Fresnillo's silver bullet

This time our tip isn't based primarily on Fresnillo's valuation. Currently, the miner is trading broadly in line relative to the performance of industry peers, and to the stock's historic earnings multiples. And we won't be delving into Fresnillo's current operational profile; suffice to say that it remains on track to achieve its production targets of 43m ounces of silver and 450,000 gold ounces in 2014. Our renewed faith is linked more to a conviction that the outlook for precious metals markets, particularly that of silver, should improve significantly in the coming months.

We maintain our view that Fresnillo is as well managed as any of the precious metals pure plays, but it's hard to ignore the correlation between the miner's share price and spot prices for the underlying commodities, particularly as it does not hedge exposure to gold and silver prices. So any sustained downturn in prices tends to have a commensurate effect on Fresnillo's valuation. That's hardly surprising when you consider that the adjusted gold/silver revenue split for the company during 2013 was 48/47, with the remaining 5 per cent attributable to by-product lead and zinc output.

Given this exposure, a note of caution is probably warranted. If anything, since we exited our tip, market sentiment towards gold and silver spot prices has weakened. Inflows into the US dollar increased, while gold demand from both India and China receded. But we view the latter factor as temporary, although it must be acknowledged that treasury demand for gold will invariably slacken when the US Federal Reserve eventually starts to meaningfully reduce its bond-buying programme. But sentiment towards the yellow metal can change quickly. Last week, traders reported an upsurge in demand as concerns mounted that the US recovery may be stalling and on the insurgency in Iraq, which boosted demand for the metal as a safe haven.

We also maintain that - based on 'all-in' industry cash costs - the price of gold is unlikely to fall below $1,200/oz (£714/oz) for a sustained period. That contention - and it is just that - is potentially significant when weighed against the gold/silver price ratio, which currently stands at 68. That is roughly the level recorded just prior to the last upward price surge recorded by silver five years ago. It is also well above the long-term average ratio of 50-55. It's logical to suggest that the ratio will converge with its historic average. Admittedly, this could conceivably be brought about by a fall in the gold price. But given that gold - despite overtly bearish predictions - has held its own around the $1,250 mark, we believe that a new floor has been established. So if the gold price stays where it is, then the only way the ratio will narrow is if silver outperforms gold. It's probably overdue anyway, given that gold has outperformed silver by a margin of around 17 per cent over the past two years.

There are a number of other compelling reasons why silver - and by extension - Fresnillo is set to outperform. Silver futures trading in China have soared, underlining an overall step-up in investment demand. Last year, trading volumes of silver on the Shanghai Futures Exchange finally eclipsed COMEX/CME traded silver futures. And while physical imports of gold into China trailed off in the early part of this year, silver imports registered a double-digit percentage increase. Fabrication demand for the metal has also increased substantially. All this is taking place at a time when silver inventories have been drained due to the collapse in the secondary market for the metal. The metal's current market price simply doesn't outweigh recycling costs. Though miners like Fresnillo have managed to increase primary supply, the overall market is actually in deficit. The fragility of the supply/demand balance is reflected in the ratio of mining supply to inventories, which has narrowed from 7:1 to 1.2:1 since 1990.