Is This the Best Contrarian Strategy for Precious Metals Investors?

Thinking about a contrarian play in the precious metals space? Consider this one.

Apr 22, 2014 at 3:28PM

Often, the word "contrarian" equates to investors attempting to catch a falling knife. You don't need to look like a used butcher's block for contrarian strategies to pay off in the long run, however. 

Recently, the precious metals markets have been consolidating following a severe decline from all-time highs. If you believe that they will someday regain popularity following another economic decline, political debacle, above average inflation, or other crisis, however, then join the club.

Numerous catalysts for a spike in precious metals exist, and Silver Wheaton (NYSE:SLW) looks well positioned to capitalize in both the gold and silver markets. Its business model provides for known costs with limited downside while allowing for upside potential based on precious metal prices increases.

This is done by upfront payments to mine operators, guaranteeing Silver Wheaton a percentage of mine output to be purchased at a predesignated price (typically around $4/oz for silver and $400/oz for gold). About 25% of the company's revenue comes from gold and 75% comes from silver.

Known costs with leveraged upside based on silver and gold price increases makes this a top contrarian selection in this sector. The business model insulates it from the operational cost troubles that have plagued miners such as IAMGOLD (NYSE:IAG), where harder rock and decreasing yields have taken their toll on profit margins.

While other producers such as Barrick Gold (NYSE:ABX) have been able to keep costs under control, it has often been at the expense of foregoing expansions and liquidating interests in less productive yet often profitable mines. That strategy has a limited life span.

The biggest disadvantage that producers like IAMGOLD and Barrick Gold face, compared to SIlver Wheaton's business model, is having to comply with constantly changing regulations on a global scale. These range from labor disputes, environmental compliance issues, health and safety regulations, taxation, permits and licensing, and civil/political disturbances. That's just the tip of the iceberg when it comes to the challenges of operating a large-scale mine that needs access to power, water, and infrastructure as well.

The beauty of Silver Wheaton is letting the producers figure out these issues. When complications arise, as they did recently when Barrick decided to temporarily suspend construction activities at its Pascua-Lama project following a challenge from a group of local farmers and indigenous communities, there is often a fallback plan. In this case, the amended plan entitles Silver Wheaton to 100% of the silver production from Barrick's Lagunas Norte, Pierina, and Veladero mines until the end of 2016 – an extension of one year. This is projected to make up the difference in the meantime, unfortunately at Barrick's expense.

If Silver Wheaton's own projections come to fruition, the next four years could see some solid growth. The company generates its revenue from the sales volume of silver and gold, and this revenue is projected to increase as more projects come online. According to the company's 2013 report, its current agreements forecast 2014 production of 36 million silver equivalent ounces, including 155,000 ounces of gold. By 2018, production is anticipated to increase significantly to approximately 48 million silver equivalent ounces, including 250,000 ounces of gold. That's a 33% increase in silver and 61% in gold.

Final thoughts
When an industry is already facing challenging times, it is best to lessen the unknown. While no contrarian play is without risk, Silver Wheaton helps to curtail that risk though its business model. Its fixed cost structure minimizes potential downside while still allowing investors to participate in leveraged upside based on precious metal price increases. This structure makes Silver Wheaton a superior contrarian play in the gold and silver sector.

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