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How to Make the Biggest, Safest Returns Possible in Royalty Companies

The interview below 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.
 
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. And his recommended portfolio averaged returns of 35% per year from 2000 through 2012.
 
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.
 
 
Stansberry & Associates: John, you're one of the world's top experts on gold and silver stocks. And follow several "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.
 
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.
 
S&A: 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 can be a big problem for mines because they often cost more to build than what was planned for – 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. By 2012, the average cost to produce an ounce of gold was close to $650... 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.
 
S&A: 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 make 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.
 
S&A: Can you provide a couple of examples of how royalty companies can grow to the sky?
 
Doody: One of the best-known royalty companies is Royal Gold. It's a great example of a royalty company that started small and steadily grew to a multibillion-dollar business.
 
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.
 
S&A: 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.
 
S&A: Any parting thoughts on royalty companies?
 
Doody: I'll just add that it's common for several of the 10 recommendations in our current "Top 10" portfolio to be royalty companies. That should tell you something about how much we like these stocks.
 
S&A: Thanks for talking with us, John.
 
Doody: You're welcome. Thanks for inviting me.
 
Summary: There are several benefits to owning royalty companies... diversification, relative safety, and high dividends. Those traits allow royalty companies to provide strong, steady growth for investors, with much less risk than the typical mining stock.

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