US Global Eyes Royalty Companies

03/05/2015 9:00 am EST

Focus: STOCKS

Frank Holmes

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

As a refresher, royalty companies basically serve as specialized financiers that help fund cash-strapped miners’ exploration and production projects, explains Frank Holmes, CEO of US Global in Frank Talk.

In return, they receive either royalties on whatever the mine produces or what’s known as a “stream,” which is a commitment to an agreed-upon number of ounces of gold or other precious metal per year.

“Much of the gold mining industry is underwater and can’t make money with these prices. We’ve seen capital programs being significantly cut back, in terms of companies looking to expand and build new mines.”

That’s according to Ralph Aldis, portfolio manager of our Gold and Precious Metals Fund (USERX) and our World Precious Minerals Fund (UNWPX).

He continues, “Those companies have been sufficiently scared enough that, even when gold prices do recover, they’re going to hold off on expansions because they might have lost the appetite to risk capital on new projects.” This is where royalty companies come in.

From an investors’ point of view, royalty companies just have a superior business model. There are several reasons why Ralph and I find these companies so attractive.

For one, they’ve typically remained 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.

Toronto-based Silver Wheaton (SLW)—the world’s largest precious metals streaming company—has secured the right to purchase silver at a very low fixed cost from 18 operating mines in North and South America and Europe.

Another reason why these companies have outperformed is because, simply put, they’re not the ones getting their hands dirty. Their only obligation is to lend capital.

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, if any, of the risks.

To elaborate on one of the points already made, these companies have extremely low overhead compared to miners. Silver Wheaton is run by 30 people—at most—and yet it generates around $500 million in revenue.

On average, that’s $16 million per employee. It’s very possibly the world’s most profitable company on a revenue-per-employee basis.

Other royalty companies that have been good to our precious metals funds are Royal Gold (RGLD) and Franco-Nevada (FNV). Both have huge cash flow, wide profit margins, and pay dividends. Since Franco-Nevada went public in December 2007, it’s torn past both spot gold and most gold equity benchmarks.

As always, I recommend a 10% weighting in gold: 5% in gold jewelry or bullion, the other 5% in gold mining stocks. Remember to rebalance once a year. “You might also get some additional benefits by rebalancing quarterly,” Ralph says. “That’s like playing chess with the market as opposed to rolling craps.”

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