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A popular way to invest in precious metals has been to purchase shares in royalty or streaming companies (just "royalty" companies here on for brevity's sake, I will clarify the distinction presently). The largest and most popular of these companies include Royal Gold (NASDAQ:RGLD) and Franco-Nevada (NYSE:FNV) for gold (NYSEARCA:GLD), and Silver Wheaton (NYSE:SLW) for silver (NYSEARCA:SLV).

Investors who have held shares in these companies for several years have made fortunes. Royal Gold shares traded at just $0.03 in 1992 and they now trade at $61. Even if investors were unable to catch this bottom the shares are up nearly twenty times since the turn of the 21st century--not bad given that gold is up just five times. Silver Wheaton investors have made over 700% on their money since July 2005 when the shares began trading on the NYSE. While it is unlikely that such returns will be achieved in the future, purchasing royalty companies seems to be the best way to invest in precious metals as they have outperformed the metals themselves as well as the mining company indexes such as the XAU and the HUI Gold Bugs Index.

Despite this long-term outperformance, recently the royalty companies have seen huge corrections. Franco-Nevada has lost over 1/3 of its value from its October 2012 peak, and it is actually down 13% since it began trading on the NYSE in September 2011. Royal Gold is down 40% from its October 2012 peak (although the company did issue five million shares at this level, which may account for this correction), and Silver Wheaton shares are down over 40% from their April 2011 peak. These corrections seem to be long overdue: as I discuss below the limited supply of royalty company shares has led to their shares being relatively overvalued with respect to their mining company share counterparts, as the lower risk business model of the royalty companies has made their shares too enticing for some investors to pass up. Yet these corrections have likely brought the values of royalty companies to a fair level where investors might consider initiating positions after they consider the benefits and risks of owning them, which I discuss below.

In this series of articles I will discuss the royalty companies. In this article I will discuss the particulars of the royalty companies' business model and I will lay out the pros and cons of investing in a company with such a model. In subsequent articles I will discuss individual companies.

1: What is a Royalty Company?

Royalty companies are financing companies that make potentially mutually beneficial agreements with mining companies. In particular there are two types of agreements that royalty companies can make: royalty agreements and streaming agreements. A royalty agreement gives the royalty company an economic interest in the mining property in question, and it benefits by receiving a percentage of the production of one or more resources produced on that property for an agreed upon time period. A streaming agreement allows the royalty company to purchase a portion of one or more of the metals produced on the property specified in the agreement for an agreed upon price. Readers who are interested in the specifics of royalty and streaming agreements should consult Franco-Nevada's website.

The royalty company is betting that the price of the resource(s) that it will receive in the future will increase. It is also betting that the mining company will be able to bring the mine in question into production, and that the mine will produce a sufficient amount of the resource in question in order to make its initial investment worthwhile.

On the other side of the equation, a mining company might choose to make such a deal for several reasons. For one it may be a small company in need of funds, and it may decide that the best way to get these funds without having to heavily dilute shareholders or pay sky-high interest rates to bond holders is to set up a deal with a royalty company. An example of this is Royal Gold's royalty contract with Copper Fox Metals Incorporated (OTCPK:CPFXF). Royal Gold is entitled to 3.5% of net profits interest of all of the metals produced (gold, silver, copper, and molybdenum) by Copper Fox's Schaft Creek Mine, which is not yet in production.

Another possibility is that the mining company is a self-defined miner of a particular resource, and the mine in question contains some of another resource. Because the company's shareholders are interested in exposure to the first resource and not the second, the mining company may decide to fund the development of the mine in question by selling its production of the non-core resource to a royalty company. An example of this is Silver Wheaton's royalty contract with Primero Mining Corp. (NYSE:PPP) that entitles Silver Wheaton to all of Primero's silver production at its San Dimas mine for $3.90 per ounce at the time (2004) plus inflation for 25 years (the deal was originally made with Goldcorp (NYSE:GG) who sold the San Dimas mine to Primero in 2010).

These deals can take a variety of forms. In general the mining company gets capital up front, stock in the royalty company, or a little to no interest loan from the royalty company. The royalty company gets exposure to the mining company's future production: it can be one or all of the metals the mine produces, it can be a royalty or a streaming agreement, and the royalty payment can be for the life of the mine or for some fixed period of time. Given that the mining company and the royalty company have different goals and different financial situations, it is not difficult for the two companies to come together and make a deal that is mutually beneficial for both parties.

2: The Advantages of Owning Royalty Companies Over Mining Companies

A: Royalty companies generally have extremely high profit margins. Royalty companies have very little overhead costs. While mining companies have to hire miners who could potentially strike for higher wages or die in the company's mines, royalty companies do not face any of these issues directly (they do face them indirectly as I discuss below). Silver Wheaton, for example, only has 24 employees according to Google Finance. Royalty companies also do not have to face rising energy costs, punitive mining taxes, environmental protocol expenses, and so on. It is for this reason that the major royalty companies all have net profit margins that exceed 30%. Silver Wheaton in particular has a net profit margin that exceeds 50%.

B: Royalty companies have extremely predictable expenses. As I stated above royalty companies do not have to worry about several of the variable costs that mining companies have to deal with. They make deals with the mining companies, which entitle them either to free resources or to resources at a fixed cost. In general they make one time payments to the mining companies they deal with, and often these payments are not in cash, but in stock or debt. Such predictability in such an uncertain market place should command a hefty premium.

C: Royalty companies are highly diversified. The major royalty companies have royalty streams from numerous sources, and they have extensive pipelines that ensure profitability and growth in the future. In general if a single royalty stream fails in the future, the damages to the royalty company will be minimal. Compare this to mining companies. Even a single lost mine experienced by a large mining company can be devastating. In 2011 Agnico-Eagle (NYSE:AEM) lost its Goldex mine and the stock proceeded to lose over half of its value (it still hasn't recovered, although gold prices are still down). The company had to take nearly a $1 billion write-down, and it lost over 15% of its production. Such an event simply cannot happen with a royalty company. The smallest royalty company of the three major ones by market capitalization is Royal Gold, which has royalty agreements on 36 producing properties and over 200 total properties. It would take several disasters to seriously injure Royal Gold and its peers.

3: The Disadvantages of Owning Royalty Companies Over Mining Companies

A: Royalty companies are not in control of their own destiny. A royalty company can evaluate a mine, the management team that intends to build it, and the financial position of the mining company. It can provide funding to the company in exchange for the rights to future production. But after that it is up to the mining company to execute. Royalty companies often make deals with mining companies on properties that are not yet in production, and it takes a lot of work in terms of construction, geological assessment, environmental assessment, economic assessment, and labor relations, in order to bring a piece of land with some valuable rocks in it into a situation where it is bringing these valuable rocks out of the ground economically. While in some ways royalty companies benefit in not having to do this themselves, the fact that they are not means that the fate of their investment rests in somebody else's hands. Furthermore, while I said above that royalty companies are not directly exposed to the variable costs that mining companies are, in reality the royalty companies do have some indirect exposure to these costs: if the costs rise to the point where the mine becomes uneconomical to run, the company may shut down the mine and that will destroy the royalty company's royalty stream.

B: There are very few royalty companies. This has two negative consequences for investors. First and most obviously, they have very little choice. There are basically three major royalty companies and a handful of smaller ones. If you do not like the managements or the property portfolios of these companies then you are essentially shut out of the royalty company market. Second, royalty companies are perceived to be lower risk companies than individual mining companies (which they are in many ways), and consequently they draw a significant amount of investor interest. Given that there are so few royalty companies the prices of the few that are out there have been bid up to high prices, as is evidenced by the performance and valuations of the royalty companies relative to the mining companies. Consider that Silver Wheaton produces roughly the same amount of silver as Pan American Silver (NASDAQ:PAAS), yet the former has a market capitalization of $10.6 billion while the latter has a market capitalization of just $2.4 billion. While it is true that Silver Wheaton has lower costs, more diversification, and higher growth, this does not justify the enormous premium investors are paying for it over Pan American Silver (a 100% premium would be more rational). The large premium is due to the fact that there is just one silver royalty company and dozens of producing silver mining companies.

C: Royalty companies do not give investors the high leverage to metals prices that well run mining companies do. This is a consequence of the fact that royalty companies have low fixed costs, whereas mining companies have high costs. While high costs mean lower profits, it also means higher leverage to metals prices. If a gold royalty company pays $400 for an ounce of gold and gold goes from $1,600 to $2,000, then the profits for the royalty company go from $1,200 to $1,600, which is a 33% increase. This certainly isn't bad, but compare it to a mining company with $1,100 costs, which is around the industry average. The company's profits go from $500 to $900 per ounce, which is an 80% increase. The lower leverage to metals prices offered by royalty companies relative to mining companies has not hurt the former thus far during the precious metals bull market, as evidenced by the outperformance of royalty companies relative to mining companies. However if there is a mania in precious metals prices owners of well run mining companies should do far better than owners of royalty companies.

4: Conclusion

Readers should take away the following points from this article. These points will help them understand the specifics of the individual royalty companies that I will discuss in subsequent articles:

A: Royalty companies are companies that make deals with mining companies. These deals usually entail some sort of advance payment made from the royalty company to the mining company in exchange for a claim on future resource production. If the royalty company receives this metal at no additional cost then the agreement is a royalty agreement. If it is at a fixed cost then it is a streaming agreement.

B: Royalty companies generally offer investors a lower risk way of getting exposure to the precious metals. They have lower and more predictable costs and therefore higher profit margins. They also do not have to worry about many of the issues that mining companies must deal with. Finally they offer investors a level of diversification that they cannot typically get through owning individual mining companies.

C: Royalty companies are not in command of their own destinies. Their success rests on the success of the mining companies that they make their royalty deals with. Conversely the mining companies have no interest in the success of the royalty companies that they make deals with unless these deals give the mining companies shares in the royalty companies.

D: There are very few royalty companies, which limits the choices that investors have. It also means that investors who like the lower risk structure of royalty companies as compared with mining companies have bid the prices of royalty companies higher than they should be, at least relative to many mining companies. Consequently the opportunities in royalty companies are not as enticing as those in mining companies at the present time, but this may only be temporary.

E: Royalty companies offer less leverage to the prices of precious metals than mining companies. Generally royalty companies offer a smaller reward with lower risk to precious metals investors compared to a higher reward with higher risks offered by mining companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.