Royalties: Bridging the Gold Price Mismatch

We’re heading into what is normally a week of extremes.

A whole lot of people have taken off and closed the books for the year. Nearly everyone else is frantically trying to shore up their yearly numbers, or soaking up the day-to-day duties of their coworkers in a short work week.

With that in mind on this Monday, let’s keep this relatively short and sweet.

I’m going to point out an often overlooked gold play. It bridges one of the biggest mismatches between gold producers and the metal itself.

Take a look at this chart and you’ll see it, clear as day:

Gold and gold miners are in the midst of a massive mismatch between prices and share prices.

Though both GLD and GDX are at the whim of paper investors, that gulf cannot be explained by sentiment.

So what is going on and what bridges the divide? Let’s do this…

Debt and Dilution

What we’re seeing here is the result of debt burden and share dilution, not just lower gold prices (though they certainly factor in).

The easy to mine, low-cost deposits that have supplied the world with gold are nearly spent. Their replacements are labor and capital intensive.

Since 2011, financing has been increasingly difficult to obtain as well. The results of due diligence by lenders are far less promising than in years past.

Issuing shares and diluting share prices worked as a low-cost financing scheme, right up until the all-in cost for many producers met or exceeded sustainable levels.

Aggregate debt in the top 10 components of the Philadelphia Gold and Silver Index (XAU) has risen from $1 billion in 2005 to $40 billion at the end of 2014.

Over the same period of time, shares outstanding have risen by 207%.

The combined effect has created a situation where gold production per share has fallen 45% from .38 oz. to .21 oz.

Gold is unchanging and irreplaceable. A large part of its appeal is solely based on this fact.

However, once you get a bunch of people involved with the logistics behind moving it from below ground to a market, things can get really screwed up.

I think it is safe to say that a large swathe of the gold mining sector as a whole is FUBAR because of this.

Three Ways

Share prices, for companies both good and bad, are now depressed to the point where two classic investor moves make a whole lot of sense.

First up is the classic value investment. Many companies that have responsibly managed their books over the past five years are trading at steep discounts.

At times, they even trade below the cost of replacing dwindling production. The smaller companies are very attractive takeover targets as a result.

The second way to capitalize is to dive into more speculative companies. Focusing on JV or speculative operations with promising, but largely unexplored, assets can and will drive gains if you buy shares before published gold deposit estimates are subsequently revised upwards. High risk, high reward.

However, the third way is one that largely flies under the radar. Essentially, it ties together the profits from the massive financing needed by gold miners and profits from extraction and production down the road.

As far as investments go, these plays are about as boring as banks (in the pre-derivative days), and rightfully so.

After all, they are financiers. They fund stuff, and that’s it.

In return, they get a cut of the action, in the form of a percentage of revenue generated by gold miners as they produce and sell gold.

They don’t get involved in operations at all. They put down the money miners need, generate better returns on capital than the miners often do, and are still exposed to the upside of gold price increases.

This style of business has held up remarkably well, in spite of the five-year gold price slump.

There are a handful of companies that do this type of business. Franco-Nevada is the largest, by far. There are also Silver Wheaton, Osisko Gold Royalties, Ltd., Royal Gold, and Sandstorm Gold.

As for valuation, it is probably better to approach these stocks like you would a bank. After all, their basic business model is nearly identical. So, price-to-earnings ratios are out, price-to-book ratios are in, and we should look at estimated 2016 return on investment capital (ROIC):

Most major banks trade between a price-to-book ratio of 1 and 2.

Part of this is the stigma hanging over banks since the Great Recession, which is well earned. Another is how the big banks can’t seem to explain to anyone what is really in their books, or what it is really worth.

The big banks do generate higher returns on investment capital though, so anticipation of rising gold prices is required to justify the cost and lesser return on investment capital.

Evaluating the Companies

Investing in the biggest, and best, name in the business is significantly more expensive compared to book value than either banks or its peers.

However, Franco-Nevada has historically been a very strong pick, and may well be worth buying with the upside potential of gold prices, and the revenue higher gold prices could bring to the company.

FNV’s dividends have returned 18.4% since inception, and it has averaged an annualized return of equity of 10.7% per quarter since 2008. Shares are up 340% since it started trading in Canada in December 2007, crushing GLD, GDX, and the S&P 500:

Plus, as analysts at Canaccord Genuity noted, in its worst quarter, the company broke even on ROE. At its weakest, it had to record a $108 million write down, equivalent to 3% of shareholders’ equity at the time.

For a gold play that is remarkable, to put it lightly.

In spite of the higher price-to-book ratio, FNV stands out for its track record, its size and diverse portfolio, and the amount of capital it can bring to bear when a good deal is available.

Silver Wheaton is having some issues, as reflected in the estimated 2016 ROIC, but the price-to-book ratio is more attractive. I think it is a good long-term play on absurdly low silver prices in the long-run, as long as you’re fine riding out how volatile silver prices have been, and will continue to be.

Royal Gold had a bad year, and some of its partners have a steep uphill battle ahead of them. A royalty agreement with Thompson Creek Metals — which is down 88% on the year with an insurmountable debt burden — amongst others, makes Royal Gold a “wait and see” prospect.

Once the dust settles from a seemingly inevitable meltdown, it’ll be time to revisit Royal Gold.

Osisko is a bit too small for me. It has a royalty deal on the books with the Malartic mine, which is world-class, but the rest of its portfolio is small and too high-risk for the gold royalty investment approach.

A hand-picked basket of small miners of your own choosing, balanced out by more stable portfolio allocations, makes more sense if you’re going to introduce that kind of exposure.

Sandstorm is way too small and weak, period. I considered not even mentioning it.

And on that dour note, I think I’ll call it quits, at least for this article.

Have a happy New Year’s Eve and Day, and I’ll see you in 2016!