Mike Kachanovsky: Silver's Scarcity Premium
Source: The Gold Report 06/09/2009
'Silver and gold, silver and gold'. . .what to invest in—silver or gold? Investors on either side of this long-running debate are passionate about their precious metal of choice. But are they looking—or listening—to the right indicators? In this exclusive interview with The Gold Report, Mike Kachanovsky, aka 'Mexico Mike' from his Investor's Digest of Canada column, discusses historical changes in the gold-to-silver price ratio, shrinking supply. . .and what to buy.
The Gold Report: Mike, you're pretty optimistic on precious metals. Can you provide us an overview of why?
Mike Kachanovsky: Right now in response to the crises that are occurring around the world, many governments have chosen to keep interest rates artificially low and issue large amounts of printed currency in the hopes of supporting their domestic economies.
When you have that much additional currency being injected into economies, it creates inflation pressures and people seek security outside of paper money and in precious metals stocks. So that's why I think you're going to see more upside in the spot market price for gold and also for silver, which has, historically, been a monetary metal.
TGR: You're focused a lot on silver. Can you give our investors a perspective on investing in silver vs. gold?
MK: In terms of the distribution of silver and gold in the earth's crust, there's about 15 times more silver than gold. If you look at the market price for the last 100 years, the ratio has trended a lot higher than that. You usually have about a 50-to-1 ratio of gold price to silver price. And so I think you're going to find that there's going to be a narrowing of that gap.
Part of the reason that silver has been at such a discount to gold is the impression that it's plentiful, which is just not the case. In fact, we know in the United States, for example, there was a 5-billion ounce inventory of above-ground silver, and that's been almost entirely depleted in the last 30 or 40 years. Now there's perhaps about 300 or 400 million ounces of documented silver inventories and I do not think new mine production will be able to keep up with demand in the years ahead. There is going to be a shortage.
Most of the gold that has been mined since the beginning of history is still sitting in bullion form some place in the world. Whereas, most of the silver that has been mined has been consumed in various industrial applications and is effectively gone forever. It's in such small quantities that it's not easily recycled and restored back to the market.
So, I think as you see silver decline in availability, you're going to see it close that gap in pricing compared to gold. I think gold is going to be rising rapidly, as I mentioned earlier, from monetary pressures—inflation and the economy. Silver should rise more rapidly just on the scarcity premium as less and less silver is available to meet worldwide demand.
These are the kind of things that will be driving factors to make silver outperform gold, and both are going to be excellent investments in the future. But I really believe that silver is going to be a much stronger performer.
TGR: What's your view on investing in precious metals mining companies vs. the commodity itself?
MK: Well, if history is any indication, the mining companies tend to deliver stronger gains in a bull market than do the metals themselves. So, for example, if you'd expect that silver is going to double in price in the next couple of years, you'd probably expect that the mining companies that are leveraged to silver would go up 5 or 10 times in value from where they are at today, just because they have that greater leverage than the metal.
I also think that a lot of these mining companies have defined resource deposits and you're going to see a lot more interest from investors to buy up these companies because they're going to be perceived as that much more valuable.
TGR: Mike, you're quite bullish on Mexico. What is it about Mexico that is intriguing to you?
MK: I think Mexico is an ideal place to look for junior mining stocks, and the reason is we almost lost a generation of development. Back in the '90s a lot of the mines in production in Mexico were basically shut down because of the lower metal prices that kicked in, and also because the domestic mining laws did not permit foreign mining companies to own more than half of any project or deposit. Those laws were changed late in the '90s to allow foreign companies to come in and own 100% of mining projects again.
You basically had a lot of great projects that were stalled that had an excellent upside. And so as soon those rules changed these projects have been vended into junior mining companies with access to funding and modern exploration technology. I believe there are more than 250 companies just from Canada that are currently active in Mexico, and many of them own 100% of their projects.
It's really been a renaissance for the whole mining industry in Mexico—and not just in silver—there's molybdenum, there are base metals, there's gold. And another big attraction is the mining and operating costs, which are so much lower than most other places of the world. Lastly, Mexico is attractive because it's very supportive in terms of mining law. Mine development is an economic priority in Mexico.
Compare Mexico to British Columbia, a jurisdiction that is similar in terms of resource potential. Part of the problem with B.C. is that it takes about seven years from the date of the discovery to actually get into operation because the process is so layered with hurdles a company has to jump to get to the point where they can dig the shovel in the ground and start moving the first ton of ore. In Mexico, they don't tolerate obstructionism. There's preferential granting of water rights and road access and infrastructure in order to accelerate the development of a mine.
So, those three factors—the strong resources, low mining costs, and favorable mining laws are what make Mexico attractive to me as an investor.
TGR: When you say junior mining stocks, are you looking at producers or explorers? And how do you differentiate between the two in terms of investment strategies?
MK: A lot of companies are having a difficult time accessing funding. There's been a lending freeze worldwide, and that's really hit the mining industry hard. Right now there are very few junior mining companies that actually have production, recurring cash flow or earnings. These companies are probably the better performers because they don't have to rely on outside sources of funding in order to advance their business model.
So if I were to rank the most desirable companies today, I would say right now you need to look at companies that are self-financing. That would be my primary target because there's less risk with those companies—they'll be able to continue their operations because they can still find the money they need to keep moving forward.
As far as the explorers, they're less attractive right now. Unless they've done a good job raising money, they are going to find themselves unable to go to the market for an equity offering without severely diluting the float. Their share prices are lower, so, as an investor, you've got an opportunity to buy these stocks very cheaply, but you have to be patient. You also have to very aware of the risks—if these companies cannot eventually get financing, they could default on the terms of their projects, and may even face the risk of getting delisted or go out of business. And mining is a risky game, that's something people should always be aware of.
From my point of view in today's market, it's very important to seek companies that are cash-flow positive, have growth in the pipeline, strong balance sheets and strong management that's demonstrated they can continue to operate under difficult market circumstances. And we don't know how long this will go on for; we could be seeing a trend reversal going on right now. Or it could go on for another couple of years before things improve and the financing becomes easier to attain. Investors have to be aware of these things.
TGR: Do you have some companies that you are following that have nice balance sheets and good management?
MK: I certainly do. For my portfolio, I track many different companies on the daily trading behavior. But I also do extensive research into anything that looks attractive, before I buy. That means digging through financial statements and all sorts of other information in order to narrow the field. There are probably 2,500, perhaps as many as 3,000, active junior mining stocks in the world; and, if you're able to narrow that down to perhaps a 100 or 150 of the very best companies out there and you know a lot about them, then you just do your buying at the most appropriate timeframes when you have the best value.
I have a number of companies I have bought and own as a core part of my portfolio, and I actively continue to add to my holdings. I think if I could narrow my choices down, the number-one junior mining stock in the world, in my opinion, would be IMPACT Silver (TSX.V:IPT).
TGR: What makes them number one?
MK: Well, they're active near Mexico City in an historic mining district that has been in production for 400 or 500 years—all the way back to the original Spanish Colonialism in Mexico. In this project, they control the entire district—more than 350 square kilometers of land holdings. From their main mill, you can look to the horizon in every direction and Impact controls 100% ownership of all of it. Impact has outlined over 1,000 historic mine workings and mines from previous operators going back several hundred years, and they have enough targets to keep them busy for 100 more.
Secondly, the development curve for Impact has been very short. In just the two years since they've taken over this project area, they've been able to put four mines into production. In fact, they're actively developing a fifth as we speak.
The third thing I like about Impact is it's one of the few junior mining stocks anywhere in the world that's been able to report recurring earnings—not just positive cash flow—but actual net earnings after taxes, administration, non-cash items like depletion and expense for management, options and that sort of thing. So, Impact is actually able to fund their operations internally; they haven't had to go to market to raise money for two years.
I also like their financial strength—especially in this market. Their working capital position is about $7 million, which is very strong and they have a clean balance sheet with no debt. They have a fantastic inventory of targets to advance for development. They have extensive exploration, they stay ahead of their operations by outlining new discovery zones, are able to make money as they go, and they own their entire district without having to depend on another partner to maintain its share of development in order to move forward on their objectives.
So, to me, Impact is one of those stocks that if you're looking for access to mining exploration and silver production—they're a primary silver producer—I think they're a must-have for a portfolio. It's trading around C$.55 to C$.60 today; so it's actually undervalued compared to many of its peers. When you have an above-average stock that is priced below average, I think it's a no-brainer. That's what I think is the best stock in the world to own if you're looking for access to junior mining sector.
TGR: What's the number-two stock?
MK: Well, the number-two stock could be one that is a little more appropriate for people who are less risk tolerant, and that would be Alamos Gold Inc. (TSX:AGI), which is also a Mexican mining company. It's obviously leveraged to gold; there's no silver. It's active in the northern part of Mexico, in Sonora. And Alamos is an intriguing company because it has about a 4-million ounce deposit, which has so far been defined in all resource categories. Their mine right now has a fairly robust operating size, about 10,000-12,000 tons per day, which is a very large mining operation. And they're producing around 150,000-170,000 ounces of gold a year, which puts them solidly in the mid-tier size.
The problem with Alamos is it's a one-mine company. They only own that one project. The learning curve took them a couple of years to get it where it's operating at their specified design capacity, and they're at that right now. Their efficiency is very high. They have tremendous exploration upside still untested on their property, so it's likely they're going to continue staying ahead of their production and adding ounces of deposits quicker than they actually develop it and take it out of the ground. So, that's a plus, but they're still a one-mine company.
Alamos is also debt free, with a large working capital position. So, I think what we're going to see with Alamos in the next 12 months is they're going to make an acquisition themselves and get some diversification in their operations either in Mexico or elsewhere so they have another working mine. Or, they're going to become an acquisition target and another mid-size or senior producer is going to take a run at them with a hostile acquisition bid.
Either way it's going to be good for shareholders; and right now, Alamos is trading around $9 a share. Alamos is another stock that I think that investors can buy regardless of what the market does. It's a low-cost producer, so if gold prices decline slightly or significantly in the months ahead, Alamos will still be able to generate a profit. Because it has so much leverage to gold, Alamos shares should rise in tandem with rising gold prices. I also think it's attractive as a hostile acquisition target; so, as an investor, there's always the chance of getting that payoff when some other company makes a move to take them out.
TGR: Do you have other properties in Mexico that you're following?
MK: I certainly do. One other company that I am bullish on right now and have been an investor in for about five to six years is First Majestic Silver Corp. (TSX:FR) (PK SHEET:FRMSF). First Majestic is attractive to me now for reasons similar to Impact—it's trading near the lower end of its range, and it's a high-quality company. For people who are bullish on silver, First Majestic should one of the companies they circle on their short list.
They're the only junior mining stock that is on target to produce about 5 million ounces of silver in the next year, and that's kind of the critical mass. When you look at the seniors and the larger mining stories, for them to make an acquisition, it doesn't make sense for them to go after a small, specialized company that produces a fairly small amount of silver. But for a company like First Majestic, if I was with Pan American Silver Corp. (TSX:PAA) (Nasdaq:PAAS) or Coeur d'Alene Mines Corp. (NYSE:CDE) (TSX: CDM) or any of the senior silver producers, I would be very interested in acquiring a company like First Majestic. Those 5 million ounces would make a very material addition to the overall production profile of any of these existing senior producers. So, that's just one reason.
The company controls a number of mines that are currently in production, and they have a very strong track record in the last few years of improving the efficiency of these mines, drilling out new resources, increasing capacity and basically adding value to each individual project to advance them further along that production curve. They're also very good at securing financing, and they've just completed a large private placement that has left them with a very strong balance sheet. They've got a lot of cash in the bank. They have achieved critical mass in terms of production in driving their costs lower. And, as I mentioned before, the larger production you can achieve usually helps to lower your production cost per ounce. First Majestic is a very strong operating company.
So going forward, if you're a silver bull, if you believe that silver is going to rise to $20 or $50 an ounce, companies like First Majestic that are currently producing, have so much leverage to silver and such large resources to find, are going to be stratospheric performers. They're probably going to double many times over along the way as you get that strength.
And the fact that there are so few other companies out there for investors to choose from that would offer those same characteristics will also help in that. The universe of gold-producing companies is small, but the silver-producing universe is even smaller. There are maybe 15 to 20 good, solid silver-producing companies that investors can choose from. And I would put First Majestic near the top of that list.
TGR: You have been following Avino Silver & Gold Mines Ltd. (TSX.V:ASM) (OTCBB:ASGMF). What is your feeling about that investment play?
MK: Yes, and I am also a shareholder of Avino. I actually went to visit their mine about a year ago, and I am very excited about the company for a number of reasons. Avino is interesting because it's one of the few companies that was active all the way back to before the mining law in Mexico was revised. They were a minority owner of their project, the Avino Mine, which I believe is in Durango, Mexico. And even after the contraction of the mining industry in the '90s, and the subsequent recovery, Avino maintained that interest. Currently, they own about 86% or 87% of that project. So, they're one of the few companies that has been active with an unbroken ownership interest in Mexico through the bad years and now into the good years.
I also like the fact that it's been very stable in its share structure. If you look at most of the junior mining stocks through the last 10 years, those that survive that long, many of them continue to issue stock every year or two just to raise enough funds to keep them going. Eventually, the number of shares in circulation expands to the point where there's much less value per share for individual shareholders.
Avino has held the line very well. They've got a strong balance sheet with no debt and several million dollars in the bank; and they have increased their ownership of their core assets. They remained active on the exploration side and discovered new ore bodies, and they also have infrastructure on site (an actual mill that was formerly operating). They have worker facilities, an office, administration, a shop, and rolling stock and spare parts—all of which a mine needs to have in order to function. Many of these assets are very expensive and, in some cases, difficult to secure in the current market. So, companies that already have these things in place are much stronger than they appear.
So, Avino is another one of those companies that trades very cheaply and has a very small float. Therefore, I believe, there is that much more leverage for upside for their shareholders when the company has to produce. I believe they're going to be in production within the next six to eight months. They've gone through the permitting work to get to the point where they're able to recommence production. I believe they're discussing with smelters now or companies that can off-take from their production, and they will be able to make a decision very soon in terms of getting back into operation.
Avino is also focusing on a brand new discovery area, the San Gonzalo deposit. It's very near surface, very high grade. They've got the permitting to go in and start mining that on a small-scale basis. Eventually, when they get back up to speed, they'll de-water the old workings of the old underground mine and advance a new tunnel underground to link up with the new San Gonzalo mine and other outlined targets. That's when they will be able to get back into full-scale production.
Their mill has a capacity of about 1,500 tons per day. When they restart operations in the next few months, their objective will be from maybe 250 to 500 tons a day. So, it will be a much smaller operation but it will be economic and cash-flow positive for them.
TGR: You mentioned some other areas you were interested in outside of Mexico—British Columbia and Quebec.
MK: I like British Columbia because it has such endowment of mineral resources and a long history of mining activity in Canada; but currently, I am a little bearish on B.C. because I believe the pendulum for regulation and environmental oversight has swung a bit too far to the extreme end. It's very difficult, time-consuming and costly for companies to get approval to move forward with development plans in British Columbia. So, it's on a wait-and-see list for me now.
I would say the second-most attractive jurisdiction in the entire world for mining, after Mexico, is Quebec in Canada. Again, one of the reasons I like Quebec is that it is a very strong center for mining. The province recognizes and understands how big a contribution the mining sector makes to their overall economy. And hence, they've created legislation and tax structure that is very favorable for mining companies to attract that investment and keep their people employed.
Quebec has reimbursed companies for up to half of their exploration expenses for projects within Quebec. That's almost like getting a private placement completed every year without having to issue any new stock. So, companies that spend $3 to $4 million drilling and defining the deposit within the province will get half of that money back from the Quebec government. That's extremely attractive; it means the money goes further, and the support for the mining industry is there to nurture and assist with development rather than putting hurdles in front of these companies.
One of the companies that I really like in Quebec is Eastmain Resources Inc. (TSX:ER). I mentioned earlier how I am somewhat leery of explorers because it's very difficult for them to secure access to funding. I like Eastmain because the company has a very strong cash position in the treasury of between $15 and $17 million. So, they're basically fully funded to carry on for several years of work without having to go to market and raise money again.
Eastmain is also very advanced in terms of their exploration work. They have over a million ounces of gold resources at their Eau Claire project at Clearwater in Quebec. They also have a joint venture in play with one of the most-respected senior gold companies in the world—Goldcorp (TSX:G) (NYSE:GG). They have the clout of a big senior partner that is advancing with them to get a second project towards production.
So, you have strong management, a great financial position, excellent operating address and all the positive attributes I look for in a junior. Eastmain also has a fairly tight share structure and a fairly modest share price. There's plenty of upside for investors to look at that stock right now.
TGR: Are there any last ideas you would like to share with our readers?
MK: I think the most important thing for investors to do is put together an investment plan and stick to that plan. One thing about trading in the precious metals stocks is that there is a great emotional undercurrent wherein people sometimes get seduced and carried away by excitement and greed. Historically, there have been so many episodes where these stocks went into these great bull markets and people got in over their heads. Conditions can change very quickly as we learned in late 2007 and all through 2008.
So, it's very important to develop a plan that makes sense for you. Be mindful of how much of your allocation is going towards these stocks, whether you want to focus on explorers or producers or a mix of the two, and which jurisdictions you want to focus on and pay close attention to.
For me, my plan is to focus on companies with proven management and a strong balance sheet where there's very limited risk that they may not be able to keep their doors open, pay their bills and remain current on their projects. I look for companies that are active in places that are friendly to mining, where there's less chance that their project will be halted or taken away from them even if they are successful in defining a resource.
I also look for companies that have growth in the pipeline because, at the end of the day, if you're right about the sector you choose to leverage in, it's still the growth stocks that tend to gain the highest multiples and perform the best. So when I look for growth, I look for either an increase in the resources—if a company has 100,000 ounces of gold defined and is able to advance exploration and improve that up to a million ounces—that's very significant growth and that generally will lead to gains in share price. Or, if you have a company that is producing a million ounces of silver a year and has a plan in place with reasonable objectives to perhaps increase that to two million ounces a year, that's a company that I'm going to want to look at. So, my own personal philosophy is to put as much money as I can into the handful of companies that reach all of my objectives for investment.
I'd also look at silver stocks right now because I believe they're going to outperform all the other companies. And I'd look at producers that I believe will be able to be self-sustaining even if this market cash crunch persists for a long time to come.
Finally, I think the potential for acquisitions is worth considering. At this time, I believe we're more likely to see a lot of acquisition activity going forward because so many great projects are basically dead in the water due to lack of funding. A lot of large companies are still successful and producing, and they are sitting on strong balance sheets, which compel them to go shopping for other assets. Mining management is aware of these dwindling resources and is always looking for the next resource. So, I wouldn't be at all surprised to see a round of very aggressive consolidation in the months ahead.
DISCLOSURE - Mike Kachanovsky:
I personally own shares in all of the companies mentioned in this interview. In addition, I am a founder of www.smartinvestment.ca and an advertising fee has been paid by Avino Silver Mines and Eastmain Resources Inc. in sponsorship of this website.
Mike Kachanovsky is a consultant providing analysis of junior mining and exploration stocks. His work is published on a freelance basis in a variety of publications, including the Mexico Mike column in Investor's Digest of Canada. Mike is a founder of the website www.smartinvestment.ca , which serves as an online community for the discussion of all topics relating to junior mining stocks.
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