Get Exposure to Precious Metals Prices While Minimizing the Risk

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Investing in gold and silver mining stocks is not for the faint-hearted, and it has been especially unprofitable during the last few years with the collapse in the share price of precious metals prices. With the bloodbath come potential opportunities, however, and investors looking to bet on a rebound in precious metals prices can significantly reduce their investment risk by focusing on precious metals royalty companies.

I believe investing in diversified precious metals royalty companies such as Silver Wheaton (NYSE: SLW), Royal Gold (NASDAQ: RGLD), and Sandstorm Gold (NYSEMKT: SAND) can allow investors to participate in a rebound in gold and silver prices while skirting much of the operational risks that a mining company would be exposed to. Investing in well-run royalty companies should also allow investors to benefit from production growth and dividends, providing an additional advantage over holding the precious metals directly in physical or ETF form.

How a royalty structure reduces risk

For those unfamiliar with how a mining royalty company operates, these firms help finance the construction of a new mine and in return receives a “stream,” i.e. a percentage of the future metals production of the financed mine. Usually, the royalty company pays a nominal, fixed cost per ounce when procuring the metals stream from the mining company, although this cost is typically much below the market price for the metals and only helps to cover some of the operating costs of the miner.

It is important to remember that royalty companies acquire the metals stream from the financed mine at a fixed nominal cost per ounce. This is because one of the main headwinds for precious metals miners in recent years has been that unit production costs have been rapidly increasing and thereby compressing profit margins. However, a metals streaming company is not affected by this cost inflation because of the terms of the financing agreement. As a result, precious metals royalty companies gain pure exposure to gold and silver market prices, without having to worry about production costs.

Although metals royalty companies aren’t exposed to cost fluctuation, they can be hurt by production shortfalls at the mines they have financed. For example, if a financed gold mine doesn’t produce as many ounces as expected, then the gold stream attributable to the financing royalty company would correspondingly shrink. On the flip side, however, if a financed gold mine produces more ounces than expected, then the gold stream received by the royalty firm may actually increase. Therefore, this exposure to mine production can offer both risk and reward, and should not be viewed as a negative factor.

Investing in precious metals streaming companies rather than in gold and silver directly differs because of this aforementioned exposure to mine production variance. An investment in royalty companies offer pure exposure to the precious metals prices without being affected by production costs, much like a direct investment in the metals.

However, royalty companies also offer additional upside because of the potential for the financed mine to produce more metals than projected, or to undertake brownfield expansion to extend the mine life. In addition, larger and more mature royalty companies can offer investors significant dividend yield. For example, the largest precious metals streaming company, Silver Wheaton, offers a dividend yield well above 2%, and Royal Gold’s dividend yield is approaching 2%.

Lineup of diversified royalty companies

I will briefly touch on three of the largest precious metals royalty companies in this article: Silver Wheaton, Royal Gold, and Sandstorm Gold.

Silver Wheaton is, of course, the largest and oldest precious metals royalty company in the world. Silver Wheaton has a well-diversified portfolio of primarily silver royalty streams from 19 operating mines. The company anticipates receiving roughly 33.5 million silver-equivalent ounces from its partner mines in 2013, with room to significantly grow its annual silver stream in the future as Silver Wheaton has also financed 4 development projects that will start contributing silver streams in the near future. The company also has the potential to add additional metals streams, and management hasn’t been shy about deploying its cash, having already struck financing deals with three separate mines in 2012 and 2013.

Royal Gold is one of the largest gold-focused metals streaming companies, and received roughly 160,000 gold-equivalent ounces in fiscal 2012 from its 36 operating partner mines. Royal Gold has perhaps even more growth upside than Silver Wheaton, with 21 financed development projects, and an impressive $673 million in cash sitting on its balance sheet at the end of March that can be used to acquire additional gold streams.

The third royalty company I will discuss is Sandstorm Gold, which is the smallest of the three. Sandstorm projects to receive just under 40,000 gold-equivalent ounces in 2013 from its portfolio of 10 separate streams. However, Sandstorm has a steep growth trajectory ahead of it, as management believes its total stream will increase to well over 70,000 ounces by 2017 thanks to several financed projects that will start production in the near future. Additionally, while Sandstorm is a small, young company, it has an impressive management team that should help calm investor anxieties. For example, Sandstorm’s CEO, Nolan Watson, was the former CEO of royalty stream giant Silver Wheaton. Finally, the firm is in good financial health, with $97 million in cash at the end of March versus zero debt.

Concluding thoughts

All three precious metals royalty companies mentioned in this article have diversified mining portfolios, solid management teams, and good financial health. Furthermore, all three offer investors ample production growth, with Royal Gold and Sandstorm with a slight edge over the much larger Silver Wheaton. Although, Silver Wheaton offers greater stability as the largest producer among the three as well as with the longest track record.

Looking at trailing price to earnings multiples, Silver Wheaton was trading at 12.6 times 2012 earnings as of market close July 15, in comparison to 26.4 times trailing earnings for Royal Gold and 25.2 times trailing earnings for Sandstorm. Given that Silver Wheaton still has good growth potential, but trades at a much more reasonable valuation than Royal Gold and Sandstorm, it may be the precious metals royalty company that deserves the closest look from investors. 

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