Alternatives
09 Apr 2020 | By Ned Naylor-Leyland

Silver’s shining playbook

We are living through very strange times but it’s worth remembering that the Merian Gold & Silver Fund was established for periods such as now.

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We are approaching the moment when investors start to pivot towards the asset class that performs best during periods of monetary debasement. Yes, we maintain (well, of course we do) that the differentiated aspects of the fund’s asset allocation model make it best equipped to take full advantage of this backdrop but, more generally, now is the time to recognise the obvious buying opportunity available for all gold and silver mining equities and, in particular, silver miners. 

Very few investors have any allocation to the sector and even those that do will be surprised by the growing earnings profile that lies ahead. This is in sharp contrast to other equities they hold that are and will continue to be materially affected by the demand-led (not to mention credit-affected) problems in the global economy. 

And that’s it in a nutshell. Presuming current (or indeed higher) gold and silver spot prices, due to lower fixed and variable costs – namely labour and energy – earnings over the next couple of quarters should rise healthily. That is in stark contrast to expected declines in earnings in almost every other sector.

 

Staying the course

The first quarter of 2020 was extraordinary. What we witnessed was a 2008-style deflationary black hole in which leveraged investors bore the brunt. Such investors exist in all asset classes. And now that massive monetary and fiscal stimulus has started, we expect the asset class and, in particular silver – to which we have significant exposure – to be the primary beneficiaries of such policies.

Typically, we would expect the fund to outperform when the sector heats up and the gold/silver ratio falls, just as it will, and does, underperform when capital is leaving the sector and the ratio is rising. For example, the fund clearly outperformed both physical gold and peer group mining funds late last year as the gold/silver ratio fell. It then rallied from 80:1 to 120:1 during the first three months of 2020, a very similar 50% rally to that seen in 2008 before the ratio then turned and fell around 70% over two years in a rapidly rising gold and silver price environment. 

On a macro level, this is where we are again, with a much more powerful tailwind of central bank and government policies, and should the gold price exceed US$2000/oz we would expect a whole wave of new investors to pour into the space. This should send the fund much higher, with the gold/silver ratio falling as a result of silver’s greater sensitivity to capital flows. 

Three stocks for which we have high hopes in this environment are Evolution Mining, Osisko Mining and Silvercorp Metals. 

Growth for Evolution Mining is expected to come from the recently acquired Red Lake Mine in Ontario, which will require significant capital investment to increase production and reduce costs. We expect the Australian dollar gold price to continue to strengthen, which will increase margins of the company’s Australian gold mines. Evolution Mining has been a strong performer over the past 12 months and is our largest mining equity position. 

Meanwhile, Osisko’s Windfall Lake is now large enough to sustain a multi-decade life of mine. The focus over the next 12 months is to build an economic case around the deposit and attract partners with expertise to build a mine. Despite having no operating risk or real issues with being temporarily shut to workers, the stock is at ~$2.70 (as at 8 April 2020) having been around $4.00 earlier in the year. Its pure play on gold makes the current discount very obvious; our models show the stock trading at 0.3x NAV. This name is not held by other funds in any size, and is a good example of how we take a genuine medium term view. 

Finally, Silvercorp continues to benefit from its location in China, where production is back to full capacity at its Ying mine. M&A remains a real possibility, the company has plenty of cash and its all-in sustaining costs of production are at a silver price of US$8. 

The past three months have seen unprecedented volatility, market moves and policy responses. Look beyond that, though, and we are looking at an enormous opportunity for investors in gold and silver mining equities, and silver miners in particular; we are primed to take full advantage.

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