Silver Miners: What Will It Take For A Turnaround?

Includes: AG, HL, PAAS, SLW
by: Northrop Puckett

While many factors affect precious metal miner stocks, the most dominant tends to be the price of the metal itself. And with silver prices down over 33% year-to-date, it begs the question: when will it bottom, or at least bounce significantly? Both investment demand for the metal and industrial demand for it have been lacking, meaning that there has been lack of buying support "double whammy" the past few months.

Industrial demand doesn't look like it will increase very much in the near term, with economies outside the U.S. continuing to slow, but investment demand is more flexible. Investment demand for silver is very correlated to the value of the dollar, monetary easing, the price of gold, and inflation expectations. Lets take a moment to evaluate these various factors affecting silver's investment demand. I'm sure you've read these "oversold silver articles" for weeks now, but I would argue that a number of things are lining up to signal a bounce in silver prices, including: potential Fed "backtracking" on tapering; historically wrong sell-side timing; and positive technical divergences.

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Tapering Comments and the Market Reaction

My belief has been that it would not be easy to "wind down" the enormous amount of Fed bond purchases because of its massive size. That doesn't mean that I don't think it shouldn't be done; just that I didn't think it could be done without inflicting damage to a still-weak economy. Therefore I didn't think the Fed would begin to taper this year. In the present economic climate, it seems like it would be impossible for bonds not to fall, with this resulting in higher treasury rates, higher interest rates, and much larger corporate, private, and U.S. government debt payments. That would risk throwing us back into recession. Is the Fed willing to risk this? Maybe.

But maybe Bernanke was just testing the market to see the reaction. After all, if he could slow bond purchases without rates rising too much, it would be worth doing. So you telegraph the move and watch to see what happens.

Or maybe the Fed honestly expects a minimal decline in bonds and equities. Fed "mouthpiece," Jon Hilsenrath, wrote a column stating that the market was misinterpreting what Bernanke said. If he truly is a sort of mouthpiece, then that statement could be semi-directed from Fed insiders. Additionally, a few Fed governors came out Monday stating that the market is incorrectly interpreting a change to a more hawkish monetary stance. I believe this also signals them being somewhat surprised by the bond and equity moves.

Regardless, I do not see the taper being as certain now that the market has reacted the way it has. In addition to bond and equity declines, we have many refi's and deals that were canceled. I can't imagine the Fed liked that result. That is another reason I believe they will tweet that tapering stance before September.

I will also cite super bond manager, Jeffrey Gundlach, who was quoted in this recent article:

Gundlach presented a hypothetical calculation showing that if interest rates were to "normalize" and increase by 100 basis points annually over the next five years, the federal interest expense would increase from $360 billion last year to $1.51 trillion.

"This really is unthinkable," he said. "It is one of the reasons why quantitative easing is likely to be in place, particularly should interest rates start to cause problems by rising more than I think they are going to rise."

So, Gundlach doesn't think that tapering will occur to the extent that it causes bonds to decline past a certain level on the 10 year (actually, we are past the threshold that he gave in the article). He even said they might increase the bond purchases.

Based on the: semi-backtracking by the Fed (through Hilsenrath and other Fed members); the reaction in the market; and the statements by a guy who knows bonds better than perhaps anyone (even Bill Gross), I expect the Fed to modify its tapering plan in terms of timing and scope. If the Fed backtracks on its QE tapering comments, I think that you will see a rally in precious metals, with shorts providing a squeeze.

In the same article Gundlach went on to address silver specifically:

The performance of gold and silver will continue to be "soft," he said, but investors should prefer silver as part of a diversified portfolio as a way to hedge against inflation. Gundlach doesn't think sliver is inherently a good investment, but he said it has a high beta and will rise strongly if inflation strikes.

So Gundlach is relatively neutral on silver prices, believing that they won't see strength, but that silver is a good hedge due to it's high beta and correlation to inflation. This is at least akin to a "hold," which given the declines of the past 6 months, seems like a sign of daylight.

Does that mean silver prices are set to rally tomorrow? Well, no I wouldn't go that far. But I do think that silver is oversold, especially after last week. And I also know that nothing goes straight up or straight down without eventually finding relief in the form of a reversal. If that is the case for silver, it may also mean that the silver miners are oversold and will catch a bounce after a final flush this week of next. In addition to the Fed modifying its taper plan, there are a few more factors that I believe are lining up to signal a silver bounce.

Historically Wrong Sell-Side Timing

Many sell-side firms seem to have a history of making the wrong market calls at turning points in the market. Regardless of the reason for this, it is worth noting if you have any contrarian bones in your body. This is occurring now for silver and it's bigger brother -- gold -- with Deutsche Bank, Credit Suisse, and Goldman having slashed metals forecasts recently. This seems like a contrarian signal to me, at least on a short-term time frame.

Positive Technical Divergences

In addition to Fed changes to tapering and historically poor timing on large bank predictions, there are positive technical aspects pointing to a bounce. From an oversold standpoint, silver prices have not been down to this low since 2010, and it has happened in a hurry. Nothing goes up or down in a straight line, and there has been no relief rally since January. The market is very oversold, at least in the short term.

Additionally, the RSI (a technical indicator) has been experiencing a positive divergence from the price over the past 6 weeks, which means that while price has continued downward, the RSI has started to head upwards. This frequently bodes well for a price bounce.

On a less significant, but still mildly bullish note, sales of American Silver Eagles for the first four months of the year were up 56% over the first four months of last year. Is this fact just a sign that there are more people looking to get their hands on physical silver, or is it a positive divergence form futures prices?

Miners and Their Metrics

While it is never wise to "catch a falling knife" it is useful to watch for the bottom with some confirmation, like a double bottom -- two price lows with the second at a higher price than the first. If you see that, you may be able to get short or intermediate term bounce in miner prices. But which silver miners would be appropriate vehicles? Let's see.


Silver Wheaton (NYSE:SLW) is kind of the star of this industry. It has the highest margins due to the fact that it doesn't mine, but simply enters into long-term silver purchase agreements with other actual miners. In this way it has avoided the 10% rise in mining costs over the past year.

Silver Wheaton has a forward P/E ratio of 12.27, and with expected 5 year EPS growth of 20%, it is pretty cheap. Silver Wheaton also has a ROE (return on equity) of 18%, which is the highest in its industry, and means that it utilizes its shareholder equity to produce higher profitability than competitors. Similarly, the company has very high operating margins of 67%, due to the fact that it has no real production costs. The company also has a long term debt-to-equity ratio of 0, so that is a positive.

The chart looks "like death," and I am a person that places significant weight on technicals, so I would look for some sort of bounce off the bottom of the channel before possibly looking for a real bounce up. But if it does catch a bid (along with silver) it might head back up to the top of the channel., above $30.

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Pan American Silver (NASDAQ:PAAS) mines silver in Mexico, Peru, Argentina and Bolivia. For what it's worth, management appears to see current precious metals prices as a short-term phenomenon, because it mentioned the possibility of making acquisitions while asset prices where low.

The company is trading at $10.73 per share, and has a solid cash stash with $3.23 of cash per share. The company also pays a solid 4.66% dividend yield and has very low debt, with a long term debt-to-equity ratio of .02.

Pan American now sports a forward P/E ratio of 10.62 and is selling a a discount to its book value, with a price-to-book ratio of .60. The company is expected to grow EPS 6% per year for the next 5 years, which isn't great, but is better than an expectation for declining EPS.

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First Majestic Silver (NYSE:AG) operates 5 silver mines in Mexico. In an uncertain world, this fact is a positive. Mexico, while not without its occasional labor disputes, is a relatively safe, democratic country to do business in.

The company seems very cheap based on metrics. This is a common occurrence though when a stock chronically underperforms, but while First Majestic has missed earnings, I do not feel that it has done so much more than other silver miners. That is no excuse, but for a company that has been beaten down so much that it now sports a forward P/E ratio of only 4.48 and a miniscule PEG of .10, it seems a bit overdone. The company has been increasing cash flow and it also has high gross profit margins, which are positives that should allow it to survive continued tough times.

In the chart you can actually see that it broke down through the channel. This is not pretty. It isn't my preferred choice from these companies.

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Hecla Mining (NYSE:HL) has properties in Alaska and Idaho, and recently purchased the outstanding shares of Aurizon Mines. That purchase gives it exposure to gold, which may help lower their beta slightly (gold beta being slightly lower than silver).

Hecla is selling for under book value, with a price-to-book value of .71, but is only expected to grow earnings 1% per year over the next 5 years. That is not impressive. If you look at it another way, it won't take much to beat expectations. Also, in March and April Deutsche Bank and Global Hunter Securities upgraded the stock.

The company also saves its money, which allowed it to make the Aurizon purchase, and it keeps its debt low, sporting a long term debt-to-equity ratio of .02.

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The Play

One thing that all of these companies have in common is that declining silver prices have caused analysts to slash earnings projections. Therefore, a sustained bounce in silver will translate to expectations of "earnings beats" and subsequent bounces in price. The length of the price bounce may only be short-term (although something longer than that could happen if inflation somehow appeared.) I am waiting for one more silver slush which I expect to coincide to a move down to 1540-50 on the S&P.

Despite the fact that all of these stocks will bounce if the silver price increases, it is probably wisest to stick to the best company in the industry. And I still believe that due to its avoidance of mining costs, and high profitability, that company is Silver Wheaton. Vehicles for that play are an outright stock purchase, or a 20/24 August bull call spread -- buying the $21 Aug call and selling the $24 Aug call. At the time of this writing that would pay a little over 3 to 1 ($3 profit for every $1 spent) if it closed above $24 at expiration.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SLW over the next 72 hours. 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.

Disclaimer: We do not know your personal financial situation, so the information contained in this article represents an opinion, and should not be construed as personalized investment advice. Past performance is no guarantee of future results. Do your own research on individual issues.