Here’s Why You Should Own Royalty Companies

If you’re at all interested in precious metals (physical metal or miners), you ought to be interested in royalty plays as well.

Royalty plays are a powerful method to profit from a rising price for gold, silver or other metals but without the hassles of physical possession; things like storage, insurance, transport and such.

And royalty plays also reflect the difficult efforts and hard-won output of mining companies but without the hassle and operating problems of running a mine.

Another way to say it is that royalty plays are like owning physical metal without actually owning any physical metal. Or they’re like owning shares in mining companies but without the mine. What does this mean? Let me explain.

Thoughts on Physical Metal

If you’ve subscribed for any length of time, you’ve likely read about the importance of owning gold. We discuss that point quite a bit here, as well as in many other publications at Paradigm Press. Get yourself some physical gold and silver, we often say.

It’s good to own physical metal. You have it, you control it and it’s nobody’s problem but yours, in the sense that you need a secure place to store your stash. You shouldn’t just toss it into a desk drawer and forget about it like old tableware or phone chargers.

When you “own physical,” as we call it, you buy real coins or bullion and take custody. This form of ownership is not a paper certificate or some sort of depository account; it’s real metal that you can hold in your hand.

And if you hold the metal, there’s none of what we call “counterparty risk,” which refers to the idea that someone on the other side of the deal might not deliver. Let’s expand that last point. Let’s say that you walk into a bank and deposit cash into a savings or checking account. It’s your money, right? Well, no, it’s not.

It’s no longer your money because once you hand currency over to the teller, it becomes property of the bank. The bank is a counterparty to your deposit, and your claim to retrieve the funds is actually just a legal obligation for the bank to repay you, or perhaps cash your checks down the line.

Along the way, if the bank goes out of business, you’re out of luck except for federal deposit insurance. Meaning that you’ll get money back from the federal insurance fund, but you’ll never see that bank deposit money again.

This should help you understand the counterparty idea. And by extension, you should understand why holding physical gold means that you hold the goods of value (gold, silver, etc.) and need not rely on anyone else. There’s no counterparty risk.

So far, so good. But suppose that you don’t want to hold too much gold (“too much” being a very subjective amount). Perhaps you just don’t want the hassle of security and storage, or you have issues with insurance coverage, or it just makes you nervous about your safety.

Okay, so you can buy gold or silver and keep the metal in someone else’s storage system, but now you’re back to that counterparty risk issue. What if the storage site has problems? What if the storage site burns down or gets raided by the FBI? (True story; this happened in California). Is there a way to at least control the gold without having to hold it yourself? Hmm… Hold that thought.

Metal in the Ground

Now, look at metals from the other direction, namely from the mouth of the mine. Way down in the pit, we have an ore deposit in the rocks. The metal is there (i.e., the gold, silver, etc.), but it’s tied up in the rocks, in the form of ore.

Of course, you can buy shares in the mining company that owns the mineral rights, but now you are truly joined at the hip with that company and management team. Can they mine that ore out of the ground, process the material and separate the valuable metals? Can they make any money at it?

Again, there’s counterparty risk to owning a mine. Think about all the operational risks: who owns the mineral rights, government permits, social license with locals, logistics and expense of building and operating a mine, issues with ongoing operations, energy costs, costs and prices for innumerable other goods, maintenance, labor and workforce issues, and much more.

Is there a way to avoid these levels of counterparty risk, yet also control metal in the ground without actually being in the mining biz?

Hmm… Hold that thought, too.

Another Way to “Own Gold” and Other Metals

Well, yes; there’s another way to own gold and other metals, besides buying the physical material or getting into the actual mining process.

This method does not involve serious funds upfront to purchase and take delivery of coins or bars. You have no storage issues. And you aren’t tying yourself to a particular mining company in a specific locale or geology, or a certain asset, or to a technical and management team with all the operational issues.

In other words, there’s a way to reduce much of the risk of owning gold or mining company plays, but you can still retain a strong whack of the upside when gold increases in price. Which brings us to royalty companies…

Here are the basics: A royalty play is not a gold miner because mining is for miners, and royalty companies do not run mines. No drill rigs, explosives, bulldozers or backhoes. No air and water permits. No road maintenance. No employees in steel-toed boots and hard hats. No big purchases of diesel fuel. No worries about the weather.

Royalty companies stay away from the messy side of things and leave mines, mining and operating risks to the mining people.

So then, one might wonder, what does a royalty company do? Well, somewhere in the life of a mine operation, the royalty company takes an up-front risk and lays out cash. Perhaps the mining company needs funds now-now-now, and management doesn’t want to dilute shareholders by issuing new shares. Whatever the reason, a royalty company buys a future claim on the output of the mine, the gold, silver or whatever else.

It’s called buying a royalty from the mine or miner.

Then when the mine is up and running (and it might take quite a while), every month or quarter the operator transfers funds to the royalty company. It’s a legal obligation. Yes, there’s still that counterparty risk, in that the mine operator must mine and produce output, and the royalty company must watch over everything like a hawk.

But the general business model is that the miner mines metal and the royalty company gets paid straight off the top; often via a process calculated as the “net smelter royalty” (NSR), meaning a payout based on how much metal comes out at the end of the smelting circuit for a particular ore.

And most royalties go on and on, long beyond the payback of the original, upfront outlay. In a financial sense, a royalty can become a gift that keeps on giving.

Royalties in Action

Let’s say that an exploration company has a promising mineral show deep in the woods, but management needs money to continue the work. What do these guys do?

Or further along, during development, the mining company needs cash to complete a particular phase of the buildout, to move the overall project closer toward completion. Again, what do these guys do?

Well, they can try to borrow money from a bank, but most banks don’t loan to miners at these stages. There’s too much time risk and operational uncertainty for conventional banking.

Or developers can go to the markets, issue shares and raise cash that way. But this involves diluting previous shareholders, and sometimes it’s tough to shake that kind of money tree.

But there’s another way as well; the exploration or development company can sell a royalty to a third party that has cash, understands the mining business and can just write a check.

Then over time (and it may be years later), the mining operation pays back that advance of funds via a royalty. And the overall royalty may be much more than the original amount that was paid upfront.

If this sounds like a banking operation, well you’re right. You can look at royalty companies as “banks” to mining plays, but they’re not banks like you would use to take out a loan for a house or car, etc. Royalty companies are specifically focused on advancing funds into mining plays, with the expectation of eventual payback in the future. Then they receive back a long tail of cash flow over and above the original investment.

Of course, this kind of resource-development funding is not easy. It all requires serious oversight. Indeed, royalty companies have staff who scrutinize mineral plays with eagle eyes and sharp pencils. Royalty plays employ geologists and engineers, as well as money managers who rival the best hedge fund analysts.

Own Royalty Plays Now

And what does this all mean? Well, the best time to own royalty companies is toward the beginning of a generally rising gold market, like what we have now. Here’s an example… Say that gold rises from $2,000 per ounce to $2,100, a 5% move. That’s a good feeling if you hold physical metal; it’s a gain that you can hold in your hand.

But that same price rise might not quickly trickle down into the mining company’s share price. Share buyers want to review the profitability of the miner and consider how it all factors in with rising costs for energy, labor, materials, taxes and more.

But what about the royalty company? Well, if gold goes up by $100 in price (from $2,000 to $2,100), that increase in royalty payout from the mining play goes straight to the bottom line.

In essence, the tendency is for royalty plays to increase in share price early in the rising cycle of metal prices, and typically the share prices for royalty plays grow faster than the increase in price of the underlying metal.

Now, let’s look at some company names. These are not official recommendations, and we won’t track them. But they are solid, well-run companies in the royalty space and I follow them.

In the royalty arena, the biggest player is a sturdy old name, Franco Nevada (FNV). Current share price is about $107, with a market cap over $20 billion and a dividend yield of 1.4%. Right now, shares are down and hover near a four-year low.

Ordinarily, I’m not keen to buy shares on a declining trend, but Franco seems to have found a recent base. Plus, looking ahead, I see rising cash flows and profitability with higher gold and silver prices. Meanwhile, management has announced dividend increases.

Another large, sturdy play is Royal Gold (RGLD). Current share price is $112, with a market cap of about $7.5 billion and a dividend yield of 1.4%. As with Franco, the current share price is near a four-year low.

I’m bullish on large royalty plays because we’re in the midst of a general rise in prices for gold and silver, and the money will flow to the bottom line, if not out as higher dividends.

Over time, and in a rising market for the underlying metals, these royalty plays should offer protection on the downside, with upside gains as events unfold.