Diamonds: Easy to buy, harder to sell

Buying a diamond is easy. Selling it is a different matter, and it's in the selling that the really tricky bit about diamonds becomes obvious; their value varies from person to person.

Even in their rough and freshly mined form values can vary enormously with experts disagreeing over multiple issues including the colour, clarity, inclusions (impurities), and the shape of the rough stone, all being factors that go into determining the ultimate value of a gem in its jewellery-ready form.

With so many variables (there are at least 20,000 variations) diamonds are widely seen as being unsuitable for individual investors, unless they have expert guidance – and only from an expert they trust completely.

What Robert Gottliebsen has uncovered in his inquiry into the diamond market (see his piece today, Why diamonds could be an investor's best friend) is a variation of the investment case for gold, another asset class which often avoids the problems of equity and property markets.

Over the past few years diamonds as an investment class have done relatively well, though that's largely because they have risen a little while almost everything else has fallen.

What drives diamond values is scarcity, or the perception of scarcity.

Top of the scarcity list is the fact that high-quality gem diamonds are damned hard to find, residing in the cores of ancient volcanoes where there were “cooked” out of carbon in a climate of extreme heat and pressure.

Potential volcanic cores are easy to find. Volcanic cores containing the primary host rock for diamonds, kimberlite, are harder to find, and that's when the narrowing down gets even tougher because for every 1000 kimberlite occurrences discovered only three or four yield commercially viable diamond deposits.

The latest problem with sub-economic diamonds in the ground can be found in the financial collapse of Kimberley Diamonds, the last company to own a Rio Tinto discovery, and the latest to go broke trying to extract its diamonds profitably.

The scarcity factors continue through the diamond processing chain, a tightly controlled production and marketing system once run by De Beers (a business owned by the London-listed Anglo American plc) but now a somewhat freer market.

Free, or not, De Beers and other diamond marketing businesses are known to restrict the supply of diamonds, releasing material when diamond demand is high (such as just before Christmas) and stockpiling when it is low.

I first encountered disputed diamond valuations more than 30 years ago when De Beers and Rio Tinto engaged in a cold war over values assigned to material from the Argyle mine in WA which Rio Tinto operated with De Beers doing the marketing.

At one time trust over values broke down completely leading to Rio Tinto re-submitting the same parcel of Argyle diamonds to De Beers without telling De Beers – a sneaky step on a business partner but one which confirmed a view that diamond values are intensely personal because De Beers put a lower value on the same stones second time around.

That incident, known as “the sorting line drift” because the values drifted on stones as they came off the Argyle sorting line, destroyed the relationship between De Beers and Rio Tinto, leading directly to Rio Tinto establishing its own diamond marketing business, and indirectly to De Beers eventually releasing its tight control of the industry.

On the positive side of an investment in diamonds there will inevitably be a decline in the supply of freshly mined material as discoveries dwindle and potential development projects become scarce.

The problem with that view is similar to the Peak Oil theory which was popular until a few years ago with many investors believing in an argument that the world would eventually run out of oil.

Peak Oil is a perfectly correct theory, with two missing links: the time of Peak Oil's arrival and the ingenuity of geologists to discover new ways of extracting oil trapped in rocks once considered too hard to crack.

Diamond supplies will probably not go through a similar process of renewal through discovery but they do face a technology challenge in the form of synthetic gems.

While there is nothing new about synthetic diamonds the process has generally yielded industrial quality material.

That's changing. New technologies are being developed which produce high-quality stones, grown atom-by-atom, and while no-one, yet, would boast about wearing a synthetic diamond there are plenty of people wearing farm-grown pearls which have largely replaced pearls collected in the wild.

The real issue for investors is one of trust. If you believe the value put on a diamond today by a reputable dealer, also ask him or her what it would be worth tomorrow on re-sale?

The chances are there will be a gap of 30 per cent to 50 per cent between the buy and sell prices, and you will need to hold on to your diamond for a long time to cover that gap.