Royalties: Better than Mining?

09/02/2016 10:00 am EST

Focus: STRATEGIES

Frank Holmes

CEO and CIO, U.S. Global Investors, Inc.

Frank Holmes, CEO of US Global Investors, has long been one of the investment world's foremost authorities on gold. Here, he explains the benefits of royalty streaming stocks relative to mining outfits and highlights four stocks offering exposure to this niche market.

Steve Halpern:  Today I'm really pleased to be able to introduce Frank Holmes, CEO of U.S. Global Investors.  How are you doing today Frank?

Frank Holmes:  Very well, thank you.

Steve Halpern:  Well thanks for taking the time.  Now you're well known as one of the nation's leading authorities on the gold sector.  Could we begin with your overview of the state of the current gold market and your expectations looking ahead.

Frank Holmes:  Sure, I think the biggest part to start off with is that I've always advocated that investors have a 10% exposure to gold, 5% bullion and 5% gold stocks.  

If you have more risk appetite, then you look at gold stocks because the volatility of gold stocks is twice the S&P, and the volatility of bullion is exactly the S&P.  

What we've seen here is that the market for gold after four-and-a-half-year decline from September 2011 to basically January of this year that decline is pretty well a normal pattern.  This one has been more challenging for everyone.  I think the big factor here is negative interest rates.  

This is so important, Steve, for your listeners because if we go back to when gold hit $1900 in September 2011, the 10-year government bond was minus 300 basis points, real interest rate.  

You take what the government's going to pay you and deduct the CPI number, and you are locking for 10 years a minus 3% a year rate of return.  That always knocks the price of the dollar down and gold up dramatically.  

Since then, even though Fed funds hardly budged you've seen real interest rates in the U.S. because CPI has fallen go from minus 300 basis points to plus 2%, so we had a 500 basis point swing and that knocked the price of gold down.  

However, this year we're seeing negative real interest rates creeping up and so they're getting more negative and we're seeing their whole world is now estimated with $12 trillion offering you negative rates of return.  

The Swiss government's 50-year government bond last month went negative. The whole Brexit issue triggered a concern of a global slow down.  Negative interest rates have always made gold rise in that country's currency.  

Steve Halpern:  So from a fundamental standpoint, you’re bullish on gold. You also note that gold is still under-owned by investors.  From a psychology standpoint -- as a contrarian view -- would this increase your bullishness?

Frank Holmes:  Yes, yes.  An interest statement I’d share with your listeners is that I was recently in New York and Toronto and Vancouver.  I went around to see all the gold analysts from the banks and brokers.  

Most interesting is the last time we posted such substantial performance, we're the number one gold fund -- the US Global Investors World Precious Minerals Fund (UNWPX).

And when you're up 150% over 12 months how did you do it?  You outperformed the Market Vectors Junior Gold Miners ETF (GDXJ) and you outperformed it for one and three years you have positive numbers.  

With that, who's buying?  If we go back when 2006 when we had these great numbers again we had incredible fund flows back then.  The fund flows are not happening today.  They're going into the Market Vectors Gold Miners (GDX) and GDXJ even though we're outperforming it.  

I said, “Well what about the institutions?” They said in Canada 8% of the stock exchange is gold-related; and the average institution is only 2%.  In America, it's only 1% of the S&P 500 (which is Newmont, which is a pure gold play).  Most of the generals have no exposure.  

I said. “Well then who's buying?  Who's buying all these gold stocks.” They said macro funds and quant funds.  I said, “Quant funds?”  I said, “So what drives the quant funds?”

We did some regression studies and we noticed that at the beginning of January, the companies that had the lowest G&A (general & administrative) expenses to revenue jumped 88% in the first quarter of the top ten names versus the market being up 35%.  

The quant funds are looking for they're doing macro quant analysis and then they'd buy the stocks, they don't care about where their land is, whatever the story is in the future.  They care about what the past is and the past quarter versus the past year.  You can see money plowing into these names.  

Steve Halpern:  Now for investors who are looking for exposure to gold, you're particularly fond of a sub-sector of the market called gold royalty companies.  Could you explain what these are and perhaps touch on their benefits relative to the traditional mining stocks.  

Frank Holmes:  Well one of the best ways to play gold I've always said is the royalty and streaming companies.  These companies serve a very specialized financiers to explores and producers.  

In return for this upfront financing, they can receive one of two forms of payments.  In one way they can receive a royalty, which gives them a royalty on that property forever.  The other one is to get a percentage of future sales.  

What really helped the Franco-Nevadas of the world was that if they went out and lent you $100 million to develop your mine in Nevada and they say well we have a right on all the gold underground.  

This money we're lending you is for 10 years and you'll pay us back the royalty, but then we have a call for everything else forever and ever.  

Well, one mine new strike went from having 2 million ounce reserves to 30 million ounce reserves, and went from a 10-year mine life to producing for 40 years.  

All that stuff has huge optionality and big cash flow.  These companies are very special in how they get acclaim on the underlying assets.  

A lot of the complexity that they avoid such as buying tractors, buying equipment, skilled mining geologists, engineers, metallurgists, they have them on staff, but they don't have to have thousands of soldiers -- foot soldiers -- out there drilling for the gold, processing the gold, trucking the gold.  

When you look at them, they're very unique.  Most of them are under 25 employees.  They have the highest revenue per employee.  

What I noticed is that the best investment banks years ago always had the highest revenue per employee.  Goldman Sachs (GS) was always two to three times greater than its peers.  

When you take a look at the Franco-Nevada (FNV) -- worth over $15 million of revenue per employee -- and Goldman Sachs is $1.2 million and you compare that to Newmont Gold (NEM), which is almost $400,000 of revenue per employee.

The margins for the Franco-Nevadas of the world -- and Silver Wheaton (SLW) and Royal Gold (RGLD) -- are so much greater than the mining companies.  That's always lowered your overall cost low risk.  

Steve Halpern:  Now you mentioned Franco-Nevada and Silver Wheaton, which I know in the past you've talked about as two of the top quality plays in the royalty streaming area.  Are you still bullish on those names in particular?

Frank Holmes:  I am.  I think they're a very important part of someone's portfolio.  I would rather own a Franco-Nevada then a Newmont.  Newmont so far this year is up higher, but also fell substantially lower.  

In the past five years Newmont is in a negative rate of return and Franco-Nevada's doubled for investors.  In a down gold market over five years, Franco-Nevada is double.  

I sort of like that type of a thought process.  I know the management.  They have professional geologists, engineers, metallurgists have all worked in these mines around the world.  They have great technical skills, so they go in and they can kick the tires before they write a check to finance these operations.

Steve Halpern:  Silver Wheaton — I assume from the name — is a similar scenario to Franco-Nevada in gold, but with an emphasis on silver production.

Frank Holmes:  Correct.  We were in the ground floor of that when it was pennies.  That concept came out of Goldcorp (GG) to finance other operations.  They were able to sell off their silver stream and get a higher multiple because there's a whole audience of investors that love the high margin business that royalty companies have.  

One of the best performing software companies in Canada, which has gone from a $30 million funding to $10 billion valuation has very similar structure.  It has these high gross margins.  

When you look at Barrick (ABX) versus say a Silver Wheaton, the gross margins and the net margins per employee and overall as a company are substantially greater per Silver Wheaton as they're ever for a Barrick.  They traded a higher PE ratio for that.

When they do a financing, it's usually done in a big premium to book so then it becomes accretive.  Well there are lots of quants that buy rising book value.  

Most of the mining companies can't show rising book value, so you're seeing that the quant world is much more pulled into that the offerings or the financial offerings that the royalty companies offer.

Steve Halpern:  Now we're just about out of time, but before I let you go you also pointed to two other companies in this field — Royal Gold and Sandstorm (SAND).  Could you just take a moment to comment on the outlook for these two streaming companies?  

Frank Holmes:  Sure.  Royal Gold is out of Denver.  Royal Gold is I call them the three amigos.  That would be Royal Gold, Silver Wheaton, and Franco-Nevada.  

The new kid on the block is Sandstorm.  Sandstorm made a big coup earlier this year when it bought Teck Resources (TCK) and immediately got the cash value.  

They had some hiccups where they're trying to buy cash flow that would come on in the future.  That didn't come on, so that hurt them.  Now, they're more focused on buying immediate cash flow companies.  I think that their stock has had a spectacular run this year.

Steve Halpern:  Again, our guest is Frank Holmes at U.S. Global Investors.  Thank you so much for your time today.  

Frank Holmes:  Thank you Steve.
By Frank Holmes, CEO of US Global Investors

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