Low Risk Way To Use Silver As An Inflation Hedge

| About: Silver Wheaton (SLW)


The article begins with a summary of previous work by the author about inflation.

Higher inflation will come eventually; an explanation of my reasoning.

The best way to invest in silver with less risk and greater potential reward when higher inflation returns.

Low Risk of Silver as Inflation Hedge

By Mark Bern, CPA CFA

I have written several articles about why I do not expect inflation in the near term (one example can be found here). I have also written (in 2010) about my expectations for the price of silver when I predicted the price would not exceed $50 per ounce over the next three to five years. Of course, we all know now that the price of silver stalled at $49.50 not long after that article was written. I confess that I was probably just as much lucky as right. I wrote an update to that article in August of last year titled, "Why Gold and Silver Prices Are Not Headed for the Stratosphere." Please do not jump to conclusions! I do expect higher inflation, as you would understand from reading those previous articles, but just not yet. I also believe that silver prices are likely to increase from current levels when higher inflation does return. When inflation does return we all need to be prepared, and holding an investment in sliver could turn out to be a very important part of a portfolio. I will explain my favorite way to invest in silver later in the article.

The problem with predicting (or trying to time) changes in market trends or economic factors that will affect market trends, such as major changes in inflation, is that no one has been able to do so accurately on a consistent basis; myself included. Take the current U.S. economy and the U.S. stock market index, S&P 500, as an example. Much of the growth in earnings per share in U.S. companies is not being derived from strong domestic economic growth. There are several "other" factors at work benefiting U.S. corporate earnings per share [EPS]. The more factors involved, especially ones outside the control of management, the more difficult it becomes to predict future earnings and, by extension, share prices.

Consumption growth in emerging economies is benefiting many U.S. companies that have had the foresight to enter and expand in those markets. This is a trend that will continue, perhaps with a few minor setbacks along the way, for several decades more. Another factor helping boost corporate EPS is the extremely (artificially) low interest rate environment that is reducing borrowing costs and helping to boost returns on capital investments (mostly outside the U.S., unfortunately). A third major contributing factor to EPS is a strong trend of share repurchases. And there are other factors at work, as well.

One of those other factors is quantitative easing [QE] by the Federal Reserve [FED]. The programs of purchasing mortgage-backed securities and Treasury debt instruments has infused a lot of cash into the financial sector of our economy allowing those firms to both improve balance sheets while also stabilizing and increasing interest rate spreads earned. QE has helped to strengthen the U.S. financial sector increasing investor confidence and creating a more "risk-on" environment for equities.

Another factor that has provided temporary support to equities indirectly is the U.S. government deficit spending. As the private sector has been deleveraging since the Great Recession, the U.S. government has been running record deficits, piling up debt to offset the effect of private sector debt actions. I am not happy about the deficits being piled upon future generations, but without it we could be experiencing deflation. The FED and Treasury are acutely aware of this and have taken unprecedented actions in an attempt to keep the U.S. economy away from the deflationary cliff.

You might be wondering why deflation is even a possibility. Again, there are several factors at work here, also. Deflation can occur when an economy deleverages because money supply can fall and velocity of money can also slow due to deleveraging. Inflation, which many argue is simply too much money chasing too few goods, is just the opposite. Inflation generally occurs when leverage [debt] levels are increasing creating both more money supply and greater velocity of money in the economy. Without the extreme actions taken by the Fed (loans and QE) and U.S. government (increased deficit spending) the natural path of the deleveraging U.S. economy would have been deflationary. My previously linked articles explain this concept in greater detail so I will not try to expand the particulars here.

Private sector debt levels in the U.S. are still excessive, but more manageable than prior to 2008. However, having simply replaced private debt with public debt has not solved the problem. Eventually, we may still face more deflationary pressure until the economy is on a better footing. How long that will take is questionable and I do not have the answer. But there is also the problem of unwinding the FED balance sheet. If the FED does so too quickly the likely result is deflation. However, if the FED decides to err on the side of creating inflation (which it seems determined to do) there is the potential is for much higher inflation than that to which we have become accustomed. The answer remains within the actions of the financial sector. Banks have built up extremely high levels of excess reserves which remain idle instead of spurring economic growth.

The question of bank excess reserves was addressed in a paper published by the New York FED appropriately titled, "Why Are Banks Holding So Many Excess Reserves?" Below is a quote from the paper that sums it up.

"Why are banks holding so many excess reserves? What do the data … tell us about current economic conditions and about bank lending behavior? Some observers claim that the large increase in excess reserves implies that many of the policies introduced by the Federal Reserve in response to the financial crisis have been ineffective. Rather than promoting the flow of credit to firms and households, it is argued, the data … indicate that the money lent to banks and other intermediaries by the Federal Reserve since September 2008 is simply sitting idle in banks' reserve accounts."

At the time of that paper (July 2009) excess reserves stood at over $800 billion, up from about $1.5 billion prior to the financial crisis. As of February 2014, bank excess reserves totaled more than $2.5 trillion (note that the "b" changed to a "t") according to FED Economic Research Data. That is a colossal amount of money to be sitting idle waiting for a good reason to enter the economy. If banks determine at some point in the future that it is safe to start lending more to put that money to work earning higher returns without counter actions taken by the FED we could see much higher inflation rates.

There are too many variables to accurately predict when or even if that will happen. The Fed may move too slowly in reducing its balance sheet (currently over $4.1 trillion and still increasing due to QE). This is important because reductions to the FED balance sheet would reduce bank excess reserves available to be loaned into the economy. Currently the total U.S. monetary base is over $3.9 trillion and the amount of currency in circulation is under $1.3 trillion (the remaining $2.6 trillion constitutes bank reserves). Several major U.S. banks could simultaneously determine that the economy is healthy enough to encourage lending by reducing underwriting requirements, thus pumping hundreds of billions of dollars into the economy over a short period of time. We must remember that when a bank lends $1 billion its reserve requirement only increases by a small fraction of that amount (about ten percent). Thus, the total lending potential represented by the $2.5 trillion in excess reserves is nearly $25 trillion because of the legal reserve requirements. That amount is about 1.5 times the total annual U.S. GDP that could be loaned into the economy. Who would borrow? With low interest rates expected to rise soon and relaxed lending requirement we might be surprised. Or rather, the FED might be surprised. In theory it could even be worse if some of the loans made by banks were to other banks which could then be leveraged even further.

Read my lips: I do not expect that scenario to happen! The point is that the money is out there sloshing around at banks (the folks we all trust the most to do the right thing). If there were a potential profit to be made by making those loans (or at least a significant increase to executive bonuses) a large enough portion (it would not require all) of those funds entering the economy could create an highly inflationary environment. And that is only one of the many possible scenarios that could cause an adverse situation resulting in inflation. Increased spending by the government to fund yet another major military engagement could cause inflationary pressure. A currency war (which is not far-fetched) could break out and cause inflationary pressure depending upon how our government and the Fed react. Any number of geopolitical events could cause short-term supply shortages in energy or other essential commodities causing inflation in those items which, depending upon how widespread the use, could spread inflationary pressure to other areas of the economy.

Once again, my point is not to scare anyone or predict anything but rather to point out that at some point in the next few years much higher inflation is still a distinct possibility. It is not a certainty. But I believe in being prepared for not just what I know but also what I know that I do not know. Inflation falls into that later category.

The question then becomes how do I protect my assets against inflation? My favorite hedge against inflation currently is silver. The gold/silver ratio is way above its historical average. Silver is consumed whereas essentially all of the gold ever mined is still held by someone somewhere. Industrial uses of silver is growing and is expected to continue to do so for many years resulting in a greater percentage of mined silver to be consumed as opposed to being purchased for speculation. But physical silver does not provide any income. Investors can actually incur expenses by holding silver. First, one must secure the physical inventory either by paying a third party or by purchasing and installing a safe. In either case, the investor should insure any physical holdings from burglary or fraud. And then many would argue that there is an opportunity cost of holding an asset that does not provide an income stream. All you have is potential appreciation or depreciation of an asset.

I prefer an asset that does not incur cost beyond the purchase price (and any commissions) that also has appreciation potential with less downside risk. I also prefer to be paid to hold the asset. There are several investments that fit my requirements but my favorite is Silver Wheaton (NYSE:SLW).

I will start with the dividend because I expect the yield to be questioned by readers looking for income. The indicated dividend recently announced of $0.09 per quarter will yield only 1.1 percent. But that is not the whole story about the dividend. The dividend is tied to cash flow. Below is a quote on how dividends are calculated from the company's web site:

"The quarterly dividend per common share will be equal to 20% of the average cash generated by operating activities in the previous four quarters divided by the Company's outstanding common shares at the time the dividend is approved, all rounded to the nearest cent."

I believe that we are now at a low point for SLW dividends and that future dividends will increase significantly in years to come. As I explain the business model and how cash flow is created this should become clear.

The total silver equivalent ounces produced in 2013 were 35.8 million ounces, representing an increase of 22 percent over 2012. The company continues to add production as it invests in new streaming agreements for silver and gold from a portfolio of mines and companies with good geographic diversification. SLW projects further production increases to 48 million silver equivalent ounces by 2018, representing another 34 percent increase in production. That is based only upon current agreements that are already in place. The company adds new agreements by investing much of its free cash flow in new projects as it identifies good candidates. Thus, actual production should be higher than 48 million ounces by 2018.

I love the business model of streaming employed by SLW management. The company makes initial investments in mines as the partner mining company develops the infrastructure for production of various minerals where silver and/or gold are also recovered in small amounts relative to the primary mineral being mined. Before its investment SLW determines, with incredible accuracy, how much silver/gold will be produced as a by-product by the mine and over how many years the mine will produce it. In exchange for SLW's initial investment the mine operator agrees to provide SLW with a predetermined number of ounces of silver or gold (or a percentage of production) at an extremely low price. SLW pays an average of about $4.12 per ounce for silver and $386 per ounce for gold.

SLW does not have operating costs for mining. Those costs are borne by its partners. SLW collects the silver and gold from its partners at those below market prices and then sells the precious metals on the open market and the spot prices, retaining the difference. The company has only 29 employees producing $375.5 million in profits.

SLW shares are currently trading at $23.46 (as of the market close on Monday, March 25, 2014) which is 27 percent below the 52-week high and 50 percent below its all-time high of $46.91 of April 4, 2011. If inflation increases significantly the price of silver is very likely to rise again to much higher levels expanding SLW's profit margins as each additional $1 per ounce the company sells it product for goes directly to the bottom line. Add to that the increasing production of ounces in coming years and you should be able to see the enormous potential upside to SLW.

If inflation does not rise significantly, but gold and silver prices remain relatively flat, SLW profits should still rise by 50 percent over the next five years driving share price appreciation. If inflation remains calm and the prices of gold and silver drop, the rising production will offset much of the downside from here. The company should remain profitable in any event and the risk of bankruptcy is much lower than that of most mining companies.

The worst case scenario would be deflation which would cause gold and silver prices to fall significantly. But even in such a dire environment those prices should remain above SLW's cost per ounce. The risk would be with production being curbed by partners. In a deflationary environment, though, nearly all stocks will take a beating. If we do enter a deflationary period, for whatever reason, it will be temporary and unless the FED is able to unwind its balance sheet with perfection the likelihood of inflation coming back is very high, in my opinion. It is merely a matter of time.

I believe SLW shares at the current price provide excellent potential appreciation potential along with likely future increases to the dividends as cash flows improve with production and the price of silver.

It is my hope that readers have found this article to be useful. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

Disclosure: I am long SLW. 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.