Sprott Inc: Waiting To Rally

Summary

• Sprott is an asset management firm focused on precious metals and mining.
• The company has successfully transitioned to a pure-play investor in the resource space.
• It has also increased its scale advantage through the acquisition of the Central Fund of Canada Ltd and Tocqueville’s gold strategy business.
• Third quarter results were strong and the prospects for 2020 look promising.
• Risks include concentration in mining, the organization’s goldbug culture, overpaying for future M&A, fee compression within the asset management industry, and possibly its valuations.

Introduction:

Sprott Inc. (OTCPK:SPOXF) is an asset management company focused predominately on managing funds, ETFs, and other investment products in the precious metal space. The organization is headquartered in Toronto, was founded in the 1980s by Eric Sprott, and is listed on the Toronto Stock Exchange under the symbol SII.TO.

Here at Contra the Heard Investment Newsletter, the Vice President’s Portfolio has had a position in Sprott since 2016, with an average purchase price of $2.36. Since it was first bought, the shares have appreciated only marginally. Still, the entity has paid a solid dividend, and has overcome significant challenges within the resource space.

Sprott’s Investment Thesis:

Back in 2016, the thesis was simple. The corporation was a best-in-class asset manager focused mainly in the contrary and undervalued resource space. It also had scale over other alternative managers, and offered unique funds. Furthermore, it had a good balance sheet, paid a dividend, and insiders owned a material stake.

Top brass appeared competent as well. This assessment has been borne out since 2016, as the outfit has survived the metals bear market and successfully implemented greater transparency requirements under Canada’s Client Relationship Model 2. It also divested its non-resource business (more on that below) and reorganized the shareholder structure after its founder left in 2017.

Sprott stacked up well against alternative investment options in the mining space too. Buying bullion, purchasing miners, and owning sectoral ETFs or mutual funds were all options.

We didn’t buy bullion for Contra, but we did purchase miners directly. I have written about three here on Seeking Alpha: Alacer Gold (OTCPK:ALIAF), Gold Resource Corp (GORO), and Major Drilling (OTCPK:MJDLF). These investments are panning out well, but we felt that buying Sprott for commodities exposure made a lot of sense as well. It’s more diversified than owning a few miners, and their team has significant industry experience.

Owning Sprott was appealing versus ETFs or funds too. Simply put – why would we want to pay annual management fees to get mining exposure when we could collect quarterly dividends instead?

To make a long story short, the thesis in 2016 seemed strong.

Corporate Actions Since 2016:

To date, this thesis remains intact – and better yet, the company has taken steps to further build on its strength. In 2017, Sprott sold its non-metals and mining business. While assets under management and revenues dropped in the aftermath of the deal, margins improved. The sale made it a pure-play within the metals space as well. Sprott then built on its commodities brand by expanding its private resource lending business. This division finances mining projects around the globe.

In 2018, Sprott scaled its physical trusts with the purchase of the Central Fund of Canada after a lengthy battle to own it. This acquisition added $4.3 billion in assets under management. Absorbing the Central Fund of Canada made the operation the third largest bullion firm in North America.

Sprott’s physical trust structure is unique because it actually holds precious metals. This means owners can redeem their units for bullion in addition to buying or selling the underlying units. Furthermore, the loot is held by the Royal Canadian Mint, which I’ve heard is hard to rob. Hoarding gold at the Mint but still being able to trade it from your desktop sure beats stuffing it under your pillow. It also beats owning an ETF, which may not own what it claims to, and cannot be exchanged for the physical good regardless.

Source: Sprott’s physical bullion trusts.

The organization currently has four of these unique trusts. The Sprott Physical Gold and Silver Trust (CEF), The Sprott Physical Gold Trust (PHYS), The Sprott Physical Silver Trust (PSLV), and the Sprott Physical Platinum and Palladium Trust (SPPP). In addition to these trusts, Sprott runs the Sprott Gold Miners ETF (SGDM) and the Sprott Junior Gold Miners ETF (SGDJ).

The firm also got into the crypto game in 2018 via a partnership with APMEX. Together they launched OneGold, an online platform for investing in digital bullion. This appears to marry the potential benefits of owning gold and cryptos nicely.

Finally, this year, the enterprise purchased the Tocqueville’s gold strategy business to further increase its scale and assets under management. The deal was announced in August and comes after entering a joint-venture arrangement earlier in the year. The Tocqueville acquisition is expected to close in the first quarter of 2020.

All told, saying that Sprott has increased its leadership position in commodities investing since 2016 would be an understatement.

Latest Results & Outlook:

Sprott announced its latest quarterly results earlier this month. Assets under management, revenues, and net income were up; the organization saw positive net flows across its different business lines too. The Tocqueville acquisition remains set to close in early 2020, and the private lending branch of the business is holding lots of dry powder to deploy next year.

Their outlook for 2020 is positive. For what a gold-focused company’s prediction is worth, they are bullish on commodities. Management has also renewed a modest buyback program, may look for additional M&A opportunities, and plans to launch a new mining investment product early next year.

The stock’s recent pullback appears to contradict the positive precious metal environment. If commodities continue to do well, we suspect that this will correct, and that the ticker will rally. If we’re wrong, the forward dividend yield is currently 4.30%.

Risks:

Sprott, like all investments, carries risk. Being a pure-play metals and mining asset manager is one such risk. Focusing on a specific sector makes them an industry leader and helps with brand identity, but it puts all their eggs in one basket. This makes their metals focus something of a double-edged sword. If commodities collapse, so too will Sprott.

Hand-in-hand with this pure-play focus is the organization’s goldbug culture. My dad likes to say that “we are all free thinkers within the limits of our own indoctrination.” This phrase often pops into my head when reading some of their publications. Many of the firm’s fund managers, executives, and board members may well self-identify as unapologetic goldbugs. This mindset will be incredibly useful if or when precious metals have their day in the sun. Until then, though, the company’s prognostications on the state of the global economy may sound like a broken record.

Overpaying for M&A is another risk. In the past, management has engaged in rationally priced purchases and divestments. The assumption is that this will continue, but you never know. It only takes overpaying on a few deals (or even one if its large enough) to screw up a company’s prospects.

Asset management fee compression is an additional risk – it’s a dog-eat-dog (or fee-eat-fee) environment out there. The entire investment industry is facing pricing pressure as passive steals active’s market share. This has reduced the fees that active funds can charge, and it’s causing intense competition among passive-only options too. Though the corporation does have mutual funds and active products such as the Sprott Focus Trust (FUND) and Sprott Resource holdings (SRHIF), most of the assets under management are passive.

Source: Sprott's Q3 2019 Press Release

On a side note, many asset managers showed up during Contra the Heard’s latest screen and watch list review process in September. You can read more about it here: Searching For A Bargain - Volume II: A Detailed Contrarian Watch List Review.

Finally, Sprott’s valuations present a mixed picture. On a dividend yield basis, the valuations look low. This is especially true given the dividend is easily supported by earnings, strong free cash flow, and high net cash on the balance sheet. Price to cashflow looks low too, and the price to book ratio is so-so. This said, price to sales, earnings, and enterprise value metrics all look high. Price to assets under management are also lofty versus peers. Perhaps Sprott’s assets are more valuable versus investment firm peers because it’s specialized in mining and metals? It’s tough to say.

This said, our best guess is that the stock is still undervalued. The resource sector has recovered slightly but remains far off from where it was years ago. As commodities (hopefully) continues to recover, we expect that assets under management will grow both organically and via inflows as more investors are attracted to Sprott’s products. However, this assessment of the corporation’s growth rate and the trajectory of precious metals could be wrong, which is why valuations are flagged as a risk.

Conclusion:

Sprott is a well-managed investment firm focused on the metals space. Over the past few years it has successfully shed its non-resource asset management business, survived the commodity drawdown, and reorganized its shareholder structure after the founder left in 2017. In addition, Sprott has doubled down on its scale advantage in mining through its acquisitions of the Central Fund of Canada Ltd and Tocqueville’s gold strategy business.

Third quarter results were strong and the prospects for 2020 look promising. Although the entire industry faces management fee compression, Sprott already has a significant foothold in low-fee products. Other potential risks include its concentration in commodities, the organization’s goldbug culture, and the possibility of overpaying for M&A in the future.

If precious metals continue to rally, Sprott may well prove to be undervalued, and could present investors with an interesting opportunity to consider.

A final word from Contra:

Investors interested in mining may want to consider attending the Vancouver Resource Investment Conference being held in Vancouver on January 19th and 20th, 2020. Contra the Heard’s very own Benj Gallander, as well as yours truly, will be in Booth #1037. Benj and I will also be making a presentation on our mining-related investments but the time and date is yet to be determined.

Disclaimer:

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research, it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

Analyst’s Disclosure: I am/we are long SPOXF, ALIAF, GORO, MJDLF. 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.