Two Big Reasons to Consider Silver Wheaton

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

Since Silver Wheaton (NYSE: SLW) reported earnings at the beginning of November, the stock has traded down by nearly 6% while the commodity, as represented by the iShares Silver Trust (NYSEMKT: SLV) is up nearly 10% (see chart). This disconnect is reason alone to take notice of the stock, but when you look inside of last quarter’s results, a second reason is revealed as well. I maintain the joint beliefs that silver is poised to move much higher over the coming quarters and that Silver Wheaton is the best way to gain exposure to the commodity.

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SLW data by YCharts

Stocks & Commodities

The divergence that can be observed between the price of silver and the price of silver stocks should be seen as a hallmark of opportunity. During periods of recession, there has historically been a divergence between the performance of stocks and the performance of commodities. Under such conditions, silver producers are treated like companies, and are thus subject to the negative pressures of a slowing economy. Simultaneously, commodities are seen as stores of wealth, becoming increasingly attractive and appreciating.

While there is a very real risk that this type of divergence can persist for an extended period of time, when economic conditions improve, and traders seem to magically awake to the fact that there is a huge divide between silver and silver stocks, the gap closes. During such reversals, there is significant profit potential if you are properly positioned. Given the risk of the trade, however, this should only be targeted if you can stand and afford to wait.

As the fiscal cliff looms in the immediate future, most economists have predicted that unless some resolution is reached, the spending cuts and tax hikes that are set to take effect will create another significant recession. It is the anticipation of this recession that appears to be driving the above divergence. Fortunately, the general consensus is that some resolution will be reached prior to dire conditions being reached.

The practical impact of this somewhat artificial recessionary environment is that in can be viewed in a far more finite context that during a typical recession. Should the fiscal cliff be avoided, as expected, the divergence should quickly reverse. This creates a real shorter-term opportunity, assuming you are willing to gamble on Congress acting responsibly – not a sure thing by a long shot.

The Dividend Factor

During the last quarter, Silver Wheaton’s inventories swelled by roughly 2 million ounces as a result of a timing mismatch between shipments and sales, as well as an actual slowdown on the sales side. These sales should find themselves augmenting future sales figures as inventories come more in line with expectations and last quarter’s mismatch is unwound. Given the company’s dividend policy of paying out based on the previous quarter’s cash flows, this same factor – which caused a 30% reduction in this quarter’s dividend – will bolster near-term dividend payments, thus making the stock even more attractive. Most of these sales are likely to be realized in the next quarter, so this catalyst will be somewhat short-lived.

Two Trades

The two ways to capitalize on the above two factors are by either owning Silver Wheaton outright, or by buying the stock as a part of a pairs trade with SLV. As a silver streaming company that is insulated against production cost spikes and that is functioning at an operating margin of 74%, Silver Wheaton should be a part of your core portfolio. If you prefer a more market-neutral and lower risk approach, buying Silver Wheaton shares while simultaneously shorting the same dollar value of SLV will give you exposure to the divergence discussed above – with this trade, you will profit if and when that divergence reverses. In either case, Silver Wheaton remains well positioned at current levels.

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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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