Silver Wheaton Versus Royal Gold: Pairs Trade Options
Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors looking to mitigate some of the risk involved in outright directional bets may wish to consider pairs trades as a viable alternative. While this market-neutral strategy is not risk-free, when properly constructed, the risks involved in a pairs trade are lower than those of a directional play because some of the systematic risk is removed. Looking at Silver Wheaton (NYSE: SLW) and Royal Gold (NASDAQ: RGLD) in a pairs context has multiple options and gives an interesting perspective on each stock. While ultimately I favor a long Silver Wheaton/ short Royal Gold scenario here, this is an interesting relationship to watch over the long-term.
Apples to Apples
While Silver Wheaton is better known in the market, both of these companies follow the same business plan. As streaming companies, neither is actually involved in mining. Instead they contract with miners to buy mining production at a pre-arranged, fixed price. The company then earns the spread between the contract price and the then prevailing market price of the silver or gold that is purchased. To put this in perspective, Silver Wheaton has roughly 800 million ounces of silver reserves at a fixed cost of $4.04. The spread between that cost and the prevailing price of silver is what the company earns. Royal Gold follows the same model in the gold market.
When considering a pairs trade, it is particularly important to compare businesses with similar business plans. This step helps to insure that external factors impact each stock in similar ways. In this instance, the biggest point of differentiation is between silver and gold. As is discussed below, this distinction is at a favorable entry point and well captured with these two stocks.
Silver versus Gold
Silver and gold tend to be affected by similar macroeconomic forces, but because the silver market is significantly smaller, it tends to be more volatile. This means that when markets are trending higher, the percent gains in silver tend to be larger. It also means that when corrections or reversals happen, the fall in silver is harder and can be significantly more painful for investors.
Over the past six months, the performance of silver and gold has been nearly identical (see chart above). Using the iShares Silver Trust (NYSEMKT: SLV) and the SPDR Gold Shares (NYSEMKT: GLD) as proxies, the performance differential is a mere 0.15%. Despite this, the precious metals market is at the outset of a new, significant uptrend. The combined forces of bond-buying by the ECB, QE3 by the Federal Reserve and general economic weakness are pushing inflation fears and flight-to-safety trades. These are both bullish for precious metals over an extended period.
In a bull market for metals, silver is expected to outperform gold. By building the trade as a market-neutral pair – meaning buying the same dollar exposure to silver as you short exposure to gold – you can earn the outperformance of silver while remaining somewhat protected against macro shocks that could threaten precious metals overall. Depending on your risk tolerance, you may wish to over hedge with gold because corrections tend to be more violent in silver. This lowers risk but decreases return.
Why Use Stocks?
Over the same six month period, Silver Wheaton has lagged Royal Gold by over 30%. Stocks do tend to lag commodities, and one could argue that six months is an arbitrary period, but the point remains that Silver Wheaton should catch up to Royal Gold if the expected bull market in metals develops. This implies that the return available by owning the stocks is significantly greater than that of owing the commodities or ETFs.
As is always the case with the risk-return relationship, the higher potential return implies higher potential risk. Part of what makes this pair so attractive is the fact that Silver Wheaton is a strong buy on an outright basis. When using Royal Gold as a hedge, the real purpose of building a pair, you are using a stock that has dramatically outperformed. While it is not impossible for this disparity to widen, it is unlikely that it will persist indefinitely. If you look at a two-year price relationship between Silver Wheaton and Royal Gold (see below), the relationship has historically normalized with solid regularity. The strength of this relationship makes this an extremely attractive pair at current levels.
Given the above, building a pairs trade by buying Silver Wheaton and shorting Royal Gold should yield positive performance results. This trade should mitigate some of the risk of the precious metals markets, while still providing plenty of upside. While both of these streaming companies is attractive, in a pairs context, Silver Wheaton is the long.
Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.