement that the industry does not look healthy. This begs the question: what are we going to do about it?

The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser. 

 

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