Should You Be Buying Silver?

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

I recently wrote about how intelligent investors can diversify their portfolios using gold investments. Gold is, however, not the only historically monetary precious metal that has been beaten down lately – silver also has the potential to resume its decade-plus upward trend.

Silver is not as rare as gold and has industrial uses to go along with its monetary properties. Because of this increased supply and demand, silver currently trades for about $20/oz, which is one-66th of the current gold price. Historically, silver’s low price has made it more volatile than gold, allowing bigger gains in up periods and correspondingly bigger hits in down periods. The gold/silver ratio has typically been between 30 and 50, implying that along with strong macro trends, silver will revert to this mean going forward.

The following article will follow the same format as the previous regarding gold.

Physical silver

It is fairly easy to buy actual physical silver. Visiting a local coin dealer will allow investors to buy silver by the gram or ounce. Typically the dealer will sell bags full of old quarters and dimes that have a high silver content (before 1964 all quarters and dimes were made from silver.) Unfortunately, if one wishes to invest a high percent of his portfolio in silver, the necessary weight makes this option prohibitive. Additionally, some coin dealers can act like unethical mechanics, recognizing new buyers and ripping them off.

Thankfully, there are ETF solutions. I mentioned the Central Fund of Canada (NYSEMKT: CEF) in the previous article. The Central Fund is a closed-end fund that currently has a 46% allocation to silver. Unlike some of the more popular funds, the Central Fund holds physical gold and silver bullion, allowing it to track the actual prices of its portfolio better and cutting down on its expenses, which are just 0.3% annually. Finally, the Central Fund currently trades at a 4% discount to its net asset value (NAV), which adds a small arbitrage kicker to the potential gains.

The most popular fund for silver is the iShares Silver Trust (NYSEMKT: SLV), which has assets under management of $6 billion. The Silver Trust is perfect for investors who want to invest only in silver without the gold exposure in the Central Fund. Since the trust’s inception in April 2006, it has tracked the actual silver price well, as shown in the below table from the fund's site. The small difference is due to the trust’s 0.5% annual expenses.

Silver miners

There are a lot fewer silver miners than gold miners due to the fact that most silver is mined as a secondary metal in a mine focused on gold, copper or some other metal. Because of this, it is more difficult to find a miner focused solely on silver. However, the same principles of operating leverage and multiple expansion apply for silver miners.

As with gold miners, I do not recommend investing in any single miner but was able to find a fund that invests in silver miners. The Global X Silver Miners ETF (NYSEMKT: SIL) invests in the silver miners present in the Solactive Silver Miners Index and charges 0.6% annually.

Though I recognize several of the names in the index, I have several problems with its composition. The index is weighted based on “free-float market capitalization.” Weighting based on free-float market cap means the index uses only the floated shares (total shares – minus shares owned by insiders) in its companies to calculate market cap, and then allocates based on size, putting more into the larger companies.

This is not unusual for an index but it is illogical. Historically, small companies and companies with strong insider ownership perform better than large companies and companies with low insider ownership – which means a free-float market cap weights companies based on the exact inverse of how it should.

Despite this problem with the index, The Global X fund is easily the best opportunity for investors looking to invest in silver miners.

Silver Wheaton's model

My favorite personal investment over the past four or five years has been Silver Wheaton (NYSE: SLW). Silver Wheaton has a fairly simple model. The company helps miners fund the exploration and beginning of operation of mines that do or will produce silver in exchange for the right to buy all or a portion of the silver produced by the mine for $4/oz going forward.

The company is able to do this because of the fact mentioned above; that most silver is mined as a secondary metal. Silver Wheaton targets copper or gold miners that are willing to sell all the silver they produce to get cheap financing for the copper or gold they are really focused on. So far, Silver Wheaton has secured contracts at 19 mines in nine countries on three continents.

In 2012, the company had silver-equivalent sales of $850 million and net earnings of $586 million. It currently trades at market cap of $8 billion, which is a multiple of 13.7x its net earnings. To value the company, I used management’s projection that in 2017 it will “produce” 53 million silver-equivalent ounces. I used this number to project revenue, keeping the 69% margin it has today and applying a multiple to the projected earnings. The following tables show the projected market cap for several scenarios and then the IRR for each scenario.

Numbers in millions

Conclusion

For investors who want to diversify their portfolio and protect their downside if the US experiences another economic calamity, silver is a great investment. I would recommend the investments discussed in this article and would advise investors to learn more about gold and silver investing.

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Mike Price, MSF owns shares of Silver Wheaton. (USA). The Motley Fool has no position in any of the stocks mentioned. 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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