There are many reasons to own silver. One reason is that owning silver and its big brother -gold-is a safe way to protect wealth against the ravages of irresponsible governmental fiscal and monetary policies. Another very good reason is the basic situation of supply and demand. In 2006, about 42% of silver supply was consumed by industrial use, about 28% consumed by jewelry, 20% consumed by photography, 5% consumed in coins and medallions, and that’s 95% of total silver supply!
This implies either a “surplus”, or “investment demand”, of only about 5% of the total. Investment demand remains small, but is growing. New demand from hedge funds and commodity funds are adding fuel to the fire. Basic economics dictates that increasing demand and a shrinking supply brings about higher prices. Moreover, the Chinese government, a major player in creating the rush on commodities of all types, announced that it had depleted its stocks of silver.
So, there are strong arguments for the ownership and appreciation of silver. But what are the ways an investor can take advantage of these fundamentals?
The most common ways to invest in silver are: futures contracts, coins and bullion, and mining stocks. Each investment type has its specific consider-ations but this article is focused on owning shares of silver mining companies. While the vast majority of investors are aware of gold’s strength over the past couple of years, few know that while gold has doubled in price since 2001, silver has done even better. In fact, it has a five-year gain of 123%.
Some mining shares have appreciated 5 to 10 times more than the appreciation of the metal itself! But before you let your eyeballs pop out of your head, this phenomenal return happens in perhaps one out of a thousand mining companies. But it does happen. When Investing in Silver Mines, there are three basic categories of mining stocks: Conglomerates, Junior Exploration companies and Silver specific mining companies.
Conglomerates: Silver is produced in quantities as a by-product of gold, copper and zinc mining. As a result, many large operations leverage their resources to diversify their production-silver being just one of the products. Because of the dilution effects of diversified products, share prices of conglomerates won’t move in direct correlation with the price of silver.
If you are investing in silver, conglomerates are not an optimum strategy to capture the price movements of silver. Conglomerates are closely followed and analyzed by professionals and they offer more transparent information and can provide excellent returns and dividends. Generally, the stock prices of these companies are high, less volatile, and normally have a lower risk- return profile. (Examples: Rio Tinto, BHP Billiton, Anglo American and Xstrata.)
Junior Exploration companies: The “home runs” have mostly been made within this category.
These companies are similar to “wildcatters” in the oil industry. They risk their capital on finding proven reserves and then they are usually bought out by the conglomerates that already have the very costly operational infrastructure to harvest and process the reserves. This category offers a very cheap way to “play the game” but the strategy is to purchase shares of many different companies in this group to diversify risk and increase the opportunity for a “strike”.
Exploration companies are truly speculative and carry the profile as the highest risk-return vehicle for in-vesting in silver.(Examples: Endeavour Silver, First Majestic Resources, Great Panther Resources, Impact Silver. Most of these companies trade on pink sheets or the Canadian stock exchanges).
Silver specific mining companies: Obviously, these companies are focused on silver production and share prices are more correlated to silver prices than the conglomerates. (Examples: Freeport McMoRan and a large number of mid-tier producers).
What to look for in a silver mining company
Where information is available, look for these key factors:
- Proven reserves (quality and quantity)
- Short term production forecast
- Proven good management team
- Any impending environmental litigation or labor strikes
- Political exposure of foreign operations.
- Good cash flow
- Good return on equity and assets
- Strong Balance Sheet (current ratio above 2.0)
Because of the variability of the factors mentioned above, purchasing silver mining shares may not be as strong a proxy for the precious metal itself as one might think. However, many investors may look upon mining shares as part of an overall portfolio diversification strategy and not so much as “holding silver.” Bottom-line, there appears to be two main reasons to invest in silver mining shares: to hit a home run or diversification.
Home run: Risk-reward says it all. An exploration company is where cheap dirt can turn into precious metal. The exploration companies hope to leverage their geological knowledge and relatively low exploration costs to make a find and sell out to the deep pockets of the producers.
Because of the highly speculative nature of the exploration part of the business, stock prices of these companies are usually very cheap but the reward can be high, indeed. So, if an investor is looking for a home run (investing at the risk end of the spectrum) mining stocks offer an avenue to boost overall return at a low entry cost.
Portfolio diversification: Modern Portfolio Theory (MPT) states that to help reduce risk, a portfolio needs to have investments with different correlations. Commodities-such as precious metals- have a very weak to negative correlation with the general equities markets.
In other words, if stocks are going down, commodities (and their proxies) are more likely to go up or at least not be as much affected by whatever is pushing the equities markets down. The conglomerates and specific producers of precious metals can act as a form of derivative for commodities. In this way, an investor can help “balance out” a portfolio by purchasing shares of conglomerates or silver mining companies.
Moreover, as we discussed, the basic supply and demand situation of silver shows it to be a solid fundamental proposition…..but probably not a home run. And in summary, owning shares of conglomerates or silver mining companies can certainly play a part in the overall investment portfolio strategy. Purchasing shares of well established producers can offer diversification and because of the supply-demand situation offer good potential growth.
On the very far end of the risk-reward spectrum, owning a variety of exploration companies can provide an exposure to a potential home run at a fairly low cost. But don’t fool yourself by thinking it’s a silver play; it’s just pure.