Diamonds in the '80s: The Prospects and Pitfalls

The media seem finally to have discovered diamonds and precious stones, although their message is sometimes confused. For instance, recently there were two guests on the NBC Today Show—one, Sheila Pine, telling viewers to sell diamonds and buy colored stones; another, David Rubin, in response to tumbling gold prices asserting that the diamond market is basically sound and that diamond prices would "recover" as soon as the new Reagan economic policy was defined.

In 1976 the wholesale price of prime investment diamonds—one-carat, D-flawless—averaged $6,700. By 1980 that priced had leaped to $60,000 but by the end of February 1981 had fallen to $44,000. But will the trend continue, or will the glittering diamond market of the last five years return in all its glory? Any attempt to come up with an answer must take into account several factors—whether Reagan's economic policies will affect the diamond picture, whether De Beers will step in to steady the market, and what can be expected from recently introduced diamond investment vehicles.

THE REAGAN FACTOR "Supply-side economics" has apparently become the battle cry of the '80s. Reagan has promised an economic revival via tax cuts, tax incentives for industry, deregulation, and control of the money supply. So far, it's breathed new life into the stock market. For diamond investors, however, the telling question is whether these measures can limit inflation, the cornerstone of the hard-asset investment market. For several key reasons, it's unlikely.

First, Reagan must get his proposals through Congress. Perhaps he'll win the budget battle, but the prospects for taming taxation are dim. Even with all the tax bills pending in Congress—another reduction in capital gains taxes, accelerated depreciation write-off, reduction in income tax rates (Kemp-Roth), and income tax reductions coupled with a value-added tax—it's not clear that a majority of either the House or the Senate will agree to get down to business and actually slash away at taxes. And, supposing they do, will tax relief come in a form that could boost investment?

Second, even if Reagan manages to win from Congress anything close to his proposed package—and it bolsters the economy—can it really control inflation? West Germany and Japan have sound economies but are still plagued with inflation. And all the signs are that OPEC partners are resolved to maintain their regular price increases and to limit crude supplies.

"Inflation," as British economist Anthony Harris has noted, "is not a problem but a cure…, the means by which an economy squares excessive claims with limited resources." This is what is happening in the United States today, squaring the excessive claims of OPEC, trade unions, and government beneficiaries. These will not disappear.

What we can expect, then, is for investors to continue to look for real wealth—real value that cannot be produced by a paper economy. For a whole decade, collectibles and gems have outpaced equities (paper), and the market is well established. Institutional money has begun flowing into hard assets. Individual investors, between affairs with the money market, continue to invest. Investment vehicles are becoming more sophisticated as limited partnerships and trusts are accepted. Communications within the market have expanded with computerized listings. Finally, brokerage firms, looking for new profit possibilities to offset equity declines, have been moving into the hard-assets market. And all of this spells strength in diamond investments.

DE BEERS DOMINANCE Any assessment of the outlook for diamonds must also take account of what is probably the second-most important cartel in the Western world after OPEC—the diamond producers' organization that is synonymous with De Beers because of the indisputably dominant position within the cartel of De Beers Consolidated Mines, Ltd. De Beers is itself the world's largest diamond producer and buyer, and it has never been hesitant to call the shots in the diamond market.

De Beers controls the market in several ways. It operates its own mines in South Africa and Namibia and is expected to be in production in Botswana by 1982. It also works under contract in Angola. Through the Diamond Trading Company (DITRA), it buys rough on the open market in West Africa and elsewhere. On the marketing side, it controls about 85 percent of the world's diamond supply through its Central Selling Office (CSO) in London. Stones are sold to its customers—manufacturers and wholesalers—10 times a year at CSO "sights." In addition to determining what quantity will be offered at these sights, De Beers exercises control through the parcels offered. Although sightholders may accept or reject an offered parcel, frequent rejections may lead De Beers to withdraw its invitation to participate. Buyers suspected of stockpiling may have their invitations withdrawn also.

For the CSO itself, of course, stockpiling is the means by which it achieves its goal—maintaining "orderly" prices. Thus it holds diamonds during slumps and releases them for sale during boom times.

There is every reason to believe that De Beers will and can continue to use its position to keep diamond prices from diving. It's been controlling the market since the company was established in 1888 (by Cecil Rhodes, a British businessman after whom Rhodesia was named and who used part of his De Beers fortune to endow the famed Rhodes Scholarships). And a recent comment by De Beers Director N.F. Oppenheimer shows that they intend to continue in that vein: "It would seem that large stocks of these diamonds are building up in the various cutting centers. At times like this it might be thought that De Beers would be getting worried, but this is far from the case. In fact, as was reported in the annual report, De Beers is, with some urgency, expanding production of diamonds into Botswana and in Namaqualand. It can do this in the sure knowledge that the relationship between it and the trade is sufficient to carry them through if difficult times still prevail when this production goes to the CSO." And indeed, in mid-March Business Week reported that De Beers had cut back diamond allocations to cutting houses—by 60 percent in the case of the US cutters.

DIAMONDS GO PUBLIC Recent developments in diamond investment vehicles promise a broadening of the market. In the United States, early 1981 saw the approval of three diamond investment funds by the Securities and Exchange Commission.

The first is the Thomson Diamond Trust, set up by the national brokerage firm Thomson McKinnon Securities. The US Trust Company of New York and the Wilmington Trust Company of Delaware serve as trustees, and a prominent New York broker was engaged to negotiate the purchase and liquidation of the stones, supervised by a trio of industry experts. The trust acquired high-quality diamonds, D to H in color and Flawless to VS2 in clarity. Initially, some 7,000 investment units were sold at slightly less than $1,000 each, plus sales costs.

A Florida diamond dealer has also won approval for Diamond Investments, Ltd. This calls for a limited-partnership, $10-million diamond fund. Both this and the Thomson fund plan for periodic liquidation over a 10-year period.

A third entry, Michigan-based National Diamond Fund, is more like a mutual fund. It plans to sell a million shares at $10 each. The fund is to be managed by a chartered life insurance underwriter and a member of the American Society of Pension Actuaries. The company's prospectus calls for the purchase of diamonds, both rough and polished, ranging from 1 to 3.5 carats, as well as other stones. The fund projects that it will have to sell 50,000 shares in 180 days to raise capital to buy the stones. Semiannually, the fund would have a 30-day stock redemption period at net asset value.

In Europe, one of England's largest merchant banks, Charterhouse Japhet, Ltd., recently announced the Anglo Diamond Investment Fund, which plans to invest $14 million in a top-quality diamond portfolio, with shares offered at $10,000 each. The fund will hold the stones for five years, trading only when appreciation is high. At the end of this period, the diamonds will be sold and the proceeds distributed to shareholders.

Thus, for the first time in years, the small and middle-range investor has access to diamond dealing. If successful, the concept could change the nature of the diamond market. In addition, these moves could spark institutional investment in diamonds. US pension funds amount to some $650 billion, and one dealer recently pointed out that if a mere five percent of this were to enter the diamond market, it would result in a bull move "unparalleled in its magnitude."

INVESTOR BEWARE If you are intent upon investing in diamonds on your own, there are, as in any investment field, pitfalls to watch out for. "Diamonds are not for everyone," warns Richard J. Harty, president of a Los Angeles diamond brokerage firm. He estimates that in 1979 investors lost over $100 million in diamond scams.

People are attracted to diamonds for capital gain, the excellent inflation hedge offered by hard assets. For example: some high-grade stones have appreciated as much as 40 percent a year, well above the inflation rate. The investment diamond market as a whole has not experienced a major price drop in the last 40 years. Diamonds also represent the most concentrated form of portable wealth; there is no ongoing management or upkeep; and there is easy worldwide liquidation—making diamonds one of the most popular hard-asset investments.

Yet "many gemstone buyers are not well enough versed in purchasing diamonds to avoid being taken," says Harty, who was president of the now-defunct American Association of Diamond Merchants. It is this lack of information that accounts for the success of diamond swindles. As insurance for the investor, he recommends knowing the major types of scams used by unscrupulous diamond salesmen.

The main technique used to defraud investors is the "guaranteed buyback," in which the firm selling the stone promises to purchase it at any time the investor wants to sell it. If a broker says he will buy back the gem with no loss to you, demand to see his Securities and Exchange Commission license. Any firm offering a guaranteed buyback is required to have a diamond sale prospectus, as in a stock sale. Buyback firms who cannot produce a license and a prospectus should be avoided.

Beware of brokers who promise to liquidate stones in less than two days. This ploy is often used in conjunction with the guaranteed buyback. With rare exceptions, diamond sales take four to six weeks.

The most common complaint attorneys general receive from investors is over pricing. Brokers tell buyers they are getting a stone at wholesale, but the actual price is retail. The best protection against this scam is to know current diamond prices before buying any stone. Rates can be found in such publications as the Gold & Diamond Exchange price matrix.

A popular way to attract buyers is to quote the huge price increases of investment-grade stones but to offer melee—small, jewelry-grade diamonds. "At least $30 million was invested in melee in 1979," says Harty. "Those little things are for beauty and adornment, not investment." Diamond chips definitely do not appreciate at the same rate as larger, investment-quality stones. Harty recommends not investing in any diamond less than one-half carat and certainly no less than one-third.

Another type of diamond swindle is the "loss leader," or "bait and switch." A broker will advertise diamonds at a certain price, usually wholesale or below, but when the potential buyer tries to purchase the advertised stones, the dealer does not have them. The broker then tries to push the investor into buying more expensive stones.

A modification of the "bait and switch" technique is to attract potential investors with wholesale diamond prices but convince them to buy colored stones such as rubies, emeralds, or sapphires. Colored stones can be a good investment, but you need to be very careful when buying them. Partly because the grading standards for gems other than diamonds are not well developed or uniform, it is very easy for an unsuspecting and untrained investor to get taken when buying colored gems.

Time-payment scams are also becoming popular because of the increasing prices for investment-grade diamonds. Investors who cannot afford to buy a stone outright can buy on a lay-away plan, paying in installments of $50 or $100 a month. Because of the high cost of quality diamonds, however, most brokers cannot afford to hold stones for investors paying as little as $50 a month. What usually happens in time-payment frauds is that the broker gets your money and keeps the stone. If you do not have the money to pay for a stone all at once, you should consider other investment opportunities. Never purchase a diamond, regardless of the price, if you do not get to hold the stone.

An old, yet still effective, scam is selling industrial-grade or simulant diamonds for investment-quality stones. This fraud is usually employed by firms selling diamonds by mail. An investor will buy a stone thinking he is getting a high-quality diamond, but upon certification the gem turns out to be a fake or of very poor quality. Brokers using this scam often seal the stone in a plastic container, with the gem placed against a black background to enhance its brilliance. The sealed container will carry a warning telling the buyer not to break the seal or the stone will depreciate. Sealing a stone does not affect its value. A $5,000 diamond will be worth $5,000 if it is wrapped in paper or plastic. While there is nothing wrong with sealing a diamond, the container should protect the stone and the buyer, not the unscrupulous dealings of a broker. Diamond investing by mail can be risky and should only be done with a reputable firm.

One of the recent systems used to defraud investors is a diamond pyramid scheme. Brokers use this scam to convince a number of investors to pitch in toward buying a large parcel of rough stones. The dealers guarantee very large and quick returns when the stones are cut and sold. The investors in a pyramid scheme never see the diamonds and usually never get a profit or their original investment back. Again: investors should be leery of any diamond purchase where they do not get to see or keep the stones.

KEEPING YOUR SHIRT The best way to avoid scams is to learn about diamonds and the diamond market before you make a diamond investment. Reputable dealers will supply investors with general information about diamonds. The literature should point out the various pros and cons of hard-asset investing. Broker Richard Harty maintains that information stating only the good aspects of diamond investing should be questioned.

Before you even approach a dealer, though, you should know your investment portfolio. How long can your money be tied up? What do you expect from your investment? And will you need quick access to your money?

If you determine that a diamond investment makes sense for you, the next step—one of the most important steps in diamond investing—is to shop around for a reputable dealer. "Avoid brokers who will only discuss the romance of diamonds and will not deal with the facts," states Harty. Be wary of sellers who are only interested in closing the deal and try to force a sale by assuring you that "diamond prices are going to double, so buy now." The number-one rule of diamond investing is: Do not buy from a broker you do not trust.

Check and compare broker prices. Watch out for low quotes over the phone but high prices in the office. A legitimate broker will tell you his sales commission—the industry average is 10-20 percent. Find out in advance how much the stone is marked up over wholesale. A diamond marked up more than 45 percent, including sales commission, should not be bought for an investment, advises Harty.

Reputable dealers will let investors examine and return a stone for a full refund within a given period if dissatisfied with the purchase. If a broker does not offer a satisfaction guarantee, look for a different firm.

Ask the broker for a list of references, and check them thoroughly. A firm's reputation can be checked by calling its bank, the Better Business Bureau, or the Chamber of Commerce. If the firm leases its offices, contact the landlord to see if the rent is paid on time and how long the firm has been in the same location. Checking references and leases can help you avoid boiler room operations.

After choosing a dealer you can trust, have him help you decide what size and type of stone is right for your portfolio. Large high-quality diamonds are difficult to sell quickly, while one-half carat stones are easier to liquidate. Regardless of size, a diamond should be held at least three to five years. In spite of advertising claims to the contrary, most investors pay retail prices for stones and get wholesale prices when they sell. This means a long waiting period before the investment shows a substantial profit. "Diamonds are not a get-rich-quick scheme," says Harty. "They are a long-term investment."

Know exactly what you are getting before paying for a diamond. Your broker should give you a detailed description of the gem's specifications. Ask about the stone's proportions as well as its cut, clarity, and color. Be leery of any broker who says he will get you a diamond with "approximately these characteristics."

The easiest way to get burned when investing in a diamond is by not getting an independent laboratory certification. In-house certificates, of course, should be avoided. The major US independent labs are Gemological Institute of America (this one has the widest reputation), American Gemological Laboratory, United States Gemological Services, Inc., and European Gemological Laboratories. Some labs seal the stone in a plastic container. If the diamond is sealed, be sure the lab sealed it, not the broker.

After receiving the diamond and its certificate, check to see whether the appraisal matches the stone. Diamonds, like fingerprints, are unique. The best way to check on a certification is to call the laboratory that graded the stone and read off the serial number. The lab will tell you if the certificate is genuine. If in doubt, laser photographs and foil reproductions of your diamond can be used to determine whether the certificate and the stone match.

Diamonds, like any investment, do carry an element of risk. To improve your odds of making a profit and not getting taken, use caution. Avoid problems by spotting a diamond scam before it has your money.

Alan Einerson is a financial columnist for Utah Holiday and Medical Tribune, has written extensively for various business publications. and is the former editor of Gold and Diamond Exchange.