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Bullion vs. Silver in the Ground: Assessing the Risks and Rewards

Many companies in the resource sector try to sell themselves to investors as proxies for the underlying commodity. Every company in the industry that has any sort of resource works out the market value of the company divided by the ounces or pounds. The implication is that if you can buy silver in the ground for, say, fifty cents an ounce, then an investment in the company will increase at a faster pace than the price of silver.

In arriving at those measures of value per ounce, of course every company uses the approach that makes them look best against a carefully selected peer group. Some use market value per ounce. Others use enterprise value per ounce. For the number of ounces, they can use proven and probable reserves, reserves plus resources, measured and indicated resources or total resources.

And, in determining the number of ounces, some companies stick with the number of ounces of silver. Most companies with byproduct gold will convert the gold to silver equivalent. A few companies will convert the base metal credits to silver equivalent ounces. I don’t like incorporating base metals into a silver equivalent, because most investors are looking at these companies as a play on precious metals.

It is vitally important that investors recognize that every ounce of silver in the ground is different from every other ounce of silver in the ground. Comparisons against peers are useful only as rough indicators of potential value and should be carefully evaluated.

Let’s look at an example of the share price of a silver company over time compared to the price of silver. Please note that this is not a rigorous analysis.  It is intended as a first pass to arrive at some broad observations.

For many years, Silver Standard was a go-to silver equity for investors wanting exposure to the silver market. As expected, the Silver Standard share price rose much faster than the silver price from 2003 to 2007. In that time, the silver price rose three-fold while the Silver Standard share price rose by nine-fold. That is, Silver Standard rose 3 times faster than the silver price.

But, look what happened in 2008. Silver lost 50% of its value, while Silver Standard lost 80% of its value. Silver Standard rebounded much faster than silver after the global financial crisis, but then lagged the silver price.

Over the past two years, silver again lost 50%, while Silver Standard lost over 80%.

Silver Standard went through a fundamental change over the past four years, which may account for the disconnect from the silver price in the past few years.

The first level observation is that the equity value of a silver company can provide leverage to a rising silver price. However, that leverage also applies on the downside.

If we look a little closer, there are some other observations. In 2003, Silver Standard had about 330 million ounces of silver in the ground. By 2007, the company had about 1.2 million ounces. One could argue that the increase in value of Silver Standard matches the gain in the silver price plus the gain in resource ounces.

In other words, there may not be direct leverage to the silver price. Rather, the share price tracked the silver price, with the extra gain coming from the growth in silver resource.

In looking at some of the larger silver-dominant companies which have been around for the past 10 years, it is very clear that most of these companies have gone through swings in value far greater than the moves in the silver price. Again, this suggests leverage to silver. But, there is more to the story.

I have included the XAU in the summary as the index does include some silver companies. I wasn’t able to find a better silver index, at least not one that has been around for a decade. The XAU is obviously dominated by gold companies, but it gives some indication of how the larger precious metals companies have performed.

Interestingly, most of the companies underperformed silver across the ten years. Half of the companies also underperformed in reaching a maximum value greater than the silver maximum.

If we looked at a broader cross-section of silver companies, which means looking at more of the exploration companies, we would see that the vast majority will have underperformed the silver price.

Now, this is a brutal time in the resource markets. Prices are down across the board, and maybe this is not a good time to be doing this kind of analysis. However, there are some useful observations.

It would appear that silver did better than the larger companies. And almost certainly, silver did better than the average company in the space.

But, silver did not do better than all equities. This analysis tells us that carefully selected companies can greatly outperform silver.

Let us have a closer look at the companies that did out-perform silver. What can we learn from these companies?

First Majestic rose more than six times faster than silver over the decade. It was more than four times ahead in reaching a maximum. So, what did First Majestic do to outperform the metal price? In that time, First Majestic developed five mines and assembled an extensive portfolio of development projects. Clearly, they weren’t just sitting back waiting for the silver price to move or for the markets to recover. Management executed on a deliberate business plan that created enormous value.

Similarly, Endeavour developed three silver mines and assembled an exploration and development pipeline.

Fortuna Ventures developed a couple of profitable silver mines to outperform silver.

Silver Wheaton pioneered an entirely new investment approach: streaming. In executing that strategy, they went from a standing start to become one of the world’s largest silver companies in less than a decade. Along the way, they generated returns far ahead of the silver price.

The conclusion here is that the companies gained in value not just from the exposure to the silver market, but also because a smart management group executed a business plan which enhanced the value of the company.

The most successful of these companies have generated gains in shareholder value several times greater than the moves in the metal price.

In short, investors reward companies for enhancing value. Those gains in value can arise in several ways:

– Expanding resources
– Advancing projects toward production
– Achieving production.

It is especially important to build a company with multi-mine status. It’s really important to understand the importance of becoming a multi-mine company.

Let’s assume that there are two mining companies, with identical mines. If those companies merged, the value of the combined company would be significantly more than the sum of the values of the two smaller companies. The higher value arises from several factors:

– There are corporate and administrative synergies.
– There may be operating synergies.
– They will most likely achieve operating efficiencies: simply put: a typical small mine development company is run by a small group of professionals each of whom wears a few hats. A larger mining company can support a team with broader and deeper skills in each field.

– Reduced risk: Investors will see a multi-mine company as being less risky, with operational risk spread over multiple mines.

– Better access to capital: a larger company can tap into institutional investors that may not be willing to invest in smaller companies.

In spite of the clear enhancements in value, too few companies merge. Now is an excellent time to be aggressive in looking for ways to add value.

Everybody wants to know if this is the bottom of the market. Quite frankly, it may be some time yet before the popular press tells us that the resource market has turned up. In my opinion, many of the companies in this sector are still grossly over-valued. They may only be trading at a penny or two, but if they have no projects and no money, how much are they really worth?

By the time that someone rings a bell and announces that the market has hit bottom, many of the better quality companies will have doubled or tripled in value. The best quality companies are always the first to recover. People closest to the industry are quietly accumulating some of the better companies.

This is the time to buy. Don’t wait until the markets are already on an uptrend.

But, be selective. A few of these companies will increase 10-20-30 fold in value over the next few years.

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