We recently published our updated Royalty Company Report for 2011 and one of the initial observations we made was that at the current price Silver Wheaton (SLW) appears to offer superior value compared to its major royalty peers, Royal Gold (RLGD) and Franco-Nevada (FNV). This has not always been the case and it is a bit surprising because higher multiples are typically attached to silver versus gold producers. Indeed, it can sometimes be hard to find good value in the silver space because of this “silver premium”. However, the current negative market sentiment has created opportunities such as the pairs trade we present today and we intend to highlight more of them in an updated Silver Producers Report along with a new list of our favorites.
We’ve published our pairs trade strategy at Seeking Alpha so we will only repeat the introduction here. If any subscribers would like to follow this trade then please leave a comment for us below so that we know to update the relative fair values periodically.
Introduction
Today we’re simply going to look at the pairs trade strategy of going long Silver Wheaton and short Royal Gold. The basis and reasoning for the trade are as follows:
- Having modeled an extensive discounted cash flow analysis of Silver Wheaton’s 19 producing and development royalties and Royal Gold’s 42 royalties we’ve determined that Silver Wheaton offers better relative value at the current price.
- Companies with predominantly silver exposure tend to trade at higher multiples to companies with predominantly gold exposure and therefore we expect relative outperformance by Silver Wheaton as positive sentiment eventually returns to the market (which we expect will happen after a final washout early next year).
- The strategy is essentially bullish on precious metals because silver prices tend to rise faster than gold (but also to drop further). Significant ongoing weakness in precious metal prices, however, would suggest waiting for an even more opportune time to execute this pairs trade, or better yet, to leg into it by making purchases over several weeks.
- Both companies own royalties on Barrick Gold’s (ABX) Pascua-Lama and Goldcorp’s (GG) Penasquito project which together account for a significant component (greater than 25%) of their overall valuation and future growth profile; having royalties on the same projects increases correlation and therefore reduces the risk of further aberrant divergence on the pairs trade.
Disclaimer: We do not currently own any of the companies mentioned herein but we may initiate the strategy described above at any time. No compensation has been received from any of the companies mentioned. This is not investment advice; should you seek investment advice we recommend you discuss the company with a licensed investment advisor or broker.
Let’s see how this trade has panned out so far (click to enlarge):
http://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1332187200000&chddm=30584&chls=IntervalBasedLine&cmpto=NASDAQ:RGLD;NYSE:SLW;NYSEARCA:GLD&cmptdms=0;0;0&q=NYSEARCA:SLV&ntsp=0
Silver Wheaton (red) is up 18.83% versus a loss of 9.07% for Royal Gold for a pairs gain of about 28% so far.
In the full version of our pairs trade analysis published at Seeking Alpha we wrote the following:
I’ll just add that it should be very possible to run a trade like this at full margin and so the gain would be 56%, not 28%. With the ability to trade this pair in size, this would have been a trade of the year for most hedge funds, if not the decade. Hopefully many more like this coming from the royalty and other models especially as we convert all data to the new format and charts. We welcome hedge funds as subscribers by the way…they just need to use the Institutional rate (still a killer deal at $997…heck this one trade was easily worth $100,000 considering most “pros” being paid huge salaries will not come up with something like this in a year, if ever).