There is an invigorating debate on SA between those who believe the safest and smartest way to own gold is via physical ownership of the physical metal and those who believe the gold miners, with their greater leverage but also the greater possibility of increasing labor, materiel and environmental costs, are the smarter way to go. Of course, there are ETFs and mutual funds that cater to each school of thought, as well.
But I believe there is a “third rail” here, and I find it more electrifying than either of the other two paths. This would be the “royalty trusts” or “royalty-override” firms in the gold and precious metals arena. I believe these firms offer a lower risk of exploration and production, a lesser -- virtually nonexistent -- liability exposure, less environmental exposure, and a way to enjoy the leverage of the miners without the headaches of operating cost and labor cost increases.
These companies receive a share of whatever resource is extracted from a producing mined or drilled property. They typically acquire this interest in one of two ways. The first is to acquire the land and/or the mineral rights on properties in an area of proven producing activity where they have ready cash and acquire the land or the rights to mine or drill. They then allow others, often with less capital but bigger dreams, to mine or drill on their properties in exchange for a share of anything the miner or driller finds.
The second primary way they acquire their interest is to provide capital to some wildcatter who is just th-i-i-i-s close to completing his mine or well but just th-i-i-i-s far away from having the money to do so. In this case, the miner/driller is willing to give up an additional piece of their share in order to get that last bit of capital needed to finish the job.
I’d like to break down the 3 “principal” approaches I outlined above with a little more granularity. You and I actually have even more approaches we might take in order to participate in the metals and mining industry...
- We can buy juniors (or some seniors, for that matter) that are still in the exploration stage.
- We can buy those firms that already operate producing properties.
- We can let someone else aggregate a whole bunch of companies to spread our risk by diversification, whether via an open end mutual fund, a closed-end fund, or an ETF or ETN.
- We can buy the physical metal, whether as bullion or in something that may add value over and above the spot price, as with rare coins or jewelry that reflects the price of gold and the skill of the craftsman.
- Or we can buy the gold or silver royalty firms.
Let’s take a look, using the 5 possible approaches listed above, at what each offers:
Every one of them gives us good exposure to rising resource prices. Bullion funds (which, for shorthand, I’ll use to describe the panoply of mutual funds, closed-end funds, ETNs and ETFs), producers, and explorers big and small will all benefit if prices rise, as will royalty firms.
But after this, our alternative choices begin to differentiate themselves. If new reserves are discovered by a particular company, shares of that operator, explorer, or a royalty trust with an interest in that one firm, will have exclusive exposure to the new reserves. Funds might benefit to the extent they own a small piece of the firm via shares, but bullion -- physical metal -- won’t be helped at all.
It’s the same with increased earnings or dividends paid. Funds may benefit a little, bullion will benefit not at all, but the producer or explorer who now pays a dividend -- and of course the royalty trust that has a piece of them -- will benefit directly. (There are typically covenants that the royalty firm gets an extra payout even before common shareholders can receive a dividend.)
Finally, if there’s a great find that a producer wants to expand upon, typically only the producer (or explorer if the find is big enough to warrant additional financing) and the royalty firms benefit from acquiring additional acreage contiguous to their find.
Those are the primary good things that might happen to our investment. With any potential reward, of course, comes a certain risk. How are each of the 5 possible investment approaches at reducing our risk?
In the “plus” categories above, the funds and bullion-holders get the short end of the stick. When it comes to risk, however, it falls nearly 100% on the head and shoulders of the explorers and producers. Environmental delays, litigation and costs? Bullion-holders, funds and royalty-override firms are only obliquely affected (by a delay in receiving cash flow, etc.) Explorers and producers are the ones who have to slog their way through all this.
Operating cost increases? If labor and other operating costs surge, it does affect funds and royalty-override firms in the sense that squeezed explorers and producers’ stock prices may be affected, but it is the explorers and producers whose actual bottom line will suffer. It is the same with capital costs -- bullion-holders, funds and royalty-override firms have a considerably reduced exposure. In fact, rising operating and capital costs may mean that royalty firms are given ever more favorable terms for additional capital or repayment concessions!
Finally, when it comes to leverage, bullion-holders get bupkus. If in fact one believes that the price of gold will rise, all of the other 4 avenues participate in increasing margins. If, for instance, it costs somewhere between $500 an ounce and $800 an ounce to mine gold (“all in” -- by which I mean the labor costs, capital expenditure debt service, environmental remediation, “the whole tamale”) and gold is selling, unhedged, for $1100 an ounce, there is a call-it $300 an ounce or more profit when selling in the spot market. Now if spot gold moves to $1400 an ounce, workers will strike for higher pay and contract drillers will want a little more for their services, etc. but these all take time to play catch-up.
In this case, royalty-override firms, explorers, producers and funds all benefit as the firms are now making a profit of $600 or more per ounce rather than $300. The bullion-holder has an asset that has appreciated from $1100 to $1400, or 27%. Not bad at all. But the others all have a piece of something that has gone from $300 taken home per ounce to $600 taken home per ounce, a gain of something akin to 100%.
Taking the good, the bad, the ugly, and the indifferent, unless I need the diversification of a fund or I want to take a flyer with a small portion of my portfolio on an explorer with a good story, a better track record, and great management, then royalty trusts are for me. They offer the best exposure to the good and the least exposure to the bad and our goal at our firm is to protect capital, then increase it. (“Catch ball, then run,” prepare cart, then put horse in front, etc…)
Among the fine companies I can recommend for your further research in the precious metals arena are Franco-Nevada (FNNVF.PK), Royal Gold (NASDAQ:RGLD) and Silver Wheaton (SLW). Here’s a thumbnail sketch of each:
Franco-Nevada (FNV on the Toronto; FNNVF.PK in the US) is my personal favorite in the precious metals area. It is not nearly as well-known, or as widely held, as Royal Gold (RGLD) or Silver Wheaton (SLW), so let me tell you what I like about it:
(1) The company is primarily focused on gold, but does not live or die based upon gold royalties alone. It has diversified into the platinum metals group as well as a number of base metals and oil & gas properties.
(2) The majority of revenues are generated from a diversified portfolio of high quality royalty properties in the United States, Canada and Australia. At a time when emerging markets are all the rage, and gold mining in Congo, Nigeria, Bolivia, et al are sought by many, I prefer my assets in stable Western democracies that respect property rights, contract law, and the rules of law, not men. 61% of FNNVF’s royalty revenues come from the USA, 21% are from Canada, and much of the rest is in Australia. Of the 61% in the USA, the biggest chunk is in Nevada, which most non-Westerners think consists of Las Vegas and a bunch of desert. In fact, most of us Nevadans outside Las Vegas live in God’s country -- the high Sierra, the Ruby Mountains, or desert communities (with the emphasis on “community”) that average maybe 50,000 or so people. Small-town America where the ethos of The West still prevails -- we keep our guns, our water and our land clean and we expect the miners allowed to mine here to do the same. From where I work, I can keep a pretty good eye on mining companies...
(3) While it isn’t as well-known as many other royalty companies, Franco-Nevada is actually the largest gold royalty company by gold revenues, gold margins and number of gold royalty interests. FNNVF uses the cash flow from its royalty investments to expand its portfolio in the resource sector and to pay dividends -- not big ones, but growing -- to you and me.
(4) FNNVF has more than half a billion dollars in working capital and another $200 million plus in marketable securities and available credit lines. GM may not be able to get credit from anyone but the US taxpayer -- for good reason -- but Franco-Nevada has banks a-plenty offering them credit -- for good reason. If opportunity knocks, they have the cash to respond.
(5) I like their margins (best in the business), their expenses (incredibly low), their management team (highly experienced), and their “overseers:” FNNVF’s board of directors include their president, who is concurrently the managing director of Newmont Capital, the finance arm of former parent company Newmont Mining (NYSE:NEM); the chairman of the World Gold Council; the president of Pengrowth Energy Trust, one of our previous Canadian Royalty Trust oil and gas picks; and the CEO of Barrick Gold (ABX.)
My enthusiasm for FNNVF detracts not at all from my respect for Royal Gold or Silver Wheaton, which a number of our clients also own.
Royal Gold sticks closer to its knitting than FNNVF. It is almost exclusively in the business of acquiring and managing precious metals royalties. They acquire existing royalties or finance projects that are in production or in development stage in exchange for royalty interests. In their most recent fiscal year, RGLD received royalty revenue from 23 producing properties. In addition, it owns royalty interests on 10 development-stage properties and over 80 exploration-stage properties -- lots of possibilities there. While Royal Gold owns royalty interests in 14 different countries, over 75% of its gold reserves and over 99% of its silver reserves are located in North America (including Mexico, where substantial silver reserves are located.)
Unlike the other two, Silver Wheaton focuses primarily on silver. Given the unusual disparity between the increase in the price of gold and the lesser increase in the price of silver, widening the already wide gold:silver ratio, some who consider a narrowing of this ratio inevitable even if gold doesn’t continue its march forward, might consider this a great opportunity to invest in a pure play in silver. SLW is the biggest silver royalty company in the world. It has 17 agreements where, in exchange for an upfront payment, it has the right to purchase all or a portion of the silver production, at a low fixed cost, from high-quality mines located in what they consider politically stable regions. From a current 16 million ounces of silver and 17,000 ounces of gold, SLW forecasts annual production by 2013 to more than double to approximately 39 million ounces of silver and 20,000 ounces of gold. No ongoing capital expenditures are required to generate this growth. Silver Wheaton does not hedge its silver sales.
I believe every portfolio should have some precious metals as a contra-cyclical anchor for other positions. I believe I’ll have another helping of the royalty companies as my preferred way to provide that anchor…
Author's Disclosure: We and / or clients for whom these investments are appropriate, are long FNNVF, RGLD and SLW.
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