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Dear Daily Crux reader, This week's installment of our popular "World's Greatest Investment Ideas" features one of the best precious metals investments in the world: royalty companies. To explain the incredible benefits of these stocks we sat down with John Doody, one of the world's top experts on gold and silver stocks. Longtime readers know John is the editor of Gold Stock Analyst, an advisory with a track record that's unrivaled in the newsletter industry. John has been studying and analyzing these stocks for over 40 years. Since he began publishing GSA in 1994, his recommend portfolio has averaged gains of close to 30% per year. His opinion on gold stocks is so respected, he's been profiled by Barron's seven times, quoted in The Financial Times, and is frequently interviewed on CNBC. He counts several of the world's best-known gold funds and investment managers among his subscribers. As our colleague Porter Stansberry says, "No one in the world knows more about gold and silver producing companies than John Doody. No one else even comes close." Whether you're just getting started in resource stock investing or you already own some of these companies, John's advice could be critical to making the biggest, safest returns possible in this volatile sector. Regards, Justin Brill Managing Editor, The Daily Crux www.thedailycrux.com The Daily Crux: John, you're one of the world's top experts on gold and silver stocks. You follow over 70 in total, including seven known as "royalty companies." Before we get into the value of owning these stocks, can you define what a royalty company is? John Doody: A royalty company is basically a mine financing entity that has sold shares to the public. These companies provide money to miners for either exploration or actual capital costs such as mine and processing plant construction. So in a sense, they compete with bank lenders and equity offerings that brokers want to do for mining companies. Royalty companies provide this financing to mining companies in exchange for one of two types of future payments. In the first type, the royalty company will finance an exploration program to receive a royalty on any future sales that are produced from any discovery – which is kind of like a sales tax – that typically ranges from 1%-5% of sales. While the upfront money can be small – often just a few million dollars – the royalties can be quite big. One royalty company we like steadily receives about $50 million per year from a site it helped fund exploration for in the mid-1980s. In the second type, the royalty company will help finance mine construction – which is much more expensive than funding an exploration program – and receive a royalty payment called a "stream." A stream is a commitment for either a certain number of ounces of metals per year or a certain percentage of ounces produced on an annual basis from the mine. In this second type, a royalty company might be able to buy streams of gold at a 75% discount to the current spot price. But in order to buy gold at that kind of discount, it has to put up a significant amount of capital upfront. As an example, one of the royalty companies we follow recently purchased a stream on a mine that's being built in British Columbia. It's a copper mine with a big gold byproduct credit. And it's going to provide them with 105,000 ounces a year. They're paying $582 million up front, and will be able to pay just $435 an ounce for gold over the life of the mine. Now, this particular mine has an expected life of 22-years. So at current gold prices of around $1,600, the company will make over $1,000 for each of the 105,000 ounces it receives each year. This is over $100 million annually, or about $2 a share. At this rate, the company's initial investment would be paid off in six years. And the company would essentially be able to buy gold for $435 an ounce a year for the next 16 years or more. So you can see how lucrative this business can be for the royalty companies. Streams are often the preferred financing methods for the mining companies. If they borrow the money from a bank, they might have to hedge the production... or the bank might want more security of other mining assets, and so forth. If they sell more shares to finance the mine, it dilutes – and irritates – existing stockholders. So it's generally an easier financing mechanism for the miners, and it's a nice stream of income that the royalty company earns over the life of the mine. ---------- Advertisement ---------- Is this a scam–or a great idea? Do you think it's possible for an investment to have unlimited upside potential... and a contractual guarantee that it will never lose even a penny in value? Most people would say it's impossible... or even a scam. But a PhD financial analyst has recently published a very interesting new report detailing at least one such investment–it can go up, but NEVER down. Click here for more information. --------------------------- Crux: What makes royalty companies such great investments? Doody: First, it's a great way to get diversification. From an investor's standpoint, the typical mature royalty company has a portfolio of anywhere from 10 or 15 up to 50 different mines that are paying them royalties and streams. So it's a broad, diversified portfolio compared to a typical mining company that might own one or two mines. And as you know, there's a lot of risk associated with a one- or two-mine company. It's common to see mines encounter difficulties for various reasons, and the related mining stocks might lose 25%, 50%, or more of their value in one day. On the other hand, if a big royalty company had a royalty on that mine, it wouldn't be a big deal, because there would be royalties from other mines that could take up the slack. You also have a degree of transparency and clarity you don't get with mining stocks. Royalty pipelines are typically pretty visible, particularly over a three- or four-year time frame. And once a royalty company has put the money in, it doesn't have any further risk. If there are capital cost overruns – and that's a big problem in the mines these days because the mines are typically costing more to build than what was planned three or four years ago – they're not the royalty company's problem. It's already struck its deal. It might take another bite of it, but that would be a new deal. It's not something that it would have to pay any portion of. The miner is responsible for all overruns in the construction budget. There's also no exposure to the rising costs of production that miners have. The production cost of an ounce of gold or silver has gone up dramatically over time. For example, the average cost of production for an ounce of gold in the early 2000s was around $200 an ounce. These days, the average cost to produce an ounce of gold is close to $600, and it's only likely to go higher. A third benefit of royalty companies is they typically pay higher dividends than even some of the biggest mining companies. They have very low overhead. I don't think any of the big ones have more than 20 employees, because you don't need a lot of people in the business. And that means that a very high percentage of royalty income – typically over 90% – goes to gross profits, and from this they pay dividends and taxes, and finance future royalties and streams. Usually, they pay out about 20% of their royalty income as a dividend, which gives you great current income and visible growth from the royalty pipeline. Crux: Based on those traits – diversification, relative safety, and high dividends – some folks might assume these stocks don't experience big growth. Is that true? Doody: No, not really. Royalty companies typically provide strong, steady growth... and much less risky growth, in my opinion. One of the disadvantages of these companies is there's a lot of unfamiliarity about them among investors. They don't really understand the unique features that makes them much more predictable in terms of their growth and their dividends. I think as their pluses get more widely known, their stock prices will react higher. Crux: Can you provide a couple of examples of how royalty companies can grow to the sky? Doody: Two of the best-known royalty companies – Royal Gold and Silver Wheaton – are great examples of companies that started small and steadily grew to multibillion-dollar businesses. Royal Gold had the original idea of exploring to grow its own properties, and then finding majors to develop them, while retaining a royalty interest in them. The company had explored and found gold on a property in Nevada called Cortez. It got a miner called Placer Dome to develop it, and Royal Gold kept a royalty on it. It was a much smaller property when Placer first got involved, and it turned into a million-ounce-a-year mine. That huge royalty basically funded Royal Gold's growth in the acquisition of more properties, and it snowballed from there. Silver Wheaton was spun-out of the large gold company Goldcorp, and had one 6 million-ounce-a-year royalty stream on a silver property to begin. It was able to use that – along with the soaring price of silver – to fund its growth pipeline to over 40 million ounces per year in the future. Both companies show how steadily growing royalties and the rising price of precious metals can combine to create explosive growth. Crux: Do you have any rough guidelines for buying these royalty companies? Doody: The most important thing to know is that the big ones trade in the market at different multiples than the smaller ones. The big companies tend to trade around 20 times royalties per share. So if a company has $2 in royalty income per share, the price would tend to average around 20 times that, or $40. Of course, that doesn't mean it can't trade between 15 to 30 times royalty income. Stocks go up and down over the course of the year. But the multiples center around 20. The smaller companies trade at about half that. In a sense, the public market won't pay the same premium for the small royalty producers that it does for the big ones. And that's probably because there's more risk associated with the smaller ones. They have fewer royalties, so they're more exposed to mine risks. And they don't get to see a lot of big deals, so they tend to get the scraps that the big guys aren't interested in. Ideally, you want to buy the big ones when they're trading around 15 times royalty income, and sell them when they're trading over 25 times income. And you want to buy the small ones when they're trading around five times royalty income, and sell them when they're trading over 10 times income. But, rather than trading in and out based on the multiple, it can be better to just buy and hold based on their pipeline of growth. Our target price for these companies is typically double the current price, and that's based only upon the projected future production from the mines they already have an interest in, and at the current gold price. We never forecast anything based upon some "pie in the sky" gold price because we don't know when or if it's going to get there. You can find stocks that are good values without relying on a higher price forecast. Our audited track record of an average gain of 41% per year over the last 10 years proves this policy right. Crux: That's a great point. Any parting thoughts on royalty companies? Doody: I'll just add that three of the 10 recommendations in our current "Top 10" portfolio are royalty companies. That should tell you something about how much we like these stocks. Crux: Thanks for talking with us, John. Doody: You're welcome. Thanks for inviting me. Editor's Note: John Doody's Gold Stock Analyst is one of the finest gold stock advisories available at any price. We consider it a "must-read" here at Stansberry Research, and give it our highest recommendation. You can try your own subscription by clicking here. |
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