Everybody knows that royalty and streaming companies are the things to own in bad gold markets. The business model means that they are not responsible for costs, so while revenue on a “same-store” basis declines with the price of gold, their profits do not shrink anywhere near as much as for mining companies.
The stocks correspondingly do well, outperforming the mining companies by wide margins.
From its peak in April 2011 to its low in January 2016, the XAU index fell by 83%. During the same time, the largest royalty company, Franco-Nevada, appreciated by 19.8%. Wheaton was up 33% and Royal over 6%. Case closed.
Where’s the leverage?
The myth is that royalty companies do not have much leverage in strong markets, and for precisely the same reason, as margins expand more dramatically for the mining company with high costs than for the royalty company. If gold moves up just $300 from $1600 to $1900, say, the miner with all-in costs of $1200 an ounce sees its margins nearly double. Royalty companies, which have profit margins of over 80%, seemingly cannot compete with that.
And there are other factors at work. In good markets, mining companies find it easier to raise equity in the market or borrow money from the banks, and they do not have to encumber part of their future production to royalty companies. That is the common thinking.
Though there is some truth in this, it is far too simplistic: royalty companies have plenty of leverage from strong gold markets, and other factors benefit the companies and the stocks in good markets as well.
More ounces produced
Where does the leverage come from? In addition to a linear increase in revenues as the price of gold goes up, royalty companies benefit from additional ounces produced. Typically, particularly in negotiated as opposed to legacy royalties, royalty companies acquire royalties on an entire land package, including land around the mine. Thus, they benefit from mine expansion that often takes place during strong markets, as well as from additional resources discovered in brownfields exploration.
Moreover, at higher gold prices, we expect more projects to go into development and production. A royalty company may have acquired a royalty on exploration land many years prior—in some cases, decades earlier. Typically, royalties on exploration land are not expensive. When the owners put that mine into production after spending many tens or hundreds of millions of dollars, the royalty company starts to receive revenue—without spending an additional dollar. Now that is leverage! The common perception is simply not correct.
A company such as Franco has over 400 royalties on exploration land. Former CEO David Harquail told me once that if gold moves up over the next several years, he would expect several of the deposits to come into production: “I can’t tell you which, but it is certain some will.” And again, remember, Franco will not pay another dollar to bring these deposits into production.
Royal Gold has well over 100 projects in its “exploration” and “evaluation” categories, in addition to the projects in development. Wheaton, by the nature of the types of deals it does, has fewer exploration projects than the other two but has more than a dozen non-producing assets, mostly on more advanced projects. Two are on very significant projects, currently blocked, but with plenty of leverage: the world-class Navidad silver project in Chubut Province, Argentina, and Barrick’s tier 1 Pascua-Lama on the border of Argentina and Chile. The company’s latest acquisitions, and some cobalt deposits, also provide upside from higher prices.
A second source of leverage is where the royalty company owns a “Net Profits Interest.” These are not as common as Net Smelter Returns, where the revenue to the royalty company comes off the top (usually from day one). With an NPI, the mining company has to recoup its capital costs before the royalty kicks in. A good example would be Franco’s 50% NPI on part of the giant Hemlo mine in Ontario, which commenced production in 2008 and did not pay Franco for another four years. The royalty itself has been acquired in Franco’s first incarnation prior to a merger with Newmont in 2002, from which it subsequently was spun off again. During that entire period, Franco did not spend a single penny developing the deposit.
Even on an NPI, the royalty company has tremendous leverage from ongoing operations. Hemlo’s production in 2019 was 213,000 ounces, up from 171,000 the year before. But as is usual once mines are up and running, the ongoing capital costs declined at the same time. So the royalties from Hemlo more than doubled year on year, the result of a 2.5% increase in production, a 13% reduction in capital costs, and an 18% increase in the price of gold. Add 2.5% and 13% and 18%, and they get more than 100%. That’s odd math but strong leverage.
Where will the new deals come from?
I mentioned above that many investors think that royalty companies are not in as strong a position to make good deals in strong markets. In truth, royalty companies have demonstrated a remarkable ability to innovate and to adapt to any gold environment. The very concept of a “stream,” pioneered by Wheaton in the early 2000s, was one such revolution in the model. In the early years, royalty companies scoured records for existing royalties they could buy, usually from landowners who kept a royalty when they sold the land to a mining company. Later, they started providing capital to exploration and development companies in exchange for future royalties. After the big resource bust in 2011, they provided capital to large base metals companies for balance sheet repair in exchange for royalties on precious metals by-products.
Now, with balance sheets restored, equity markets open, and interest rates excessively low, they are looking to play a role in providing capital for mine development, in conjunction with bank debt and some equity, thus reducing the loss of off-the-top revenues in exchange for a larger royalty but also reducing equity dilution and providing banks and equity markets with a level of comfort from the due-diligence respected royalty companies have performed. Once again, the common perception is actually a misconception.
Cyclicality benefits royalty companies
There is something else, though. Mining is a notoriously cyclical business. It may take five years or more for a gold mine to be developed and start producing, far more for a large base metals mine. By the time the mine is actually generating revenue, the cycle may have changed! The royalty companies tend to be more contra-cyclical than the miners have been in the past. With strong balance sheets, they were able to take advantage of the opportunities during the 2011-2016 bear market, while many miners were trying to repay debt by shedding assets they had purchased just a few years earlier. From 2010 to 2012, Franco did not make a single meaningful acquisition. But from 2013 to 2016, it was one of the most active investors in the space.
During these lean years, in fact, very few large companies were actively buying anything, apart from Franco, Wheaton and Royal.
The acquisitions in the bear market laid the groundwork for profits in the strong markets. Most of the major royalty and streaming companies have done calculations based on existing assets: Were they not to make another single acquisition, they could continue off current assets with the same (or higher) revenues and the ability to pay the same dividend for decades.
So the companies themselves will grow and perform well in strong markets, even without making additional acquisitions, and this is reflected in the stock prices. From the low for the XAU in January 2016 to mid-2020, all three of the major royalties outperformed the XAU index.
More investors like the royalties
One additional factor helps the major royalty companies in a strong market: as the gold price moves up, more generalists enter the space. They will naturally turn to the big companies, those whose names are familiar, such as Barrick or Newmont. They will also turn to the major royalties that have consistently generated profits, have consistently paid dividends, and have actually had their stock prices move up during multi-year periods.
I have focused so far on the “big three” of royalty and streaming companies; these companies remain solid buys. At the same time, select small royalty companies have the ability to generate outsized returns as they grow, and with that growth, their valuation multiples expand. My favorite—a very good buy right now—is actually International Man’s “#1 speculation.”
These royalty companies are the cornerstones of my portfolio and should be for you. We can have high confidence that they will produce for us in good times and bad. The royalty companies are indeed the gold investor for all seasons.
Editor’s Note: In this rare message, legendary gold investor Doug Casey shows you the secret to how he invests and the most lucrative “insider” way of multiplying your gold mining stock returns.