For those of you who have been following the precious metals sector you know that things continue to look dismal. Silver slumped 27 percent this year, the biggest loss among the 24 commodities in the S&P GSCI Spot Index, while gold dropped 17 percent on speculation the Federal Reserve may reduce U.S. monetary stimulus. The general trend of the precious metals sector, one of downward momentum and negative investor sentiment, looks to continue, with no telling when the rebound will occur. My article today will focus primarily on the current situation of silver, and whether the recent movements in silver prices warrants a buying opportunity for investors or whether it is best for investors to stay away from a potential "value trap".
Last Tuesday, Silver gained 6 cents to trade at 22.47. But stocks in the precious metals sector were extremely volatile as concerns eased about an early cut in U.S. monetary stimulus and as investors took account of a prolonged shutdown at the world's second-largest copper mine (Grasberg's copper mine).
Short Term Outlook
Based on Tuesday's volume in the precious metals sector, we are already seeing investors holding off on trades until Friday. On Friday, the U.S. non-farm payrolls report will show the employment situation--the key factor for the Fed's decision on monetary policy. Expectations remain that the Federal Reserve will continue its stimulus program to bolster the U.S. economic recovery. As these expectations hold up, a solid report should lead to another day of rebounding silver prices.
Long Term Outlook
The longer term outlook in silver prices, in my opinion, is much more certain. Over the past year, the underperformance of both the Chinese and Indian economy has led to a massive drop in silver prices. Under the new Chinese administration, with Xi Jinping as president, China is willing to sacrifice short-term economic growth in order to deliver structural reforms to the government for sustainable growth in the future. Despite some good numbers coming out of China last week, with China's manufacturing PMI index inching up to 50.8 in May, I believe China's GDP growth for 2013 will fall to below 6% given that China missed nearly every single forecast number in Q1, and given the industrial and power generation slowdown during the first three months of 2013.
India continues to struggle with a rapidly declining middle class consumption and a worsening econotrade deficit. The country's structural hurdles are leading to a deterioration of the countries investment situation, and a soft-landing in 2013 may be warranted. This is not good for silver prices as India is one of the world's leading consumers of silver (and gold).
In addition, Barclays Bank recently noted that silver imports in China were down 28% in the month of April year on year (confirming a decline in silver consumption in China).
What I would tell investors is to look at mining companies with the following characteristics:
- Diversified asset portfolio with low political risk
- Access to capital funding
- Low all-in costs of production
- Conservative balance sheet-i.e. low debt levels
- Healthy pipeline of high quality projects.
I continue to like Silver Wheaton (NYSE:SLW), one of the world's largest silver streaming companies, as it meets all of the above characteristics. SLW currently has 17 long-term silver purchase agreements (14 to 25 years of a mine's production) with cash costs of approximately $4 per ounce of silver. That is, for the next 14 to 25 years, Silver Wheaton will be able to purchase silver at $4 per ounce and sell silver at $20-35 per ounce (whatever the prevailing market price of silver is). This provides the company with a +60% net income margin and a +80% EBITDA margin.
The streaming business is relatively new to market, extremely profitable, and offers a real hedge against falling metal spot prices. On the contrary, a rise in silver prices should play heavily in SLW's favor as margins will rise significantly. SLW also has a healthy balance sheet, an experienced management team, and a strong pipeline of projects. Its common stock is currently trading at $24.75 per share and has fallen over 30% year to date.
Why silver fans should buy SLW?
- Cost certainty - silver cost fixed at $4/oz
- Leverage to increasing silver prices - as silver prices increase, margins increase
- High quality asset base - including one of the largest mines in South America (Penasquito owned by Goldcorp (NYSE:GG))
- Exceptional growth profile - 4 additional silver agreements currently in the developmental phase
- Dividend yield - pays a generous 2% dividend
Wall Street analysts are looking for a $40 price target on SLW's common stock or a 62% upside to the stock by the end of the year. I'm looking for the stock to rebound to the $34 level (the level in which the stock opened the year at). This warrants an investment opportunity with a 37% upside.
Disclosure: I am long SLW, GG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.