“Depending on how bad a crisis gets, gold ranges between being the best answer and the only answer.”
— John Train, Preserving Capital and Making It Grow
Gold, an inert, unchanging metal, is immune to the foibles of human beings. Gold stocks are not.
I would like to share with you how big-brained and highly paid mammals drove gold stocks into the ground even though gold itself has not done badly. The yellow metal has doubled in the last 10 years. Meanwhile, gold stocks have been halved.
At Grant’s Fall Investment Conference, I heard a thoughtful presentation by John Hathaway. He is the co-manager of the Tocqueville Gold Fund. Hathaway joined Tocqueville in 1997, though his investing career began in 1970.
Hathaway is a gold bull, but he lacks the fangs you’d normally associate with that crowd. Then again, running a gold fund for the last 10 years ought to be enough to humble any gold bug.
Hathaway’s gold fund track record is the kind of thing that gives money managers nightmares. Down 23% year to date. Annualized returns of minus 30% for three years running and minus 20% for five years. Meanwhile, the S&P zips along at 12–13% annually. For a decade’s worth of work, the Gold Fund has produced an annual return of negative 0.2%, versus 6.8% for the market overall.
As bad as that is, it’s a lot better than gold stock indexes. So Hathaway showed, in a way I’m sure he’d rather not repeat, his stock picking chops. A man with a lot of scar tissue, he took the podium and quietly shared what I thought was an astounding slide, pictured below.
This chart really fascinates me. And I think part of it is the inescapable irony. Gold’s great appeal is that it isn’t paper and you can’t dilute it. And here gold stocks have diluted their shareholders (doubling the shares outstanding!) andleveraged up more than 40-fold!
If you want to know why gold stocks have done so badly, you can start with this chart.
What’s also interesting is that all this capital thrown into mining hasn’t done much to expand the supply of gold. “Mine life in the gold industry is currently 13 years,” Hathaway said, “which is one of the lowest levels over the past 30 years.” Discoveries have slowed to a trickle.
Now, for the first time in years, many gold stocks are cheaper than the cost to rebuild (or replace) assets. Replacement value is a good anchor to windward. If you consistently buy good assets below replacement cost, odds are good you won’t lose money.
That’s because markets respond to incentives. So, either two things happens: The stocks get bought out by bigger miners looking to add production or the gap narrows as the demand for new mines rises and the existing supply runs off. Replacement value isn’t going down. And gold isn’t going out of style.
Hathaway offered some speculations on the gold market itself and where the gold price might go. I’m far less interested in that question, because it is unknowable. I was more interested in his stock picks…
How to Thrive in Any Gold Market
After listening to his recommendations, I was surprised he did not mention any gold royalty or streaming firms such as Royal Gold and Franco Nevada.
Royalty and streaming companies don’t do any mining themselves. They finance part of a mine’s development in exchange for a percentage of what the mine produces over time. They are akin to financiers. As such, they escape a lot of the dirty work of mining. Their returns on their capital are better. Yet they still have upside to the metal itself.
In the gold stock universe, they’ve held up remarkably well. A 10-year look back at Franco-Nevada, the largest of the royalty/streamers, shows a price return of 325%, excluding dividends. This during a time when gold stocks, as measured by the GDX, were cut in half.
The question is always what to pay. As businesses, their return on invested capital is still low. ROICs for this group have been sub-5% for the last couple of years. And 2016 doesn’t look to get better. See this table, which shows the estimated 2016 ROIC for each, from Canaccord Genuity:
Investing is not just about finding a neat business or betting on something that’s worked in the past. You need to justify it based on the price you pay today. The basic way to price any business is to think about what it earns on the capital invested in it.
So Franco-Nevada is a great company. But is a business that earns a sub-5% return on its invested capital worth 2 times book value?
The analysts at Canaccord Genuity asked the same question in a May report titled Royalty Returns. They compared the royalty companies to banks. Which is not a bad comparison, considering that the royalty companies are, in essence, financiers:
The banking sector is generally valued on a price-to-book basis. Bank of America is at 0.72 times, while Goldman Sachs trades at 1.04 times. Bank of Montreal trades at 1.54 times, and Toronto-Dominion at 1.80 times. Scotia is at 1.68 times. Even assuming the average is 1.5 times, royalty/stream companies trade at a substantial premium to this metric.
These financials earn higher returns on their equity than the royalty stocks.
Yet the analysts come down on the side that the royalty companies deserve the premium because of the upside leverage to gold and silver, an upside absent from the banks. That makes sense as a hypothesis, but I’m not sure it should be that way.
In any event, I wouldn’t buy the group. I’d buy the best-in-class player: Franco-Nevada (FNV). It is really without peer. Another interesting note from Canaccord:
Since 2008, FNV averaged an annualized ROE of 10.7% per quarter. The company’s dividend policy has returned 18.4% to shareholders since inception, and in terms of yield (assuming a three-year trailing purchase), the company also stands alone. In its worst quarter, Franco generated breakeven ROE. In its weakest time, it recorded a $108 million write-down (or 3% of shareholders’ equity at the time).
That is a heck of a record for a precious metals stock.
And regardless of what I think the price-to-book should be, the market has been consistent in rewarding FNV with a multiple that closely tracks the price of gold (which, in turn, influences FNV’s return on equity).
Arguably, there is a lot more opportunity for FNV now. With gold miners struggling, capital is harder — and more expensive — to get. FNV has plenty of dry powder for deals. It ought to face less competition.
If you have a high conviction on the gold price, these royalty stocks belong in your portfolio. FNV, in particular.
That’s all for now. Hard to believe we’re almost done with 2015.
Thanks for reading, and I look forward to writing you again soon.
Sincerely,
Chris Mayer
