Stocks/International

Lyn Alden Schwartzer

Filtering Through the Noise to Find Value

Gold Royalty Companies Have Been on Fire Lately

Gold streaming and royalty companies have been among the most successful stock groups over the past several months, but is it time to take profits?

This article examines some of the details and differences between gold streamers and discusses their role within a diversified portfolio.

Gold Exposure

Starting in mid-October 2018, I added exposure to precious metals in my real-money model newsletter portfolio, with a focus on gold streaming and royalty companies, which I weighted heavily.

Although silver has been a bit of a drag lately, the money-weighted return of this section of the portfolio has been a sizable 17% over 8 months thanks to my high weighting of gold streaming and royalty companies compared to gold/silver ETFs and gold/silver miners.

I added SPY and TLT on the chart for comparison. Gold royalty and streaming companies have been absolutely roaring lately. But is it sustainable?   

I receive a lot of emails and questions about my favorite gold stocks, so I figured it was time for an update.

The Royalty and Streaming Model

The vast majority of stocks within the popular VanEck Vectors Gold Miners ETF (GDX) are mining companies. However, there are five companies within the ETF that are financiers of gold miners rather than miners themselves. These are Franco-Nevada (FNV), Wheaton Precious Metals (WPM), Royal Gold (RGLD), Osisko Gold Royalties (OR), and Sandstorm Gold (SAND).

Gold streaming/royalty companies pay money up front to help develop mines, and in return they get either a percentage of the profits from that mine, or they get to buy a certain amount of gold from that mine at a very low cost, like around $400 per ounce.

It’s a good deal for the miner in many circumstances because the cost of their financing is tied to the price of the commodity they mine, rather than fixed at an independent level. So, financing a mine with a streaming/royalty deal could cost more for the miner than typical debt if the gold price does well, but on the other hand it won’t hurt the miner as much as typical debt if the price of gold falls.

Of course, it benefits the royalty/streaming companies as well. All three major gold streaming/royalty companies (Franco Nevada, Royal Gold, and Wheaton Precious Metals) have outperformed the price of gold and the gold mining index over the past decade. We’ll see if the smaller ones, Sandstorm and Osisko, go on to do the same. I suspect they will.

The business model of streaming/royalty companies is a lot safer than miners, because their break-even prices on gold are so low, at hundreds of dollars below mining AISC values. So, if you’re interested in a buy-and-hold gold investment rather than a trading vehicle, streaming/royalty companies are near the top of the list to consider along with physical possession of coins/bullion.

The royalty and streaming companies are tremendously efficient, with among the highest revenue-per-employee ratios out of all companies in the world. For example, Franco-Nevada earned $653 million in revenue in 2018 with 34 employees.

Dilution or Debt

The hardest part of the gold streaming and royalty model is getting started. When all you have is a little bit of capital and know-how, you need to issue debt or equity to finance your initial investments in mine development.

Wheaton, Royal Gold, and Osisko use a normal debt/equity model, where they permanently retain some degree of debt on their balance sheet.

Franco-Nevada and Sandstorm operate in a primarily debt-free way. They usually have zero debt, and only occasionally and briefly take on minor debt for liquidity, which they quickly pay off. In exchange, they tend to dilute their shares a bit more aggressively, as they pay for new projects with the currency of their own shares.

This chart perhaps best describes the pain of a royalty and streaming start-up from inception:

Sandstorm has grown tremendously over the past decade but has underperformed the S&P 500 since its inception due to major share dilution to achieve that growth.

However, starting in late 2017, the company indicated that they reached a state of maturity where they no longer need to regularly issue shares to fund growth. Many of their initial royalty and streaming investments are now actively producing metals and profits, meaning that Sandstorm can fund its future growth with cash flows, and only issue new shares if management wants to do so for a particularly compelling opportunity. I personally waited to buy Sandstorm until this stage of maturity was reached, which has paid off so far.

Risks to Consider

All gold streaming and royalty companies are levered to the price of gold, although they can withstand low gold prices if they need to. Therefore, they are not good investments for investors that are bearish on the price of gold over the long term.

For the larger streamers, like Franco-Nevada, a key risk is that they are so large that they may have insufficient opportunities to make deals that “move the needle” and deliver significant growth relative to the existing size of the company. Franco-Nevada has diversified into oil, and Wheaton Precious Metals has invested in cobalt, for example, as they seek to grow outside of just the gold and silver industries.   

For smaller streamers, apart from the initial problem of share dilution, a key risk is project concentration. Sandstorm for example has a large stake in the Hot Maden mine development project in Turkey, which should be one of the most profitable gold mines in the world when it is developed in a few years and could more than double Sandstorm’s revenue. If this project were to fail, however, Sandstorm’s growth rate over the next five years would be severely impacted. Sandstorm is very well-managed but likely has the most variability of potential outcomes over the next few years due to this major project.

Final Thoughts

Some investors avoid gold royalty and streaming companies because they prefer more explosive upside potential.

Mining companies with high AISC or high debt that are barely staying afloat when gold is in a bear market have the highest return potential if the price of gold were to soar in price, because the amount of operational leverage they have on the price of gold is immense. They can easily go bust, or go up 10x or more, depending on how gold performs. These can make for good trading vehicles for shrewd investors, but have very high levels of risk.

The biggest gold producers, like Newmont (NEM), Barrick (GOLD), and Agnico Eagle (AEM) have less explosive potential but more stability if gold were to enter a significant bear market.

And then lastly, gold streaming and royalty companies have lower explosive potential than both groups, but have the strongest defense against low gold prices, because their break-even price of gold required for profitability is extremely low, and two of them (FNV and SAND) generally operate with zero debt. However, their efficiency, high profitability, and substantial durability allow streaming and royalty companies to survive and thrive year after year to stick around and enjoy the big bull markets when they come, and as a group they have dramatically outperformed almost all gold miners over the long run.

Investors that have enjoyed 20-30% rates of return from gold streaming and royalty companies over the past 8 months might consider taking profits at this point. Trimming a position isn’t an irrational thing to do, especially if you are overweight in a specific stock.

However, I believe that continuing to dollar-cost average into gold royalty and streaming companies is most likely going to be a profitable strategy over the next several years. We’ll have dips and peaks along the way, and re-balancing a portfolio or adding new capital month after month allows investors to buy the dips in what is generally a very strong sub-industry.

My thoughts on gold itself can be found here: 

https://www.fatrader.com/p/analysis/As-a-Value-Investor-These-Are-The-2-Gold-Charts-I-Focus-On-201905015705.html

While we may encounter price declines in the gold royalty and streaming companies if gold were to take a dip this summer, I have a bullish outlook on these businesses over a 5-year period, and keep a small part of my portfolio invested in them.  

This is not personalized investment advice.

Lyn Alden Schwartzer covers North American stocks and international equity ETFs with a focus on fundamental valuation. Her background is a blend of engineering and finance, and she uses a dispassionate long-term quantitative and qualitative approach to filter through the noise and find value in stocks and markets around the world.
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