Since spiking in the first half of 2016, silver and silver miners have had little love. Since then the ETFMG Prime Junior Silver Miners ETF (SILJ) has fallen roughly 50% in value from $20 all the way to $10. We believe both SILJ and silver (NYSEARCA:SLV) are currently one of the best short and long-term opportunities in the market.
Macro-Economic Themes
Precious metals saw their last major rally during late 2016. During that time financial asset fears were running high and economic data was subpar following the culmination of the international debt crisis.
Oil appeared to have bottomed out, which signaled deflationary pressures were subsiding. Nevertheless, the central banks surprised the markets and delayed rate hikes in the United States and cut rates in Europe and Japan. This caused long-term rates to see a sharp decline which then allowed for inflation acceleration concerns to rise. Thus, supporting a sharp rally in silver and gold.
Today, we believe the situation is surprisingly similar to that of late 2015, right before silver saw a large rally. Similar to then, the U.S Dollar lost its rally, economic data missed expectations, inflation was low (with the potential to rise rapidly due to delayed rate hikes as in the ECB today), and international debt repayment fears were spiking. These macroeconomic pressures could, and more likely than not will, create a perfect storm for silver.
On top of that, the gold to silver ratio has recently hit its long-term resistance zone of 80 oz of silver to 1 oz gold.
Similar to after late 2015 and the financial crisis, the gold to silver ratio was at this level before falling over 20% both times. This alone signals that silver should outperform gold in the coming year to two years by possibly 20%.
Thus, we believe silver will rally over the coming year to between $17-$20, which is the rough area silver rose to in early 2016. There is no telling where exactly silver will be beyond a year from now, but we believe prices should rise to and remain above $20 for an extended period of time as the gold to silver ratio falls back to its long-term average of 50-60.
Corporate Fundamentals
We found it best to take a look at the top 10 holdings within SILJ to determine if the fund was a better investment opportunity than silver directly (SLV). For that to be the case, there would need to be meaningful undervaluation in SILJ given a rise in silver prices.
In order to estimate future cash flows, we looked at the gross and operating margins for the companies as well as their enterprise value to EBITDA. Here are our results for the ETF's top holdings (which make up over 70% of the fund):
As you can see, the typical company in the fund is relatively small at an average market capitalization of just under 1.5 billion. Enterprise value is typically just over 2X revenue, margins are relatively high (the U.S average is about 10%), and EBITDA multiples are very low at 6.4 (less than half of the S&P 500's average). Even considering the current low price of silver, these companies look like a good investment.
To take it a step forward we will estimate the breakeven price of silver for these firms and extrapolate that information into the macroeconomic pressure for higher silver prices. We will estimate that the typical silver spot price in Q1 2018, when the latest earnings data was released for our purposes, was roughly $16.5 per ounce. Given an EBITDA margin of 25%, that gives us a rough breakeven estimate of $12.4 per ounce.
Given a 25% rise in silver to $20 per ounce, we estimate that the typical firm in SILJ will see their EBITDA per ounce rise from about $4.1 to $7.6, or a 85% rise in net EBITDA. At its current multiple that, of course, implies an 85% rally in SILJ over the course of one to two years, but we believe the actual result could be even better as valuations return to market standards.
Silver miners have a lower EBITDA multiple due to perceived market risk. These firms currently operate in a tough macroeconomic climate. On top of that, their long-term growth prospects are determined via new discoveries and thus are limited.
That said, we believe the market is putting too high a valuation premium on these companies. They have low debt, strong margins, and bottoming revenue. We expect that multiples eventually rise from 6.4X to 9X, granting another 40% potential upside for SILJ. Combined with our macroeconomic outlook on silver, this gives SILJ a potential 120%-180% upside over the coming year or two. Granted, SILJ is extremely volatile with yearly volatility typically between 30% to 100%+, but we still see great reward per unit of risk.
Great Technical Positioning
Currently, the technical point of both SLV and SILJ is excellent for a long opening. Prices took a large hit during the culmination of trade-war fears last month and are just beginning to pare back losses.
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