The Case for Silver Miners

by: SL Advisors

By Simon Lack

A consequence of the reflation following the 2007-08 credit crisis has been enormous growth in the money supply and the prospect of near-zero short term interest rates at least into next year. Many commentators forecast higher inflation down the road, in some cases much higher inflation. This doesn’t seem plausible in the near term with the amount of excess capacity in developed economies, and with the U.S. unemployment rate stubbornly closer to 10% than 9% there’s clearly plenty of slack in the labor force. Nonetheless, for many investors a modest allocation to gold is a prudent hedge against this outcome.

We prefer silver to gold, and silver equities to the commodity itself. Most of the demand for gold comes from jewelry and investment, whereas around 50% of silver demand is for various industrial applications. This creates more stable demand but does introduce some sensitivity to global economic growth as seen in 2008-09 when industrial demand dropped nearly 14% over two years. However, this also means increased industrial demand can drive up silver prices without requiring a pick-up in general inflation, whereas gold prices respond much more to perceived and actual inflation.

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Source: The Silver Institute

Silver has many valuable features ranging from efficient electricity and heat conductivity to anti-bacterial properties leading to its use in certain types of bandaging and medical clothing. While the growth in digital photography has steadily eroded one source of demand, this has also reduced the supply of re-used silver from scrap. Its conductivity properties lead to its use in many areas of electronic component production (such as TVs) and several nascent industries use silver, including solar energy panels and RFIDs (radio frequency ID tags, used to track products in shipment). This combined with a pick-up in investment demand (the iShares Silver Trust, SLV has a value equivalent to 285 million ounces) has maintained steady demand for silver.

Supply of silver is dominated by mine production, and most silver is produced from mines whose primary purpose is some other metal (often zinc or gold). Mine output has been rising steadily, but you’ll also note that scrap supply has been falling along with demand from traditional photography since this represents one of the cheaper sources of silver recycling.

Source: The Silver Institute

A very interesting feature of the silver market is that both supply and demand are relatively inelastic. Since most mined silver is produced as a by-product, the economics of the primary metal typically drive mining decisions, making supply relatively insensitive to price. On the demand side, silver is usually a very minor input to the industrial applications for which it’s used, leading to relatively price-insensitive demand as well. Consequently, changes in supply or demand are largely accommodated through price fluctuations which is why the price of silver is so volatile. And if gold does rally due to inflationary fears or other reasons, silver will surely follow.

Investing in silver equities rather than silver itself provides operating leverage as well as the potential to invest at less than a company’s intrinsic value. There are few pure silver producers in the world, just as there are few pure silver mines. The largest silver producer, BHP Billiton (NYSE:BHP), is not a primary silver producer and the second largest, Fresnillo (OTCPK:FNLPF), trades at 27 times 2010 EPS, which strikes us as fully valued. Of the other three primary silver producers listed below, CDE is clearly the cheapest. They were widely regarded as having overpaid for the Palmarejo mine that they acquired in Mexico, production from their Kensington mine in Alaska was delayed for environmental reasons and at San Bartolome in Bolivia environmental concerns have slowed output at elevations above 4,400 meters. However, much of this negativity has been reflected in the stock price which we estimate now trades 19-20% below the net asset value of their proved and probable reserves. The company expects Palmarejo to generate 50% of their cashflow this year, Kensington began output in June and the company should be profitable for the second half of 2010 and beyond. We think this represents an attractive way to invests in assets at below their value with some downside protection and potential upside if gold and silver resume their move upwards.

Disclosure: Long CDE