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USGI: As Trade Tensions Intensify and Global Outlook Sours, Gold is Peaking

USGI: As Trade Tensions Intensify and Global Outlook Sours, Gold is Peaking

An overview of precious metal royalty and streaming companies

The price of gold has surged lately on safe haven demand as the total value of negative-yielding debt across the globe touched a record USD15tn. On August 7, the yellow metal traded above USD1500 an ounce for the first time since September 2013, and we could see further upside potential the longer the U.S.-China trade war persists.

There are a number of ways for investors to play this. Many prefer physical gold, either in bars and coins or gold-backed ETFs. Such funds attracted USD2.6bn of net global inflows in July alone, raising their collective holdings to 2,600 tonnes—a level unseen since March 2013, according to the World Gold Council (WGC). Other investors like gold mining stocks. Others still, Ray Dalio among them, cover all the bases with positions in physical gold ETFs, large-cap producers, small-cap explorers and royalty and streaming companies.

It’s that last group, royalty and streaming companies, that I want to discuss. Here at U.S. Global Investors, we invest across a broad range of tiers within the mining industry, but we recognize the royalty model—practiced by Franco-Nevada, Wheaton Precious Metals, Royal Gold and a few others—as simply superior.

To explain why, let me back up a bit. 

Peak Gold Has Arrived

A lot of people don’t realize this, but the supply of gold is shrinking. If you’re a metal producer, it’s a much more challenging financial and mineral environment today than it was in years past. Just look back over the 1970s, 80s and even 90s. In every decade, the industry managed to find at least one mega gold deposit that yielded 50 million ounces or more, at least 10 that yielded 30 million ounces and numerous others that yielded between five and 10 ounces. That’s all changed. In the past 15 years or so, we’ve found no 50 million ounce deposit, no 30 million ounce deposit and only a few of the smaller deposits. Those that have been discovered are of below-average grade. 

We can point to a few reasons why this is happening, but I believe the main contributing factor is also the simplest: We’ve reached peak gold production. The low-hanging fruit, as it were, has already been picked. Producers must therefore dig deeper, and in more remote, less hospitable regions and jurisdictions, to pull up smaller and smaller amounts of metal.
As you might imagine, this is expensive work—prohibitively expensive work, in fact, for many miners. Production costs are rising. And unlike with the oil industry, no “fracking” method has been developed yet to extract gold from hard-to-reach areas.

That’s where royalty and streaming companies come in.

An Excellent Pick-and-Shovel Play 

These companies are essentially specialized financiers. They provide producers with upfront capital in exchange for royalties or rights to a stream of future deliveries of metal, normally at a fixed, lower-than-market price. They then can sell the metal for a profit.

We consider this a win-win-win, for not just the royalty company and producer but also the investor.

For one, royalty and streaming companies typically remain well-diversified. Whereas any given mining company might own only one or two mines—which may or may not be operational—royalty companies can stay profitable by receiving regular streams of revenue from multiple sources. Investors get broad exposure to various junior miners as well as precious metals, from gold to silver to palladium, by owning Wheaton Precious or Royal Gold. Through Franco-Nevada, they can get additional exposure to energy, as some 16% of the company’s revenue is now sourced from oil, gas and natural gas liquids (NGLs), according to second-quarter data.

Another reason why we find these companies so attractive is that they’re not the ones getting their hands dirty. Their only obligation is to lend capital, making them an excellent pick-and-shovel play. They don’t build the mine’s infrastructure; they’re not responsible for cost overruns or maintenance; they don’t experience capital cost inflation; and they don’t have dozens of miners and other personnel on their payrolls. Royalty companies, therefore, enjoy many of the upsides of being in the precious metals industry, but face very few of the risks. 

Strong Balance Sheets, Attractive Shareholder Rewards

That includes debt risk. Mining, as you probably know, is a debt-intensive business. In the March quarter, Newmont Goldcorp reported 35.5% debt-to-equity. Franco-Nevada’s, on the other hand, was as small as 3.4%.

To elaborate on one of the points already made, royalty and streaming companies have extremely low overhead compared to miners. They’re among the most profitable firms, in fact, on a revenue-per-employee basis. Wheaton Precious generated an incredible USD22mn in revenue per employee in the 12 months through the end of March. Franco-Nevada wasn’t far behind at USD21mn per employee. Royal Gold stood at USD18.42mn per employee. Compare that to majors Barrick and Newmont, which generated much less on a per-employee basis.

That’s translated into wide margins and healthy dividends. In the five-year period through March, Franco-Nevada, Wheaton Precious, Royal Gold and Osisko Gold Royalties had a combined dividend growth rate of 12%. The S&P 500, by comparison, had one of 9%. Over the same period, miners trimmed dividends by as much as 21%.

The Smart Money of Metals and Mining

“I never touch gold [mining] stocks because you’re letting a layer of idiot management between you and the price of the commodity,” Kevin O’Leary, Mr. Wonderful himself, recently said on CNBC. “The history of managers of gold companies is abysmal. I’m just telling the truth… Why touch that? It’s full of volatility and bad management.”

I don’t necessarily disagree with my friend Kevin. Many investors, including myself, have been burned by select gold mining stocks for the reasons he mentions. There are gems, to be sure, but to be successful in the industry—especially the juniors—investors really need to do their homework.

Royalty and streaming companies make it easy. We like to call them the smart money of the metals and mining space. Their management teams are world-class. They take on very little debt and deploy cash reserves only at the most opportune times. And because mining production costs continue to rise, the appetite for streaming deals is very healthy. This puts Franco, Wheaton Precious, Royal Gold and their peers in an exceptionally good position going forward.

 

About the Author

 Frank Holmes, CEO, US Global Investors

 

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