Soaring silver miners: Fresnillo and Hochschild Mining

There are a number of entrenched dynamics that make gold an attractive proposition these days - and where gold goes, silver tends to follow (but with added rocket fuel).

In fact, some call silver the long shadow of gold. It’s a riskier and more leveraged play on the same dynamics of widespread currency debasement and non-existent bond yields.

The correlation is slightly obscured by larger industrial demand for silver, but they are correlated nonetheless.

Silver is more volatile because it is a smaller market with lower liquidity. Back in the 70s and 80s the Hunt Brothers cornered the entire private market, taking a huge leveraged position and causing the dramatic price spike in the chart below.

They allegedly held one-third of the entire world supply of privately held silver.

This remarkable situation prompted the jeweler Tiffany's to take out a full page ad in The New York Times, saying "We think it is unconscionable for anyone to hoard several billion, yes billion, dollars' worth of silver and thus drive the price up so high that others must pay artificially high prices for articles made of silver".

This standoff was ultimately resolved through a combination of changed trading rules on the New York Mercantile Exchange (NYMEX) and Federal Reserve intervention. By 1982, the London Silver Fix had collapsed by 90% to $4.90 per troy ounce.

In conclusion: a smaller and more volatile market. You can see below that even today total annual silver supply is a fraction of that of gold.

With everyone talking about the gold price hovering around the $2,000 mark, there are signs of life in silver as well.

This is purely anecdotal, but I’ve heard a couple of institutional investors in the space throw out some eye-catching silver price predictions that blow historic norms out the water. They are talking their own book of course, but what’s more concrete is that they are seeing considerable inflows right now.

Investment demand shows a 10% gain so far in 2020 as investors actively accumulate silver. As of June 30th, global ETF holdings reached a fresh all-time high of 925 million ounces (Moz).

The two spot prices are taking a breather, but the sheer tectonic scale of modern monetary theory (QE, negative interest rates) and the resulting institutional asset rotation into alternative stores of value suggest to me this could be a trend that runs and runs.

The 6y chart view of this basket of silver miner candidates tells a story, with recent strong breaks above the 200-day moving average:

I think silver is worth a look for the following reasons:

• Investment inflows will continue in the second half of 2020 (and likely beyond) thanks to its safe-haven status,
• Low interest rates have reduced the opportunity cost of both gold and silver,
• Unprecedented liquidity injections by central banks should increase their purchasing power, and
• Silver is a smaller, riskier market than gold but with possibly greater potential upside.

There aren’t many dedicated silver miners that I’m aware of. I’ve taken a first look at Fresnillo and Hothschild Mining below but if you’re aware of any promising candidates just leave a comment.

This cost curve chart from Metals Focus gives a useful sense of perspective in terms of judging how efficient these miners are:

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Fresnillo (LON:FRES)

Market cap: £9.6bn

Net cash (debt): - $300m

1y relative strength: 114%

AISC: $13.5

Silver production (2019): 54.6Moz

Fresnillo (LON:FRES) is the world’s largest primary silver producer with seven operating mines in Mexico, as well as a number of other long term exploration prospects in Mexico, Peru and Chile.

Improving sentiment for silver is obvious on Fresnillo’s StockReport, with healthy relative strength and improving broker forecasts.

It also qualifies for two Momentum Screens: Earnings Upgrade, and Value Momentum.

With a market cap of nearly £10bn and annual revenues upwards of $2bn, FRES is no tiddler. That scale hopefully makes it one of the safer miners - but it might also limit upside.

It has a very manageable net debt position of £300m, as well as strong liquidity and financial health ratios.

FRES has proven itself to be reasonably cash generative and has made consistent dividend payments over the years.

The group says it’s policy is ‘guided by the principle of providing shareholders with full exposure to gold and silver prices’ so there is a good chance of free cash flow and dividend payments increasing over the next couple of years assuming spot prices continue to appreciate.

Again, that is far from certain - but my view is that an extended run of increasing spot prices is quite possible.

DYOR of course and I welcome a debate on this point.

Investment case

ETFs aside, Fresnillo looks like a financially safe and operationally stable large cap miner in the silver space. It sails past the Financial Health checks, which partially explains the impressive Quality Rank of 82.

The group is financially stable and well invested. It has a modest net debt position of c£300m and it makes a point of investing throughout economic cycles - so if there is a prolonged uptick in silver prices, this miner is well placed to capitalise.

It also has high quality assets and long life returns. It is among the largest concession holders in mineral-rich Mexico, with c1.8m hectares of surface land.

According to FRES its portfolio of low cost gold and silver mines, high potential development projects and advanced exploration prospects “contain over 2,171.5 moz of attributable silver resources and 38.4 moz of attributable gold resources”.

The group’s ability to control costs and generate good returns on capital and operating margins in less favourable price environments bodes well for the future.

Half Year report

The group recently updated the market on trading and the outlook sounds encouraging. CEO Octavio Alvídrez commented:

The combination of higher commodity prices and lower costs has resulted in a significant rise in profitability during the first half. Our performance improvement initiatives we have set out in previous reports are having a positive impact. We remain committed to delivering a sustainable improvement in our operating performance and maintaining the momentum in the improvement plan into the second half.

Some financial highlights:

• Gross profit up 56.3% to $321.2m
• Operating profit up 232.1% to $216.9m
• Profit before tax up 136.6% to $127.9m
• Adjusted earnings per share up 40.5% to 11.8 cents
• Free cash flow of $242.6m (versus an $80.7m free cash outflow in H1 2019)

Conclusion

First impressions are that this is a reasonably safe, profitable miner that is well-invested and therefore well positioned to benefit from rising silver prices.

Production is down only slightly year-on-year despite the spread of COVID and FRES maintains its full-year targets of 51-56moz silver and 785-815koz gold.

The miner has plentiful resources - about 2.3bn oz of silver and 39m oz of gold - and says it operates at a consolidated silver cash cost of $7.31/oz compared to the current silver price of around $27. It’s track record for returns on capital suggests quality assets and a disciplined approach to capex.

DYOR as always, but if you’re looking for exposure to the silver price then the world’s largest primary silver producer seems like a sensible place to start.

Hochschild Mining (LON:HOC)

Market cap: £1.19b

Net cash (debt): -$57.3m

1y relative strength: 35.7%

AISC: $11.9

Silver production (2019): 16.8Moz

Hochschild Mining (LON:HOC) currently operates three underground mines - two in southern Peru and one in southern Argentina - and also owns numerous long-term projects throughout the Americas.

With a modest amount of net debt and strong financial health scores, HOC also presents itself as a potentially ‘safe’ silver miner.

The group’s current score of c1.8x is solid, but not as encouraging as Fresnillo’s liquidity. HOC also pays dividends but the track record here is a little patchier.

It appears to trade at a pretty attractive discount to its peer group.

But a look at HOC’s most recent update shows COVID-related operational disruption - so is the discount warranted?

2020 Revised Guidance

HOC has confirmed that its flagship Inmaculada site is back to full capacity and its revised FY20 production target is for 24-25m silver equivalent ounces at a silver equivalent all in sustaining cost of between $14.5-15.0.

There are ongoing restrictions in Peru and Argentina but the group expects to “deliver a solid second half of production with strong expected cashflow generation.” You can see from the table below just how much Q1 and Q2 production was hit.

I don’t think HOC is out of the woods yet. It has clearly faced more disruption than FRES but then again that relative valuation discount prices some of this in.

What’s more exciting is the average realisable prices reported by HOC in Q2 2020:

• $1,826/ounce for gold - up 35.7% (Q2 2019: $1,346/ounce), and
• $19.8/ounce for silver - up 33.8% (Q2 2019: $14.8/ounce for silver)

If those numbers continue to trend upwards over, say, a two-year horizon then a couple of quarters of disrupted operations might be a small price to pay.

Alternatives

Both FRES and HOC have a Speculative RiskRating, meaning their share prices are quite volatile.

With much less dedicated silver miners around, and a smaller, more volatile market, ETFs could be an attractive option for some.

I’m more of a stock picker but I can clearly see the case for more broad-based exposure here.

The leveraged nature of the silver price would give plenty of scope for upside if the bull case plays out. The iShares Silver Trust (the biggest silver ETF out there) has had a stellar year in terms of share price.

In one of Edmund Shing’s excellent Market Musings posts he points to another silver ETF: the SILJ Junior Silver Miner.

At the moment I’m considering stakes in both FRES and HOC to dilute away some of the company-specific risk. Of course spot prices can go down as well as up, but the bull case for silver looks attractive to me and I will continue to investigate ways of gaining exposure here.

If anybody out there is thinking along the same lines it would be great to spark a conversation on the topic.