Tips on How to Play Silver

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After a strong start to the year, the price of silver has turned negative. Furthermore, it has been underperforming gold despite the fact that we will often see silver outperform gold in a bull market. While it is hard to say why the price of silver is underperforming, it could be due to the fact that silver is more economically sensitive than gold, and economically sensitive assets have been underperforming as of late.

Silver has numerous industrial usages, from photovoltaic cells in solar panels to everyday electronic devices — the device you are using to read this article has at least some silver in it. The underperformance could also be due to waning Indian demand. Last year, Indian imports of gold declined because the government imposed tariffs with the intent to restrict gold imports. As a result Indians simply switched to buying silver, and Indian silver demand soared. As the tariffs are reduced gold demand is rising, and this is cannibalizing silver demand.

Despite the weak performance of silver, I suspect that at some point the price of silver will begin to outperform gold, and I suspect that it can begin to perform well even in a weak economic environment. Silver still plays a crucial monetary role, and as poorer emerging nations become more affluent — especially in Asia — investors will demand precious metals. With gold out of reach, investors will turn to silver.

Another factor that will drive silver is the fact that many silver mining companies cannot turn a profit mining for silver, or if they can turn a profit, it is generally minimal. First Majestic Silver (NYSE:AG), one of the most efficient silver miners out there, reported just $5 million in earnings in the first quarter on $65 million in revenues. That company is foregoing planned expansions in order to reduce costs and increase cash flow.

Silver Standard Resources (NASDAQ:SSRI) recently reported a loss, and it is also suspending development of its largest silver mine, Pitarrilla, in part because the silver price is too low. Seeing that this mine will average about 15 million ounces of production this is a big deal considering that only about 750 million ounces of silver are mined annually.

Given these factors, investors should consider taking a position in silver and related assets. I think investors have time to do so. The price of silver saw significant resistance in 2008 at about the current price level. Once it got about $20 per ounce in 2010, it quickly rose to nearly $50 per ounce, or the all-time high reached in 1980. The price has since come back to roughly the $20 per ounce level, which has become strong support. I suspect that it is going to consolidate for a while before rising higher.

Given this, I think one position that makes sense is the Credit Suisse Silver Shares Covered Call ETN (SLVO.PK). This fund buys silver and sells covered calls against the position. This means that investors will get a hefty dividend, especially given that silver’s volatility increases the value of call options. If silver does nothing, investors in SLVO shares can expect an income well over 10 percent and possibly over 15 percent. The only downside comes if silver rises substantially, in which case SLVO investors lose out on much of the upside.

Another excellent silver play is Silver Wheaton (NYSE:SLW), which has substantially outperformed its silver mining peers, the price of silver itself, and America’s broader stock market indexes. Silver Wheaton makes deals with mining companies to buy silver streams (i.e., agreements by which the mining company sells an agreed-upon amount of silver to Silver Wheaton at an agreed upon price, about $4 per ounce). The business model has worked extraordinarily well, and Silver Wheaton has high profit margins and incredible growth ahead.

Of course, investors can also buy mining companies, but these aren’t for the faint of heart. As previously mentioned, many of them simply aren’t making profits with silver this low. One that stands out as comfortably profitable – Tahoe Resources (NYSE:TAHO) — operates in Guatemala, and this brings a significant amount of risk with it. Thus, you should buy silver miners only if you can stomach the volatility and a lack of profits in the near term. However, if you pick the right silver miners and buy them in this environment, then you can make an extraordinary amount of money.

Disclosure: Ben Kramer-Miller is long First Majestic Silver, Silver Standard Resources, and Silver Wheaton.

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