Demystifying Silver

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of the biggest challenges faced by investors when considering silver companies is the reality that looking at earnings consistency and other common metrics can be seriously misleading. Over the past several years, silver prices have ranged from below $25 per ounce to over $50. What this means for these metrics is that the variability in earnings is likely to be dramatic and not a good forward-looking indicator of where the stock may go. This applies equally to a streaming company like Silver Wheaton (NYSE: SLW), my favorite silver play, as to more traditional miners like First Majestic Silver (NYSE: AG) or Pan American Silver. To state that any of these companies saw earnings or revenue fall by 50% or more, simply misses the point.

The Pull of Precious Metals

Investors have long sought investments in silver and gold for reasons ranging from pure supply and demand considerations to safe haven and inflation protection motivations. Commodities tend to be uncorrelated to other asset classes, but perform well when economic chaos strikes. Furthermore, particularly to the uninitiated, there is a certain appeal to owning an asset that conjures images of treasure chests and mystery. Keeping all of this in mind, precious metals have offered very handsome returns over certain periods in the past several years and should not be discounted; rather they should be more thoroughly understood.

For example, in its most recent earnings announcement, First Majestic saw earnings slide by 19% and revenues plunge by 50%. At first glance, this seems like the type of report from which you should run, citing a weakening revenue stream as a strong catalyst to sell. If this were the case, you would miss the fact that the company reported record production of nearly 2.5 million ounces and that silver has rebounded 15% from the company’s average sale price last quarter. These later two facts paint a very favorable forward-looking picture that is easily overlooked when the stock is considered under more traditional measurements.

When the product that a company sells can fluctuate by 100% very quickly, using revenues or earnings can be misleading. If our favorite consumer electronics company experienced this type of price volatility, the market would erupt with chaos, yet this is the nature of silver. Considering what the numbers really mean and not taking them as proof of anything on their own is a critical step to making sound investment choices in this segment.

More than Video Streams

Silver Wheaton remains my pick in the silver sector as a result of its business model, its reserves and the efficiency with which the company is run. As a silver streaming company, Silver Wheaton is not exposed to quite as much volatility as a typical miner. This is due to the fact that production costs have been swelling recently and causing the spread that a miner can earn to be compressed. Silver Wheaton contracts with various high-quality miners to buy their silver production at a set and predetermined price; the company then earns the spread between the contract price and the prevailing market price. Silver currently trades in the low $30’s and the company has a contractual average cost of $4.04.

With reserves of over 800 million ounces, or 1.3 billion ounces if we include both measured and indicated and proven and probable, the company is sitting on the single largest reserve in the world. At current silver prices, those reserves are valued at over $40 billion against a market cap of $15 billion. Not a bad ratio. Additionally, because of the company’s business model it is able to achieve a 75% operating margin that should set it apart from most other companies in any sector.

The Trade

With Silver Wheaton just breaking a new 52-week high and crossing $41 per share, some may be concerned that the stock has peaked. To the contrary, I believe that the stock has cleared an important barrier and is poised to run higher. In the interim, the company has put an aggressive dividend policy in place that should provide downside protection. Silver Wheaton is an absolute buy for your core portfolio.

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.

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