Stocks/International

Lyn Alden Schwartzer

Filtering Through the Noise to Find Value

I Bought Sprott Inc. Here's Why.

One of my recent investments was a position in Sprott Inc, which is an alternative asset manager that focuses primarily on precious metals and to a lesser extent on other natural resource investments.

It’s a relatively small position, but I plan to hold it for years under most potential scenarios as the rest of this economic cycle plays out, so here’s an overview of the company and why I went long.

The Role of Precious Metals in a Portfolio

In an era where real cash and bond yields from banks and sovereign bonds in developed countries are near-zero or below-zero, holding some wealth in the form of precious metals has a lot of appeal to many people.

My overall views towards precious metals and how to value them can be found here:

Since it peaked in 2011, gold has been in a bear market for nearly 9 years, but recently has hit a six-year high and its getting a lot more attention in financial media. Another way to view it is that it was in a five-year bear market from 2011 through 2015, and has been in a bull market since early 2016 after bottoming.

I have no particular opinion about the short-term movements of any metal, but I am bullish for the multi-year long-term as the rest of the business cycle plays itself out. In particular, my view towards silver from this price point is very positive, and I have a constructive outlook on gold as well.

I began collecting gold and silver coins as a child in the late 90’s, sold my whole collection in 2011, and began buying back into the precious metals space in the 2016-2019 period so far.

There are various ways to build exposure towards precious metals, including physical coins and bullion, mining stocks, royalty and streaming companies, and exchange-traded funds. Interestingly, Sprott Inc. represents one more axis with which investors can diversify into the precious metal space, as the company makes money from fees related to investors’ desire to own precious metals.

Sprott Inc. Overview

Sprott Inc. is an alternative asset manager that focuses on natural resources, and has about 90% of its $10.6 billion in assets under management (AUM) in precious metals.

The Canadian company trades with the ticker SII on the Toronto Stock Exchange, and trades over-the-counter (OTC) with the ticker SPOXF for other investors. It’s a relatively small and lightly-followed company, with a market capitalization of under $700 million. It pays a dividend yield of over 3.5%.  

Like many companies whose fundamentals are correlated with gold and silver, Sprott has been in a long bear market:

In general, this has been a rough period for commodities overall, with one of the widest historical differentials between the performance of commodities and the stock market: 

However, I estimate that there is a high probability that Sprott’s total return performance will better over the next five years than it has been over the past five years.

Sprott’s biggest business is managing various exchange-traded funds related to gold and silver.

A dilemma that metal investors face is that physical investment has a variety of frictional costs, while more liquid and low-cost avenues of exposure such as ETFs have less security that many gold buyers want to have. Avi has explained in detail with a great presentation why popular gold ETFs such as the SPDR GLD fund are riskier than they may appear to many investors.

Exchange-traded products represent a spectrum of quality, and Sprott offers exchange-traded gold, silver, platinum, and palladium funds that are higher on the quality spectrum compared to popular funds such as GLD, albeit with higher expense ratios. These funds represent somewhat of a middle ground between the convenience of ETFs and the security of physical ownership, and can have a role for some investors within their overall precious metal exposure.  

Specifically, Sprott operates:

  • CEF: Gold and Silver Fund
  • PHYS: Gold Fund
  • PSLV: Silver Fund
  • SPPP: Platinum and Palladium Fund

These four funds represent about three-quarters of Sprott’s AUM and are the most important part of their business from a financial perspective.

What makes these funds special is that they are redeemable for physical metals. Subject to rather high minimum thresholds, investors can redeem their shares for physical metal transported to their home via armored truck. Sprott stores the metals in an allocated account with the Royal Canadian Mint in Ottawa.

Overall, while it’s not the same as directly owning physical coins and bullion, this is a more reliable form of liquid precious metal investment than some of the larger, cheaper funds that are not redeemable and that do not hold all of their metal in allocated physical accounts.

Additionally, Sprott has invested in a blockchain platform that allows investors to have gold exposure tied to the security of blockchain technology, and has partnered with APMEX and other companies in this endeavor. I expect this to play a rather small role in Sprott’s profitability going forward, but gives the company exposure to every potential way that investors may want to gain exposure to metals.

For miners, Sprott operates two funds, with one being for larger gold companies and the other being for smaller players:

  • SGDM: Sprott Gold Miners
  • SGDJ: Sprott Junior Gold Miners

These are factor-based investments weighted by growth and balance sheet strength rather than weighted strictly by market capitalization, which gives them some differentiation from popular funds such as GDX and GDXJ. However, they only represent about 2% of Sprott’s AUM and have underperformed their benchmarks over five years, so I do not yet have much of an interest in them from a business perspective.

Sprott’s remaining investments consist of managed accounts, private investments, and lending activities to junior miners.

The company has a very strong balance sheet, with more cash than debt at the current time. They have been able to pay a 3.5% dividend through a very long bear market in natural resources. Earnings and free cash flow are choppy due to various factors, but Sprott currently trades for about 15x annual free cash flow.

Risks and Conclusion

Sprott’s management fees, interest, and commissions are strongly correlated to the price of gold, silver, and other natural resources.

SPOXF currently trades slightly above $2.50 USD per share.

During the height of the 2011 bull market in precious metals, the stock reached nearly $10/share, almost 4x as high as the current share price. On the other end of the spectrum, the stock bottomed at just over half of the current share price in early 2016 as the entire natural resource sector bottomed. Along the way, it has paid a $0.03 CAD quarterly dividend year after year.

The company offers strong correlation to gold with operational leverage. The higher the price of gold and other precious metals, the more money their percentage-based management fees on their funds bring in to the company, as long as their allocated and redeemable funds continue to be of interest to investors.

However, because their expenses are relatively fixed (mostly compensation and other overhead), an increase in revenue generally results in a larger increase in profitability and share price movement for Sprott. Likewise, a deep bear market in natural resources along with fixed expenses can result in very low or nonexistent profitability.

Overall, Sprott has proven to be safer than a typical mining stock due to lower capital costs, with a higher yield and lower risk of insolvency if the prices of metals dip very low. Along with physical holding, miners, royalty and streaming companies, Sprott represents a very different way to profit from precious metals.

Investors interested in Sprott’s allocated and redeemable funds that want to effectively eliminate their expense ratio can also invest in Sprott itself with a small position, as the dividend yield from a small stake in the company covers the expense ratio of a larger stake in one or more of their funds. In a sense, the expense ratio from the fund flows to Sprott, which then partially flows back to shareholders as dividends.

There are multiple ways to have precious metal exposure, and outside of bubbles like in 2011, I like to invest in a broad way in the space, including physical, miners, royalties, and in this case, an asset manager.

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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