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November
17, 2006
By:
Don Hansen
SILVERAXIS.com
As
a follow-up to my “value strategy” article,
a very recent situation in silver mining
shares exemplifies the extent to which the
gold and silver mining sector provides ample
opportunities for both investing and speculating. Unfortunately,
many newsletter writers and the buzz on
the Internet are focused exclusively
on speculating, resulting in an emphasis
on explorers with lots of story but little
substance. On the positive side, this can
create opportunities for mining share
investors who look to balance risk
and reward instead of make a killing in
the markets. To clarify terminology, I
define speculation as being primarily focused
on potential return with few facts to adequately
assess risk, and investment to be a process
of focusing on return using widely available information
to evaluate both risk and the probability
of achieving a stated level of return.
The
situation to which I refer involves Esperanza
Silver (EPZ in Vancouver and ESPZF on Pink
Sheets), Silver Standard (SSO in Toronto
and SSRI on Nasdaq) and the San Luis project
they jointly own in Peru. In this case,
bonanza grades of both gold and silver have
been found according to recently
reported drill results. Esperanza shares
went up dramatically on the news and have
since traded over CDN$3.00 (US$2.50) per
share. With approximately 37 million shares
outstanding at last report, this comes to a US$90
million market cap. Meanwhile, Silver Standard,
with a market cap around US$1.5 billion, barely
budged on the news.
So,
it looks like a junior explorer has
hit the jackpot and is all of a sudden a
great investment while Silver Standard is
too stodgy a silver stock to warrant investor
enthusiasm. Well, looks can be deceving;
please read on.
The
reality about San Luis when you dig beneath
the headlines is that Silver Standard is
currently on its way to owning 55% of the
San Luis project and can earn an 80% interest
if it funds it through to production. So
while Esperanza shareholders should be excited
by the prospects of a world-class discovery,
Silver Standard shareholders stand
to also benefit, perhaps more so. To see
why, we need to roll up our sleeves a bit.
Let's
assume that San Luis is a world-class deposit
and deserves a pre-feasibility valuation
of US$1.5 billion. If Silver Standard decides
to fund 80% of the project, then $1.2 billion
of that value would naturally accrue to
Silver Standard shareholders. Not bad considering
Silver Standard currently has a market cap
of approx. US$1.5 billion--an 80% return
on a single project--when you keep in mind
this is just one of many Silver Standard
projects in the pipeline. True, San Luis'
net present value would be affected
by mine development costs, but it should
still be an attractive number even for a
silver company the size of Silver Standard.
If
Silver Standard were to share development
costs with Esperanza, it would then be left
with 55% of the project, still a significant
asset if San Luis turns out to be world-class.
Whether Silver Standard decides to fund
the project and earn 80% or share development
costs and retain 55% is a financial decision
outside the scope of this commentary, but
in either case Silver Standard shareholders
would have all upside and no downside (remember,
the stock price has not taken this project
into account).
Now,
what about Esperanza? 20% of $1.5 billion
is $300 million representing a potential
200% upside to the current $90 million market
cap. Without the burden of development costs,
such a 20% carried interest might perhaps
be valued even higher by the market. And
should Silver Standard decide to share development
costs, Esperanza could retain 45%. Depending
on how Esperanza approaches project
funding, the 45% joint-funding stake might
be worth less or more than a 20% carried
interest. In any case, it is clear that
should San Luis turn out to be world-class,
Esperanza would have a significant upside
from current prices.
But
what about the risks? As I have pointed
out, Silver Standard shareholders have let
out a collective yawn as San Luis is simply
another project in a large portfolio of
silver projects, many of which could become
world class. So it would probably be safe
to say that if San Luis does not pan out,
there would be little to no impact on Silver
Standard's share price. I would pretty
much call that zero risk.
In
the case of Esperanza, San Luis is one of
two flagship projects and most likely responsible
for much of this junior explorer's perceived
value. If San Luis fails to advance as a
project for any of a multitude of reasons
and Esperanza is unable to replenish it
with another prospective project, the share
price could drop significantly, perhaps
as much as 80%.
So
which stock should be purchased to gain
exposure to this exploration story? That
depends entirely on what your risk tolerance
and expectations are. Esperanza is clearly
a speculation play on the San Luis project.
Silver Standard is obviously a diversification
play on silver ounces in the ground, although
the company does plan to start developing
its Pirquitas project in Argentina next
year.
I
personally choose to try to be the best
investor I can be while keeping speculation
in my portfolio fairly limited, so I would
choose Silver Standard. History’s most successful
investors from Warren Buffett to our
own Rick Rule in the resource sector all
teach that consistent investment success
is about reducing risk while getting a good
return. On the other hand, someone looking
for maximum exposure and short term gains
using money they can afford to lose may
decide that Esperanza is the better way
to play this developing story. And there
is always the opportunity to purchase both
Esperanza and Silver Standard in whatever
relative proportion is suitable for a
particular investor.
My
objective in this article was not to recommend
that you buy either Silver Standard or Esperanza
but rather to point out that in order to
be the most successful in terms of our own
investment goals, we need to understand
the difference between speculation and investing.
Hopefully this will allow us to make choices
with which we will be happy. In addition,
understanding our own investment philosophies
allows us to evaluate whether or not we
have the skills and knowledge necessary
for what we are doing and why. In my
own case, I am not a mining professional
so my ability to evaluate the risks inherent
with mining-related companies is limited.
That is why I try to think more like an
investor than a speculator in this market.
That is also why I developed the "value
strategy" presented in an earlier
article.
**
Don
Hansen is a retired entrepreneur who has
been investing in silver mining stocks since
2001.
Disclaimer:
We hope others will find this approach interesting
and useful in making their investment decisions
but we caution all investors that this is
not an investment recommendation and that
each investor must consider his or her own
investment criteria, horizon, suitability
and other factors before making an investment
in these or any other stocks. Inexperienced
investors should consult with a registered
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herein is believed to be accurate but we
make no guarantees to that effect. We are
under no obligation to correct errors or
update any information, which is only timely
as of the date of publication. Forward-looking
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all viewpoints expressed herein are solely
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represent the opinions of www.silveraxis.com.
The author and/or persons associated with www.silveraxis.com
own shares in some or all of the companies mentioned
and therefore are biased in their favor.
No compensation was received from the companies
mentioned nor was the author asked by anyone
to produce this commentary.
Copyright
© 2006 Don Hansen - contact www.silveraxis.com
for reprint permission
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