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TheStreet Open House

Silver Stocks: Long/Short Strategy

Stocks in this article: SLWSSRIABX

NEW YORK ( TheStreet) -- Our top silver stock pick for months, Silver Wheaton (SLW), has been the top gainer and Silver Standard Resources (SSRI) has been the top loser among the silver stocks, year to date.

Based on our outlook, buying Silver Wheaton and shorting Silver Standard Resources will likely generate more gains on a risk-adjusted basis than investing in any of the silver stocks. For 2010, Silver Standard is estimated to report a loss of 3 cents per share, in comparison to the earnings of 64 cents per share for Silver Wheaton, according to analysts polled by Bloomberg.

Silver Wheaton's production is expected to increase 35% this year following the acquisition of Barrick Gold's (ABX) silver mines and Silverstone Resources this past year. The silver miner expects to increase annual production at a CAGR of 23.7% until 2013, positioning itself among the world's top silver producers. The miner's production costs will continue to be below the industry average, benefiting from the 13 silver purchase agreements that allow the purchase of production at a low fixed cost.

Investors remain cautious about Silver Standard, even after the appointment of a new president and CEO in the last week of May. Although the company has seen some improvements since the resignation of the former president and CEO in January, the stock continued its decline. The company transitioned from a development company to a producing company this year. Robust second-quarter results and the reiteration of full-year guidance will be critical in rebuilding some of the confidence that has been lost. Hence, short positions in the stock must be verified on the announcement of results.

In addition, investors will remain cautious on the company's start-up operations experience and capability of delivering on the Pirquitas mine. Also, the company's profitability from Australia operations will decline on the country's "super" profit tax, which will impact overall profits of the company.

According to TheStreet Ratings, the stock is graded "D" (Sell), in comparison to the "B" (Buy) for Silver Wheaton.

Result of Long/Short Strategy on Year-to-Date Performance

If an investor had invested 50% in buying SLW and 50% in shorting SSRI early this year, the absolute return for this portfolio would have gained 26.3% with no sector risk. In comparison, the S&P 500 and silver for spot delivery New York Mercantile Index gained only 0.08% and 10.9%, respectively, year to date. The beta for the long/short portfolio would have been -0.04, calculated as the weighted average of the two betas, much better than SLW's 1.22 and SSRI's 1.31.

In a beta-zero strategy, the portfolio is constructed to have zero beta. In order to achieve zero beta for the portfolio, investors should have invested 51.8% in a long position of SLW and 48.2% in a short position of SSRI, early this year. Absolute return of this portfolio would have been 26.7%, which becomes a risk-adjusted return of the portfolio, since the beta is zero.

Silver Wheaton has been the star performer among silver stocks, surging around 38.1% year to date. On a risk-adjusted basis, the stock outperformed the S&P 500 index during the past six months. Other major silver producers, Compania de Minas Buenaventura (BVN), Mag Silver (MVG) and Pan American Silver (PAAS) gained 17.3%, 11.5% and 12.4%, respectively, year to date.

Meanwhile, Silver Standard Resources declined 14.3% year to date. Coeur d'Alene Mines (CDE), Hecla Mining (HL) and Endeavour Silver (EXK), declined by 13.1%, 10.0% and 3.3%, respectively, year to date.

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