Last week's cuts by the European Central Bank (ECB) played a significant role in the sell-off in the price of silver. Using iShares Silver Trust (SLV) as a proxy, the price of this commodity dropped by over 4% before recovering somewhat heading into the weekend. The turbulence in the commodities markets has dramatically ticked up over the past several weeks, and shows no signs of slowing down. Recent comments by the Federal Reserve have indicated that the U.S. economy continues to show signs of weakness, and that Fed action is on the horizon.
Where Does The Fed Stand?
The Fed's position is articulately and succinctly outlined in a recent article by Marc Courtenay. What Mr. Courtenay refers to as a "Lehman Moment" -- another instance of significant instability in a major global financial institution -- remains a possibility. Furthermore, a close reading of the Federal Open Market Committee's (FOMC's) minutes from last week reveal that the U.S. central bank is moving rapidly towards taking additional action.
Additionally, Mr. Courtenay points out that this position is in the main stream when he quotes The Wall Street Journal article titled, "Fed Weighs More Stimulus": "Fed officials expressed worry about risks to the American economy stemming from the euro-zone debt crisis, the possibility of a 'significant slowdown' in China's economy and the prospect of deep U.S. government spending cuts and tax increases..."
An additional factor impacting a likely Fed move is the fact that it is an election year, and the state of the economy will absolutely be a central issue. Even if Ben Bernanke was not inclined to print money as fast as his printing press will allow, which he is, the Fed will be under significant pressure from the White House to take any action possible to stabilize the economy by Election Day.
In fairness to Ben and his apparent need to attempt to end modern civilization, in the deflationary environment facing most major world economies, there is an argument that providing some inflationary pressure is appropriate; it is not simply a case of the U.S. attempting to inflate away the significant debt that has been created by runaway spending in the last few years.
Although it will initially be seen as a positive for the stock market, that Fed action makes it very difficult for banks to make money. Making money is one of those pesky little factors that keep "Lehman Moments" at bay. Banks make money by lending money and earning an interest rate. When rates are forced to zero, profits are harder to create. Finding a balance between protecting the financial institutions and stimulating spending is a tricky job. Since pouring money into the system as fast as possible has not worked, the clear solution is to pour in more money.
The initial stimulus will be a positive for stocks, and thus may put pressure on commodities, but as investors realize that real interest rates have become negative, precious metals will become increasingly attractive. Mr. Courtenay cites recent comments and actions by billionaire Eric Sprott, who recently predicted that the price of gold has the potential to spike as much as 20% higher by year end.
Another point on which Mr. Courtenay and I agree is that in the current environment, Silver Wheaton (SLW) is an attractive option.
Silver Wheaton's Business Model Sets It Apart
While the bulk of the above discussion focuses on why silver is a good investment at current levels, it is important to consider Silver Wheaton relative to its peers. The company's peers include Pan American Silver (PAAS), Coeur d'Alene Mines (CDE) and Grupo Mexico SAB (GMBXF). BHP Billiton (BHP) is often classified as a competitor, but its highly diversified nature makes it a bad comparison.
On a valuation basis, using the trailing twelve month price-to-earnings as the appropriate metric, Silver Wheaton trades at a P/E of 16 relative to 16.9 for Coeur d'Alene, 5 for Pan American Silver and 8.9 for Grupo Mexico. Based on this comparison, Silver Wheaton does not appear to be the most attractive of its peers, but this falls far short of telling the complete story.
It business model is where the company truly excels, and that's its key differentiator. There are a variety of names that are frequently given to this model, but essentially, Silver Wheaton is a middleman. The company contracts with other miners and buys their future production at locked prices. In certain cases, Silver Wheaton must lay out cash to secure the contract, but in many other cases, it simply pays a royalty and collects the remaining spread between the contract price and the prevailing price.
To put this information into perspective, Silver Wheaton currently has control over approximately 800 million ounces of unmined silver at an average cost of $4 per ounce. With this level of reserve, the company has the largest supply of silver in the world. At the price it controls that silver, any uptick in the price of silver results in a pure profit increase for Silver Wheaton. It is this business model that makes pure valuation estimates less appropriate for comparison than might otherwise be the case.
Overall, Silver Wheaton offers a unique opportunity for investors to participate in the price fluctuations of silver while simultaneously investing in a solid and well-run company. Given the current prospect for silver, I believe this company is a sound addition to any investor's core portfolio.