Royalty Overview

If I could pick one investment strategy to pound the table on this is it. Royalty is King!

Backtesting

Past results don't indicate future results, but it's worth looking at the backtesting data. Junior gold miners on average lose money and are only valuable as a short. Gold historically has lower volatility but has low returns. Royalties have had high returns.

It's really notable that Royalties pair well with various combinations of traditional equities (represented the S&P500 ETF SPY) and with shorting the junior miners.

Asset Return Max Drawdown Sharpe Ratio
SPY 9.28% -48.85% 0.55
GLD 1.35% -13.11% 0.10
GDXJ -4.23% -87.07% 0.03
33.33% FNV, 33.33% WPM, 33.33% RGLD 14.40% -60.02% 0.59
75% SPY, 25% GLD 8.66% -39.19% 0.60
100% SPY, -25% GDXJ 9.17% -26.69% 0.56
25% each FNV, WPM, RGLD, -25% GDXJ 9.65% -30.89% 0.69
33.33% each FNV, WPM, RGLD, -25% GDXJ 12.22% -42.33% 0.65
33.33% each FNV, WPM, RGLD, -50% GDXJ 12.52% -34.64% 0.76
50% each FNV, WPM, RGLD, -50% GDXJ 17.32% -54.41% 0.69
25% each FNV, WPM, RGLD, SPY 13.61% -53.69% 0.63
25% each FNV, WPM, RGLD, SPY, -25% GDXJ 12.26% -32.25%% 0.78
50% SPY, 16.66% each FNV, WPM, RGLD 13.15% -47.30% 0.70
50% SPY, 16.66% each FNV, WPM, RGLD, -25% GDXJ 12.06% -20.65% 0.97
62.5% SPY, 20.83% each FNV, WPM, RGLD, -25% GDXJ 15.23% -27.1% 0.96
62.5% SPY, 20.83% each FNV, WPM, RGLD, -50% GDXJ 14.45% -22.05% 0.86
37.5% each SPY, FNV, WPM, RGLD, -50% GDXJ 18.12% -41.5% 0.86

Profit Pools

Within industries different types of companies have different ability to capture profit due to their place in the industry. Some will have consistently great returns on capital and some will have consistently terrible returns on capital.

In gold mining sector the royalty companies have consistently great returns on capital and very low cost of capital. Meanwhile junior miners and explorers tend to have consistently terrible returns on capital and very high cost of capital. We could make a basket of companies that represented the royalty companies and went long that basket, and we could make a basket of junior miners and exploreers and short that basket. Then we wouldn't have to follow any individual companies. After all some royalty companies will do badly and some junior miners will do well, but it's hard to know which ones. But it's relatively easier to know that the fist basket will do better than the second basket.

Asset Valuation

How do you put a value on royalties to figure out what the company that owns royalties is worth?

A cashflowing asset is worth the present value of future cashflows.  That's a lot easier to do looking backwards at what the cashflows were, rather than looking forward at what the cashflows are. Still, guessing at this is our job as investors.

I'll use ounces of gold, but you can substitute lb of copper or tons of iron ore or whatever your royalty is on.

Most analysts will give a Net Asset Value (NAV) based on the mine plan, a discount rate, and a concervative metal value.  They'll put it in a discounted cashflow (DCF) spreadsheet.

The mine plan is usually based on Proven & Probable (aka reserves) and doesn't usually include Measured and Indicated or Inferred.

If year to year production in the mine plan is pretty steady you can save yourself a spreadsheet task and get close with a simple forumla using an 8% discount rate:

NAV = reserve oz * royalty rate * price of gold per oz * 0.92^(life of mine /2)

Quick & Dirty Asset Valuation

Production Project value in US Dollars = (Proven oz + Probable oz + Measured oz + Indicated oz) * royalty rate * spot price of gold per oz

Usually proven and probable is included in M&I so this calculation is very fast and the data is usually easy to get.

This quick and dirty valuation is usually greater than most NAV calculations due to lack of a discount rate and inclusion of Measured and Indicated resources.

This method also usually understimates the true value of the asset cashflows.

The primary way royalties outperform NAV is by drilling.  NAV increases if we add to reserves.  If production stays the same adding to reserves can be seen as extending mine life.

Drilling can upgrade confidence of existing resources. It might convert Inferred to Indicated, Indicated to Measured, Measured to Probable, Probable to Proven. That's part of why the Quick and dirty valuation holds up well, it gives full credit for M&I getting converted to reserves but no credit for Inferred and no credit for new discoveries. The gain from those excluded items often exceeds the discount rate.

When a mining company increases production they essentially turn some of those longer dated dollars closer to the present and increase their value. It costs the mining company to increase production, they have to go buy equipment and hire more people and such.  A royalty company pays none of that, they get 100% of the increase in the value of the dollars being closer to now.

Expanding the mill shortens the mine life if done in isolation.

It's worth saying the main reason we prefer first quartile cost producers is not because they will stay open, but because they will generate enough cash to drill and expand their mill.

If a company adds x% to mill capacity and x% to reserves so their mine life stays the same, then they just added x% to NAV. For example a 20% mill expansion that happens with a 20% reserve increase means NAV increases 20%.

Development Assets

Quick and Dirty

Development Project value in US Dollars = Production Project Value * percentage likelyhood of becoming a mine * (1 - artibrary discount percentage)

The NAV approach usually is to use a higher discount rate for development or construction projects. Kevin MacLean has noticed that the market typically gives developers a 17% discount rate. It's a little imprecise as it's conflating the present value of future cashflows with the uncertaintly of those cashflows.

Royalty Companies and Cost of Capital & Overhead

Royalty companies are at their core a kind of specialty finance.  Like a bank they have a cost for the money they use to acquire or originate royalties.  

Imagine two theoretical simplified royalty companies, F and E.  F is large with lots of assets many of which produce a steady stream of cash.  F can also borrow money incredibly cheaply because it has lots of assets and cashflow so lenders know they are a safe bet to pay their loans on time.  E meanwhile is small with just a few assets.  If they borrow money it is at very high rates to compensate lenders for the risk.

Company F Company E
asset value $10 billion $50 million
royalty revenue $1 billion $5 million
borrowing cost 3% 15%
return on investments 10% 10%
company overhead $20 million $10 million

Company F is in an enviable position.  Despite having twice the company overhead as Company E after paying its overhead it has $980 million cashflow a year to reinvest.  Its biggest problem will be finding enough deals to reinvest in and deciding how much of its leftover cash to return to shareholders via buybacks and dividends.  If it does manage to find more good deals than it can fund from its own cashflow it can easily borrow money and still make a very tidy profit borrowing at 3% and investing at 10%.

Company E however is still bootstrapping a new royalty business.  Despite its lower company overhead, after paying its overhead it has to go raise another $10 million every year just to keep the doors open, diluting existing shareholders.  With no cash leftover from its royalty revenue it also has to borrow money to fund purchase or originating new royalties.  But because its borrowing costs are higher than its returns it has to issue even more shares to pay the loan.  

The hope of company E is that eventually they can increase their asset value and the resulting royalty revenue.  If they can get big enough they can cover their company overhead from their royalty revenue.  If they get bigger still they can have some royalty revenue to reinvest.  If they get bigger still their borrowing costs might get below their return on investments.  In other words, if they are successful someday they might become company F.

But it's far from certain if company E can pull it off.  If they can continue to find investors to issue shares to without making their current shares worth too little.  If they can continue to scale up out of the cash burning hole they started in.  If they can pull themselves up by their bootstraps.

Two questions I ask about any royalty company I look at investing in.  Is their borrowing costs below their investment returns?  Can they fund their overhead out of their revenue?  If the answers to both of those are yes then I start looking at valuation.  If the answer to either is no I don't look at valuation at all and instead start looking at what their plan is to make the answer to both of those questions a yes.