Will Silver Catch Up to Gold?

Why is silver underperforming, and is this an opportunity or a sign of something else?

While it is difficult to know why exactly silver is underperforming in just a two-and-a-half-month timeframe, the most obvious answer to this is that silver is not just a precious metal — it is also an industrial metal, and about half of silver’s demand comes from industrial applications while only about a fourth of silver demand comes from investors. As we have seen this year, industrial metals such as copper and lead have underperformed, which signals economic weakness. If there is, in fact, economic weakness, then it follows that there will be less industrial demand for silver.

While this is certainly a plausible explanation I think that this is creating a long-term opportunity in silver. There are several reasons for this.

First, silver is undervalued relative to gold. While it takes about 65 ounces of silver to buy an ounce of gold, only about 10 ounces of silver comes out of the ground for every ounce of gold that comes out of the ground.

Second, while we might be seeing a decline in the demand for industrial metals, more generally, silver is in a unique position where the demand for silver is rising at a faster rate than the demand for other industrial metals given the fact that new usages are being discovered for silver. While this rise in industrial usages for silver was significantly offset for a long time by falling demand for silver in photography, the demand for silver in photography has become essentially negligible. Now we will see industrial demand for silver rise with the rise in demand of popular products such as laptops, smartphones, and photovoltaic cells used in solar panels.

Third, investment demand for silver is rising at a faster pace than investment demand for gold. While gold is primarily seen as an investment, silver is not. But the trend is such that a greater percentage of silver is going toward satisfying investment demand.

Not only is this a long-term trend exemplified by record demand for American Silver Eagles and by rising demand for shares in the world’s largest silver-backed ETF — the iShares Silver Trust (NYSEARCA:SLV) — but we are seeing exogenous events driving silver demand. The best example of this is the surge in Indian demand last year resulting from government restrictions on gold imports. Since Indians were pushed away from investing in gold, they turned to silver.

Ultimately, as long as there are fears that the economy is heading towards a slowdown or a recession we will have those investors who speculate that the prices of all base metals — including silver — will fall. But this is creating a buying opportunity for longer term investors.

Those interested in investing in silver have several options. The most obvious is the previously mentioned iShares Silver Trust. However, long-term investors might want to look at the lesser-known Sprott Physical Silver Trust (NYSEARCA:PSLV). Not only does this fund have a slightly lower expense ratio (0.45 percent versus 0.5 percent), but it has better tax treatment for long-term holders.

Long-term holders of the iShares Silver Trust see their gains taxes as gains on collectibles, or at a punitive 28 percent. The Sprott Physical Silver Trust is treated like a stock, which means that if you hold it for less than a year then it it is taxed as ordinary income. But if you hold it for longer than a year then your gains are taxed at the capital gains rate, which means that you will be taxed at either 15 percent or 20 percent depending on your tax bracket.

Investors looking at silver miners need to be cautioned that silver mining companies often have exposure to several other metals such as copper, zinc, lead, and gold. While this doesn’t make them bad investments, it could mean that several silver miners might not be suited for all investors, especially those who are looking for silver exposure.  There are a couple of companies that appeal to such investors.

The first is First Majestic Silver (NYSE:AG), which strives to maximize its silver exposure. While this exposure has fallen a bit in lieu of zinc and lead exposure, the company still has more than 85 percent silver exposure. First Majestic Silver operates five mines that are all low-cost mines in Mexico. The company has a phenomenal track record of keeping costs low and of growing its production and reserves.

For this reason investors have often been willing to pay a premium for First Majestic shares to the company’s book value and to the company’s peers. Recently, though, the stock has underperformed, which might be presenting investors with an opportunity.

But keep in mind that one reason for this might be the fact that all of the company’s mines are located in Mexico, and the Mexican government just levied a 7.5 percent royalty on all mining companies. This will not only hit the company’s bottom line: It also means that Mexico is a slightly less appealing place to mine, and it heightens the possibility that the Mexican government could raise taxes again.

The second company is a new producer, Tahoe Resources (NYSE:TAHO). The company recently began producing at the Escobal mine in Guatemala. It will produce 20 million ounces per year with very low production costs for years to come. Furthermore, Tahoe will get about 85 percent of its revenues from silver. There are a couple of risks to holding this stock.

The first is that the shares have been performing extremely well as of late because investors are enthusiastic that management was able to bring the large Escobal mine into production. As a result the stock is probably somewhat overvalued given the company’s estimated production metrics and the current silver price. The second is that the mind is located in Guatemala.

Investors were concerned that the government would delay the project in the past, and I think that kept the stock down for a while. But now that the mine is producing that fear has abated. Yet I think investors should still be concerned, especially considering that many locals are against the mine. Still, if you believe that the silver price will rise, Tahoe Resources is a solid long-term holding, and it should be purchased on a pullback.

Disclosure: Ben Kramer-Miller is long First Majestic Silver shares.

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