A Silver-Linked Dividend Without the Silver Lining

Hecla Mining Co. is copying Newmont’s strategy. It announced last month that its dividend will be linked to the price of silver:

All dividends, including those in the third quarter, would increase or decrease by $0.01 per share for each $5.00 per ounce incremental increase or decrease in the average realized silver price in the preceding quarter.

Here’s the resulting payout diagram:

Data from January 1999 to October 2010 show that, with the brief exception of the summer of 2008, silver prices have never been above $25. Prices above $30 are a phenomenon of the last twelve months. Expecting silver prices to go up in the future, Hecla is giving investors extra leverage…if its prediction comes true.

But investors can also bet on silver prices with ETFs, such as the iShares Silver Trust Fund (SLV).  By opting to invest in the SLV rather than Hecla over the past two years, investors would have been systematically better off, with the exception of the last two months of 2010.  This year, the comparison looks particularly bad for Hecla: investors face a return to date (October 7) of 1.7% with the SLV, compared to a negative return of approximately -50% in Hecla.

It is therefore no surprise that Hecla’s management is trying to persuade investors that investing in Hecla is like investing in silver. But investors should be reminded that the similarities are not that strong. Factors such as the quality of the management, the company’s costs per ounce produced, the stage of the company’s mining ventures, and political risk all impact silver exploration companies in a way that does not impact silver itself.  Silver companies practically only outperform silver when they exercise a real option that actually strikes silver!

Speaking of options, an investor can easily replicate Hecla’s silver-linked dividend policy by buying, for each share of Hecla, 1/500th of an Asian call option on silver with a strike price of $25, for a payoff equal to:

C(T) = (1/500) max{Average Price of Silver(past quarter) – $25, 0}

This alternative has the advantage of lower risk, dependent only on silver prices rather than on Hecla’s management and financials. Hecla’s dividend offer does not have a silver lining.

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