Mining is one of the worst businesses in the world.
This sentiment is shared by some of the top mining experts including Rick Rule, Marin Katusa and Jeff Phillips. It’s also shared by top mining executives in the world including Goldcorp’s (GG) chairman Ian Telfer and billionaire entrepreneur Ross Beaty.
Finding, building and permitting a mine can cost a fortune. These are huge expenses a company must deal with before a mine produces anything.
Plus, there are other risks that could delay production. They include environmental issues, engineering problems, strikes or new taxes brought on by a new political regime.
There is one set of mining stocks that avoids most of these pitfalls. In fact, these stocks have a history of outperforming most gold and silver producing companies … in both bull and bear markets!
They’re called royalty companies. And right now, these stocks could provide huge profits for investors over the next few years.
Let me explain …
Royalty companies do not operate mines. They do not have thousands of employees. Nor are they responsible for huge cost overruns — which happen often in the mining industry.
Instead, royalty companies are more like financing companies. They make upfront payments to resource companies that need money to complete their projects. In exchange, the royalty company gets a portion of the future production.
For example, Royal Gold is one of the largest royalty companies. Despite having fewer than two dozen employees, the company generated more than $300 million in sales over the past year.
The reason is simple. Over the past 20 years, Royal Gold has acquired royalties on dozens of gold mines. The mines’ owners do all the hard work needed to bring a project to the production stage. Once these mines produce, Royal Gold receives a check (usually a small percentage) of the total production.
Most royalty agreements cover the entire life of a mine. This means Royal Gold collects its share of production for decades. Even better, Royal Gold’s share of each project is measured as a percentage of output. That means the value of its royalties increases as the price of gold rises.
And if anything goes wrong, the mines’ owners are on the hook. They’re the ones who have to worry about the unexpected costs.
Aside from the original payment to the miner, the downside risks for a royalty company are almost nonexistent. The chart below shows the benefits of this business model compared with a conventional miner …
Over the past few years, royalty companies have been quietly building up their portfolios. And recent deals are with some of the largest mining companies in the world. These deals are likely to provide massive cash flow to royalty companies for many years.
You see, in 2012 we were in one of the biggest bull markets for mining. Gold and silver prices were hitting new highs. Plus, interest rates were near record lows.
This allowed the largest mining companies in the world to borrow money at dirt-cheap prices. They then used this cash to buy into more mining projects — some which required much-higher metal prices to be economical.
Since 2012, the resource industry collapsed. Metal prices are down sharply from their highs. And mining stocks have watched their stocks fall by more than 50% over the past three years.
Most large mining companies are now sitting on boatloads of debt. In an effort to ease this burden, they are selling a portion of their production to royalty companies.
These upfront payments are a low-cost way of financing. It’s a much better option compared to taking out high-interest loans from the bank or diluting shareholders by issuing more equity (secondary offerings).
In short, royalty companies are one of the lone bright spots in an industry that still struggling to recover. These royalty companies — due to their strong balance sheets — have been able to take stakes in some of the best projects in the world. Plus, they were able to dictate favorable terms on these deals.
Some of the largest royalty companies include Royal Gold (RGLD), Franco-Nevada (FNV), and Silver Wheaton (SLW). It’s no surprise these names are trading well off their lows. They are clearly in an uptrend and outperforming most mining stocks over the past six months.
I expect this outperformance to continue. These new deals will result in massive amounts of cash flowing into these companies for many years. I’m sure royalty companies will use this cash to further expand their royalty portfolios.
If you are looking for a safer way to play a potential rebound in the resources industry, then buy royalty companies. These stocks are likely to move much higher over the next few years as money pours in from their new royalty deals.