GUEST POST: Silver Goes Institutional

Friday, November 20, 2009

It is a special delight to present the following guest post by Sean Rakhimov, editor of, who sees first notable moves from institutional investors into the silver sector.

The Institutionalized Silver Market
by Sean Rakhimov
  • Where were are
The new realities of the precious metal markets are inescapably obvious. In the classic - three legs up, two legs down - bull market pattern, we are undoubtedly in the second "institutional" or "big money" stage. For Elliott Wave fans this would be the 'C' wave, characterized as the longest with a potential break mid-way. Regardless of your interpretation, the evidence suggests that big money is moving into this space in earnest. One could argue that the breakdown in the second half of 2008 threw a monkey wrench into this theory. Indeed, it was a rather painful event for most investors, but in technical terms it did not look all that bad as evidenced here. If anything, it helped anchor the previous move from $253 to $1000. We're not chart experts and are only using this to establish a base for the points we really want to make.

If you're still questioning the main premise of this article, we'll briefly remind you that the likes of John Paulson, Paul Tudor Jones, David Einhorn and a host of lesser known money managers have recently joined the party as has been amply discussed by others. The purpose of this missive is to shed some light into what it might mean to you, the "average investor" and if there are angles to be exploited in that regard.

We also have to mention the blockbuster purchase of 200 metric tonnes of gold by India's Central Bank from the IMF. With that deal in the books there should be no doubt in anyone's mind that gold and silver are hitting the mainstream.
  • What does it mean?
Assuming that is the case, the logical question to ponder is: what does it mean? In other words: how will this fundamental factor impact the market, how will it manifest itself in the share price of mining companies, and how can you and I get in on the action? During this stage, we envision the emergence of two major developments that should be of interest you.

1) These early and prominent leaders into precious metals will be imitated and followed by their less bold or, if you prefer, more conservative peers. That goes for both fund managers and central banks. In that light, if there ever was a time to follow the trend/money, this would be it. We're in the early stages of acceptance of gold (to be followed by silver) by the establishment as a legitimate investment instrument. These are not yet panic days, but naming gold as an investment choice won't raise eye-brows at cocktail parties going forward. You might still get some show of bewilderment, though not far beyond this coming Christmas season. Better yet, it might buy you a few nods of approval on this stretch. Certainly, you won't be instantly discarded as a screw-loose maverick, as was the case only a couple of years ago.

Further into 2010 and beyond, it is likely to become fashionable and perhaps understood that anyone with any sense of the market "has to have SOME gold"; and if you don't, your fellow fund managers will send you condescending looks as if to say "Don't you know everyone is in on the gold game?".
But everyone won't be, it will take time for a lot of newly converted believers to move into gold space and, more importantly, there isn't enough capacity in the sector to accommodate any significant influx of money. The thing to note here is that many funds that never had any exposure to precious metals or commodities will enter this space for lack of better alternatives, at least with a portion of their portfolios.

2) Expect substantial growth in assets under management of the better established precious metal funds, due to inflow of new funds from various sources, including funds operating in other sectors. Another reason will be the rise in share prices of precious metal fund holdings, which will suddenly make them viable competitors for investment dollars with their peers. For instance, a Vanguard Gold Fund would evolve from an obscure specialty fund with comparatively measly assets under management into, at first, a solid and sizeable fund, and later, a top performer and flagship within the group.
This should happen across the board and around the globe. Since success breeds success, it should be followed by increased percentage allocation of investment portfolios to the best performing funds. Remember Fidelity's Magellan fund getting so big it had to close doors to new investors? We expect things to play out in that direction. Not right away, but somewhere on the horizon, in the mania stage.
  • What is a poor fund manager to do?
Imagine you are a fund manager in some non-hard asset sector: bonds, financials, healthcare, tech, etc. Through some soul-searching and head-scratching (and some kicking and screaming) you arrive at the idea that you have to move into hard assets. Trouble is, you have no clue where to begin and how to value resource stocks. Short of hiring a mining analyst, who will be hard to come by for a while, and seeking outside help, these are the main options we see available to ‘do it yourself’ money managers:

  1. The first thing you do is look at the ETFs and other similar vehicles that provide exposure to the sector without having to deal with the nitty-gritty picking stocks. But the space is crowded;
  2. Then you look at the indexes and drill down to the blue chips. That's nice, yet you soon discover that valuations are defying gravity;
  3. Next, you check the top holdings of the best precious metals you can find and move into them;
  4. Do your due diligence and try to make your own picks, but that is a whole lot of work.

This is where things get interesting, so let us set the stage. In the diagram below we tried to identify the dominant money flow trends and highlighted them in shades of green based on where each group of investors is likely to direct the majority of their investment capital (yes, every player in the space will be at once the recipient and allocator of capital). We intentionally downplayed the impact of retail investors at this time, as their day in the spotlight is yet to come during the final blow-off stage of this bull market.

  • How to play it
One of the biggest investment themes of the past decade has been the China play. Everyone knew there was an opportunity there, but finding a way to bet on it without excessive risk was difficult. Eventually it evolved into a "Buy what China buys" strategy. Taking a page from that book, we think a similar approach can be applied here: one should buy what the best investors are buying in the precious metals sector. When we say "best" we don't mean in absolute returns, but rather, those best equipped to identify the most attractive opportunities.

As you can see, we believe the main beneficiaries from money flow trends will be the mid-tier companies; those with established resources and production. This group should be the main focus of precious metal/resource funds and at the same time, become a takeover target for the majors. The acquisition of Canplats by Goldcorp, is a good example of what we're talking about.

The main criteria that may be helpful in spotting these companies are:
  1. Established resources in the ground. Some of the hard and fast numbers to help sort companies are 5+ million ounce gold or 100+ million ounce of silver deposits will be picked off first, however all ounces are not created equal and other considerations apply in the selection of potential takeover targets.
  2. Production profile. Ultimately, production is the goal for majors, so the closer the project is to production, the more attractive it becomes. We would be looking at companies producing 200,000+ oz of gold with 15+ year mine life.
  3. Market capitalization. Another filter investors can use when looking at these stocks is market capitalization. Mid-tier companies, depending on various factors and development stage, will usually sport market caps of $200-300 Million at the lower end for explorers, to $1-2 Billion at the higher end for producers. Certainly, these are not all-encompassing brackets, but by and large the companies discussed above will fair somewhere in that range.
Most likely, all three prerequisites listed above will be true for a good takeover candidate. There are many other considerations which may be important in each specific case – such as grade, project economics, infrastructure, access to water, power and workforce, geopolitical concerns in the country where the assets are, and so on. But we are trying to keep it simple.

We certainly don’t mean to imply that companies elsewhere in the spectrum will not perform well or should not be considered. On the contrary, rising tide will lift all boats without holes in them. Speaking of holes, this is an industry where one drill hole can change the fortunes of all but the largest companies on any given day. So, by all means, entertain all options. That said, this market has gone institutional and the trend is your friend.


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