Guide to Silver Investing Protecting Your Wealth 101 Palisade Research - 2016


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Introduction Investors buy precious metals for several reasons: 1. To diversify their portfolio 2. To protect their wealth against inflation and systematic financial trepidations 3. To make money when precious metal prices increase Even though silver does not get as much airtime as gold, it can still fulfil the listed reasons successfully—provided that investors approach it with the right mindset. Before we get into the details, let us get one thing out of the way, we will not try to time the market—nor will we forecast silver price. We’ll leave that to the market pundits. Instead, we will focus on two things, the role silver plays in a diversified portfolio and the ways to invest in it.

Silver Fundamentals Silver is a precious metal, like gold, platinum or palladium. Throughout history it has been used as currency and a store of value; today it is also heavily used to produce jewelry, photovoltaic (solar) panels, water purifiers, and other products. This is what makes silver unique among precious metals; it stands right at the intersection of industrial and investment markets. On the industrial side, the outlook for silver is positive. According to The Silver Institute, in 2015 mine production growth hit a four-year low of 2% per year. Concerns about future supply reductions remain.

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At the same time, jewelry production hit a record high. On balance, physical silver market realized a deficit for the third consecutive year. This deficit in 2015 was 130 million ounces, 60% higher than a year ago, and the third-largest on record.

Note that even though the silver market was in a state of deficit for the past three years, its price decreased, instead of rising.

On the investment side, retail investment for physical silver increased by almost 25% and set new records in 2015. However, silver prices slid based on uncertainty about the Fed’s interest rate policy and the turbulence in China’s equity markets. Interest rates matter for silver and other precious metals. Rising interest rates support the value of paper currency. When the US dollar becomes stronger, precious-metal prices come under pressure. The opposite is also true, investors buy gold and silver when they see currencies weakening. Silver and gold find their way into retail investors’ portfolios as “real assets,” or investments that provide protection against economic catastrophes. Such as when GDP growth is slowing down, leading to lower or negative interest rates. Or macroeconomic shocks like the Great

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Britain’s decision to leave the European Union (Brexit); investors look at assets that would act as “safe havens.” Along with gold, silver belongs in this group.

Silver In Your Portfolio We established that the market views silver as both an industrial metal and an investment asset. How should you apply this knowledge in constructing your portfolio? First, keep in mind that the best way to invest in silver is to have a long-term perspective. Weekly or monthly market movements, let alone daily ones, are almost impossible to predict. Even though some short-term traders are successful, most investors should not try to beat the market every day. Silver can store value in the long-term; prudent investors should recognize that. Second, silver is volatile, even more so than gold. There are many reasons for this, one of them being the small size of the market. In 2013, it was about 3.5 times smaller than the gold market, based on trading volumes on futures and options exchanges, as well as London’s over-thecounter bullion market. This detracts institutions from the silver market, yet for retail investors somewhat lower volumes are not as much of a problem. The volatility of silver is high but it is way below modern records. In 2011, annual volatility reached 61%. In 2015, it was 24.1%. The chart below illustrates our point – volatility of silver (and, for that matter, gold) has been decreasing over the past five years. Silver can improve the return and risk profile of a diversified

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portfolio. The Silver Institute looked at return and risk parameters of various hypothetical portfolios and concluded that over multiple time periods the best results were achieved by a portfolio that included 5% gold and 5% silver. In the chart below, Portfolio 7 is the most diversified one (it includes stocks, bonds, gold, and silver)—and it has been the bestperforming one from 1968 to 2013.

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This happened because silver as an investment class provides the following benefits: •

Diversification – Silver has low correlation to equities, strong negative correlation to the US Dollar index, and strong (yet not perfect) correlation to gold. A portfolio that has all of these assets is better protected than a more concentrated one.

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A True Alternative – Think about it, gold is not on the radar of many investors because it is deemed too contrarian. Silver is an alternative to gold. When markets become volatile, gold will make headlines while silver may quietly outperform. In June 2016, when the UK voted to leave the EU, gold price went up by 4%. At the same time, silver rose by 4.3% on a daily basis.

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Inflation Protection –Silver is negatively correlated with inflation, providing protection of purchasing power. We think that silver’s inflation-hedging properties are as important as ever, even despite the low headline inflation numbers. Even though economic growth remains weak, and inflation expectations are not high either, the US government’s loose (and inefficient) monetary policies may give rise to runaway inflation in the future even without a corresponding pickup in economic output growth. In that case, precious metals like gold and silver should act as safe havens and see their prices rise.

From an allocation standpoint, we agree with Ibbotson Associates that concluded that investors will benefit from allocating up to 15% of their portfolio to precious metals. With this in mind, let’s see how to put this information to use.

Silver Investing There are many ways to invest in silver, but not all of them provide direct exposure to silver’s attractive investment characteristics. In fact, investors need to be careful; some of the products offered in the market can do more harm than good to their portfolios. Let’s take a look at each one of them.

Bars And Coins These are the most traditional silver vehicles, and many think of them as the purest form of silver investment. However, the real picture may not be so simple. First, coins and bars are sold at a premium, coins more so than gold. If silver price per ounce is $20, there will be no coins or bars available at the same price. Manufacturers and sellers will add their

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premium on top of spot to cover production and marketing expenses. In 2013, premium reached 25% over spot price! In other words, when you buy silver coins you always pay for more than the actual silver content. One solution to it is to buy bars, in bulk, and in areas without sales tax—all this should reduce the amount of money you pay over spot price per ounce. Some shops also charge for processing credit card transactions, so cash is ideal if that is the case with your local dealer. Another issue with physical silver is storage. Some investors don’t trust banks to hold their bullion; others have no issues with doing so and store silver in secure rental vaults. Whatever camp you belong to, make sure that your silver (and other physical assets) is securely stored and, if you feel like it needs extra protection, insured. Dedicated silver investors will still say that the benefits of owning physical silver and gold outweigh its risks. If a true economic catastrophe unfolds, financial institutions may tumble and become another source of risk, holding your bullion on their premises maybe dangerous. Our recommendation is to do what feels right for you. At the end of the day, silver is a “safe haven” asset, and you should feel that it is stored safely.

Silver ETFs Exchange-traded funds are investment vehicles that track assets or indices. Since its inception in 2006, iShares Silver ETF (SLV) has remained the largest ETF backed by physical silver. Every share price of this fund represents claim on one ounce of silver, so its share price tracks silver price very closely. There are other silver-based ETFs whose shares track silver price through futures and options. They are not backed by “real” silver. Thus, may be more volatile than physical-silver based ETFs because their prices are based on futures, not spot, markets. Despite the convenience of physical ETFs like SLV, some investors still stay away from it. Their reason is simple, counter-party risk. Even though shares of this fund are linked to physical silver, it is still outside their reach. The physical silver is held in New York and London vaults. Investors can redeem the metal, but only in large batches of 50,000 ounces. Smaller orders get queued and executed with a delay. This introduces price risk as silver prices may fall while the physical metal is delivered. This represents a dilemma for many investors. Bars and coins are attractive because holding them does not involve counter-parties, yet ETFs provide liquidity and lower premiums.

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Our recommendation, as always, is to diversify. Purchasing shares of ETFs will drive down the average premium of your silver portfolio, while owning physical metal will ensure peace of mind. A word of caution for the boldest silver investors: some ETFs offer leveraged exposure to the metal’s price. Their names include “2x”, “3x”, “Ultra,” and other marks. Be cautious in buying these as returns are unpredictable and they have high expense ratios. Returns of leveraged ETFs are reset daily, which means that over longer periods of time they will deviate wildly from the returns of the underlying asset. If silver rises by 20% over the next month, there is no guarantee whatsoever than a 2x ETF will realize a 40% gain. Everything will depend on how the price behaves between these dates. Higher volatility will create an unpredictable pattern, where you may end up with a significant loss. Another reason to remain cautious of these products is cost. While the “plain” iShares ETF has a 0.5% expense ratio, a leveraged product like VelocityShares 3x Long Silver ETN has a ratio more than three times as high at 1.65%. In short, we recommend long-term investors to stay away from leveraged or short ETFs unless it really fits the risk profile of your overall portfolio. Lastly, investors who feel comfortable with the stock market should instead take a closer look at silver mining companies.

Silver Mining Companies Neither physical bullion nor silver-based exchange-traded products provide yield for investors. If you purchase either of these asset classes, you do it for diversification purposes, and to counteract inflation pressures. But there is a way to purchase cash-generating assets related to silver (and, for that matter, other precious metals). We are talking about mining companies, of course. Let us state upfront, investing in mining companies can be risky. The silver market itself is complex, yet mining companies deal with an extra set of uncertainties. Geology, availability of financing to develop projects and build mines, quality of management, jurisdiction risk—all of these add up to make investing in mining companies quite a daunting task.

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However, there will always remain investors looking to profit from mining companies trading on public exchanges. They are attracted by the following characteristics of these stocks: •

Companies producing silver generate cash flow and may pay dividends;

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Exploration-stage companies, if successful, can deliver excellent returns on investment. Returns exceeding hundreds, if not thousands, of percent, still occur.

In short, even despite the lottery-type payouts (very low number of extremely high gains versus low average returns), there are rational reasons to buy even the early-stage resource-sector juniors. When it comes to early-stage companies, investors should consider these qualities: •

Track record of the management team. If the people in charge have a history of exploration success, their next venture could face better-than-average odds. Note how careful we are with this statement. This does not work every time. However, business teams that have found economically viable deposits in the past will be looked at more favorably by the market.

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Continuing the previous point, good companies will be able to raise capital even in the toughest of conditions, and do it on good terms. More entrepreneurial management teams will be able to tap into equity and other types of financing easier. It’s vitally important for the company’s top executives to combine both technical and capital markets expertise.

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The best management teams will understand how to extract the most value out of their projects. Their options vary from bringing the project to production on their own or in partnership with another company, optioning it to a major, etc. The team needs to have a vision for their assets and be able to communicate it to the investors. If you are interested in a resource sector junior, or if you are already a shareholder, call the company’s investor relations representative and ask them about the roadmap for its key projects. A clear vision is a good sign.

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Jurisdiction matters: governments can become too greedy and demand more in taxes and royalties, killing a mining company’s margins. Fraser Institute publishes a global survey of mining jurisdictions. Even though it is true that there are a lot of opportunities outside the beaten path (or away from the most stable and predictable jurisdictions), investors need to understand the risks that baked into emerging or frontier markets.

When it comes to more mature mining companies, there are a few extra things to think about:

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How does the management deal with costs? A producing company needs to stay on top of its cost structure and deliver margins under various commodity price scenarios. If silver prices go down by 10%, will the company be able to generate free cash flow for the shareholders? Will it keep paying dividends?

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Large- and even medium-sized majors often engage in merger and acquisitions. Not all of them add value. As a current or potential investor, try to understand the company’s past M&A history. Did it overpay for its purchases? If so, it might have incurred write-offs later on. Did it take on too much debt to finance its empire-building activities? If so, can it service the debt now and can it repay the principal?

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Political risk matters, too. You cannot move a mine out of the country if its political climate changes to the worse. Did the government of the jurisdiction the company operates in introduce “windfall” tax increases or nationalize mining assets in the past? Or did it work to make mining companies’ lives easier?

These questions do not cover all aspects of mining due diligence, of course. Rather, they show that investors interested in buying silver mining companies need to ask themselves a specific set of questions before they buy any shares. We should also mention here that there are only a few silver mining companies on the market. Most of the silver production—about two-thirds of it—comes from mines where silver is not the main product. In those cases, investors need to consider the outlook for the other commodities being produced. If ¾ of a company’s revenue comes from gold and only ¼ from silver, it is clear that silver price will not be the most significant driver of its share price. It sounds obvious but can save investors from unnecessary pain. Finally, we need to mention mining companies ETFs. These are funds holding shares of multiple silver mining companies. We suggest that you avoid these. Even though they look attractive and diversified, they cannot replace a portfolio of quality companies producing silver. When you buy an ETF, you get both the good and the bad ones—for a fee. There are better ways to get exposure to silver-focused stocks. Wellrun, capitalized (or profitable) companies that can keep their costs under control are all you need. ETFs will give you those, but bundle them with underperformers that will act as a drag on your portfolio. We’ll repeat: silver mining ETFs may not be the best way to go.

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Summary Silver is a unique commodity that offers great diversification potential and—if approached carefully— capital gains potential. We think that the current market environment is promising: demand exceeds supply, investment demand is growing, and the global economy still faces uncertainties that push investors into safe-haven assets. Given all this, we believe that gold’s little brother has all it takes to shine. One chart we would like to point out is the gold to silver ratio. Since the Bretton Woods system ended in August 1971, the ratio average has been around 57. We are currently at 66. Historically, the ratio used to value silver has been under 20.

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This means silver is undervalued relative to gold, and will return the average as it has done so many time in the past. Every investor will decide what assets fit his or her bill best. From our point of view, a combination of physical metal, metal-backed ETFs and a portfolio of quality silver stocks is a great way to get into the silver. Silver has now outperformed gold in a big way this year, and the fundamentals are saying there is still a lot more to go.

Subscribe to Palisade Research to read about silver and gold companies we have in our portfolio. You never know, you may find a couple of gems for yours. www.palisaderadio.com www.palisade-research.com.

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