The stock market has had a good, yet somewhat volatile, year. Despite beginning the year on a sour note, the broad-based S&P 500 has climbed nearly 5% year to date. However, silver stocks have had an exceptional year -- and even that may be an understatement.
Year to date through the close on Oct. 19, eight of the nine silver miners had returned more than 119%, with the "worst" performer, Silver Wheaton (NYSE:SLW), up 98%. Oh, darn, right? Additionally, four silver miners had at least tripled, and Coeur Mining (NYSE:CDE) led the pack with a 361% year-to-date gain. Added up, we're looking at average gains throughout the industry of 191% in 2016.
Why physical silver and silver miners have soared in 2016
Why has silver delivered such blisteringly phenomenal results in 2016? It probably boils down to a few factors.
To begin with, the opportunity cost of owning physical metals and metal miners remains exceptionally low. Opportunity cost is simply the idea of giving up a nearly guaranteed gain in one asset for the opportunity of a greater return in another asset. For example, if buying a U.S. five-year Treasury bond yields around 1.2%, but the rate of inflation is higher than 1.2%, then forgoing the nearly guaranteed interest earned on a bond in favor of purchasing precious metals may very well make sense. Remember, precious metals have no yield, but occasionally the metal-mining stocks do, depending on their profitability. As long as interest rates remain low -- and nothing is currently suggesting that the Federal Reserve will boost rates multiple times anytime soon -- the opportunity cost of passing up interest-based assets remains quite low.
Secondly, supply and demand have favored continued interest in silver. According to the Silver Institute's 2016 World Silver Survey, physical demand has consistently outpaced supply since 2013, which is a critical element to buoying physical silver prices. Basic economics tells us that if a product is in demand and there's not enough supply to go around, the price of that product will rise. In 2015, there was a 129.8 million-ounce silver deficit, with investment demand for silver coins and bars growing to an all-time record high. As long as the demand for silver continues to increase while supply growth is tepid at best, the stage could be set for physical silver's price to move higher.
Psychological and historical factors have also played a role. Silver, like gold, tends to react well to economic uncertainties. With China's growth slowing, a U.S. election upcoming, and Brexit looming, there's enough uncertainty to spur investment demand.
Furthermore, physical metal investors have been paying closer attention to silver with the lustrous metal trading outside of its average historical variance to gold. During the 20th century, gold was valued at an average of 47 times silver on a per-ounce basis. As of Oct. 19, this gold-to-silver ratio stood at 71.9, leading some traders to believe silver has more upside potential than gold.
Long story short, the fundamental case for a continued rally in physical silver and silver mining stocks remains firmly in place.
Cash flow is king in the silver-mining industry
However, the silver mining industry has nine companies for investors to choose from, ranging from large-cap Silver Wheaton with a nearly $11 billion valuation, all the way down to Great Panther Silver with a $228 million valuation. Choosing which silver miner may be the most attractive isn't easy, which is why we'll turn to future cash flow per share estimates from Wall Street for some help.
The simple goal is to find the silver miner with the lowest price-to-future cash flow per share ratio (P/FCFPS). Cash flow is of particular importance for mining companies since it fuels the maintenance of existing mines and funds the expansion of new developments.
For this exercise, I examined the 2017 cash flow per share (CFPS) estimates for all silver miners, excluding only Great Panther Silver in the process, since there are no Wall Street estimates on its future cash flow. Of the eight remaining silver miners, here's how things shook out in terms of P/FCFPS:
- Coeur Mining: 6.3
- Silver Standard Resources (NASDAQ:SSRI): 7.5
- First Majestic Silver: 8.6
- Hecla Mining: 8.7
- Pan American Silver: 10.1
- Fortuna Silver Metals: 10.9
- Endeavour Silver: 13.4
- Silver Wheaton: 14.2
One thing that's not in the least bit surprising about these results is finding Silver Wheaton to be the "most expensive" based on future cash flow. But its valuation actually does make sense if you dig below the surface (pun fully intended).
Silver Wheaton isn't a mining company in the traditional sense. It's a royalty and streaming company that provides upfront capital for mining companies to develop or expand new or existing mines. In exchange for providing this capital, Silver Wheaton receives long-term or life-of-mine contracts that allow it to purchase silver, gold, and certain other byproducts at well below spot value. In Silver Wheaton's second quarter, it wound up taking delivery at an average per-ounce price of $401 for gold and $4.46 for silver, providing a healthy margin for each metal. It would take a near collapse in physical metal prices for investors to question Silver Wheaton's business model, thus making it worthy of a higher premium than its peers.
I was also quite pleased to see one of my personal core portfolio holdings, Silver Standard Resources, priced so inexpensively on a forward basis relative to its peers. A big boon for Silver Standard has been its recent acquisition of Claude Resources, which closed in June. Claude relied heavily on its Seabee mine, but production had been stuck around 50,000 ounces, give or take a few thousand, for a few years. However, the ahead-of-schedule commissioning of the Santoy Gap pushed annual production above 70,000 ounces, quickly turning Claude into a healthy cash flow positive business. Adding Claude will help further diversify Silver Standard's product portfolio and immediately boost its cash flow and earnings potential.
The cheapest silver mining stock based on future cash flow
But the cheapest silver miner of all, even after an impressive 361% year-to-date return, is Coeur Mining. What makes Coeur such an interesting silver miner is that it's one of the few that's been able to ramp up production while also reducing its expenses.
During the second quarter, Coeur Mining wound up expanding its silver equivalent ounce production by 19% over the sequential first quarter, which was mostly attributed to a 64% increase in tons milled at its flagship Palmarejo mine in Mexico.
A recent release of its third-quarter production results demonstrated a bit of a retracement compared to Q3 2015, but this is merely as a result of transitioning from both underground and surface operations to entirely underground operations, which will offer higher ore grades and margins. In terms of underground operations, Coeur Mining increased the number of tons mined by 33% over Q3 2015. As underground operations ramp up, so should Coeur's margins and profitability.
At the same time, Coeur Mining's move underground should help it reduce its capital expenditures over the long-term, and its efforts to reduce debt will also help in the expense department. In July, Coeur Mining wound up repaying $99 million toward a term loan, reducing its debt by nearly 20% and lowering its annual interest payment by $9 million. That may not sound like a lot, but it could translate into an extra $0.055 in EPS a year.
It's tough to find miners with falling costs, improving margins, and production growth potential, but Coeur Mining appears to have it all.
Sean Williams owns shares of Silver Standard Resources, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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