Why Silver Wheaton Looks Good

Source: http://www.flickr.com/photos/sirqitous/

Source: http://www.flickr.com/photos/sirqitous/

The price of silver has performed terribly over the past three years, having lost roughly half of its value. Yet it appears to have found major price support in the $19-$20/ounce range. Ultimately, I think that the price of silver is going much higher. Demand for silver has been climbing due to a wide array of new industrial applications. Silver can be found in your smart phone, in solar panels, medical devices — even in underwear. Furthermore, investment demand for silver has been soaring as well given recent fears regarding the safety of the banking system and the viability of the dollar, the Euro, the Yen, and fiat currencies more generally. As a result, we saw record demand for American Silver Eagles in 2013.

The most obvious way to invest in silver is to simply buy silver. Silver American Eagles, Canadian Silver Maple Leafs, and Austrian Philharmonics can be purchased through any coin dealer, and the good dealers will offer you a fair price relative to the spot silver market. However, many investors are interested in leveraging their exposure to silver. They may also want a dividend as well. For those investors, I think Silver Wheaton (SLW) is a solid investment.

Silver Wheaton is a streaming company. It makes front end balloon payments to mining companies in exchange for an agreed upon amount of silver mined at an agreed upon price. For example, Silver Wheaton has an agreement in place with Goldcorp (NYSE:GG), whereby the company paid for the right to buy 25 percent of the silver produced at Goldcorp’s Penasquito mine in Mexico for $3.90/ounce.

This is a great business for several reasons. First, Silver Wheaton gets leverage to the silver price, but it remains comfortably profitable even if the price of silver falls. Second, Silver Wheaton generally has fixed costs. Third, if Silver Wheaton makes a streaming deal with a mining company, and the mining company finds more silver, then the deal applies to this newly found silver at no extra cost to the company.

Currently, Silver Wheaton trades at roughly 19-times 2014 earnings estimates, which is a slight discount to the S&P 500, which trades at about 22-times earnings. However, Silver Wheaton’s earnings can jump meaningfully if the price of silver rises, as I believe it will. Furthermore, Silver Wheaton will pay a dividend equal to 20 percent of its cash flow.  Therefore, in many ways, Silver Wheaton is like a silver bond, as it will pay a dividend that rises and falls with the price of silver.

Before investing in Silver Wheaton, readers should note a couple of things. First, the company has been branching out into gold recently. Last year, it made a very large deal with Vale (NYSE:VALE) to buy two gold streams — one on the Salobo mine in Brazil, and another on the Sudbury mine in Canada. The company also made a deal wth Sandspring Resources for a gold stream on its Columbian Toroparu mine. As a result, slightly more than a quarter of the company’s future cash flow will come from gold.

Second, the company operates through its Caymen Islands subsidiary. Therefore, it pays very little taxes. There is the risk that the Canadian government will go after Canadian companies operating out of the Caymen Islands, including Silver Wheaton. Therefore, there is potentially a sizeable tax liability in the company’s future.

Third, the company is fairly valued, not undervalued. This is not necessarily bad. Warren Buffett says that, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Silver Wheaton is the former. The company has done a stellar job of generating shareholder value having outpaced the major stock market indexes as well as the prices of silver and gold. Over time, I expect this track record to continue.