Frank Holmes: Royalty Companies Have Outperformed and Will Continue to ShineMonday May 09, 2016 16:04
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Palisade Radio Host, Collin Kettell: Welcome back to another episode of Palisade Radio. On the show with us today is returning guest, Frank Holmes. Frank is the CEO and Chief Investment Officer of U.S. Global Funds. There is also an award winning blog that is read by 40,000 people, including myself, each and every week in 170 countries around the world which can found at www.usfunds.com. Frank, welcome to the program.
CEO and Chief Investment Officer, U.S. Global Investors, Frank Holmes: It is great to be here especially on a casual day, Friday, and gold is up $25.
CK: Yeah. It has really been exciting the last three months. I got so used to for the last four years that you would get beaten up for seven or eight days in a row for one good day and it seems like a complete reversal. I guess the thing that we should start off with here, Frank, is you are very invested in the mining and metals sector. Do you think gold has made a bottom? Maybe that is an obvious question at this point. But what is 2016 going to look like?
FH: Well, let me go back in the history books. When you look at the past 30 years, the average decline, what is the percentage of that decline, it is almost a case study perfect bottom Dec. 15 - 17 that gold fell for four years. It fell 44%. The average cycle drops 45%. It is perfect. Now we have the first leg of this rally coming out of it and most people are in denial of it, but bullion usually has a run for the next couple of years and it will not be straight up but it usually appreciates 70%.
CK: Well, that is fantastic. Let us talk about gold versus the gold stocks. You have always maintained that there is a place in everyone’s portfolio, call it insurance for the physical metal. You are very good at talking about different weightings and how to allocate properly to the metals. There is also a place for the mining stocks. Over the last four and a half years when we had a bad decline in the metals, the mining stocks, by some metrics, were actually in the worst bear market they have been in in the last ninety years. Now we have just seen this huge rubber band effect which has propelled them upwards. What do you think we are going to see in the mining stocks as opposed to the metals themselves?
FH: Well, I think that you are going to get this ratio again where gold stocks are moving 2% to 3% for every 1% move in bullion. I think that is in motion again because many of these companies have repaired their balance sheet. They have refinanced. They have streamlined their organizations and I think that they are much more disciplined on where they spend money on the allocation of capital. This, by the way, happened in airline industry, just a waste of capital. The stewards today, the CEOs in boards are much more paranoid about capital destruction.
CK: Very good. Well, I think that you deserve quite a bit of credit. One of the most important things is when you are in a bear market and you are in a sector to pick the best, most stable stocks that do not decline like the rest of the sector and you have been talking about the royalty companies. The royalty companies as compared to call it the majors like Barrick and Newmont held up very well over the last four years. Now as you will discuss in a moment they have seen pretty strong gains coming out of this bear market.
FH: It is a real shocker that in the past five years Franco Nevada has doubled and the average big cap gold stocks are up 50%. They were up 70% and now they climb their way back. The royalty model is a superior business model and, yes, Franco Nevada, it just gets a nice royalty on mostly assets of Nevada that are produced by both Barrick and Newmont, so a safer bet is to buy the royalty company. In fact that was the first deal I ever took public as a young broker back in 1982 was Franco Nevada and before merging with Newmont in 2001 it enjoyed even in a falling gold market. It grew at a 36% c.a.g.r, a compounder annual growth rate.
CK: That is fantastic. The idea of a royalty company, for those who do not know, is to put an upfront capital expenditure into either development or mine construction for a guaranteed offtake over time at the set gold price. In terms of what we are going to see over the next few years, do you think that these royalty companies will outperform the majors or since the majors were so damaged are they going to potentially be the better place for investor money?
FH: I just think it is a safer bet when we look at the revenue per employee. Look at Newmont. It is about $300,000 of revenue per employee. You look at Goldman Sachs, it is over a million dollars of revenue per employee, and when you look at Franco Nevada it is $15M per employee. They have so much more margin and they are frugal. Silver Wheaton is another company that Randy Smallwood was in our offices this week and they are doing about $600M in cash flow with 30 employees. That is $20M of revenue per employee. That is a great model. Now what is really important for the listeners versus a gold loan is that gold loan gets paid off over ten years or five years and that is it. When you get a royalty you get it forever so future discoveries are made at 20 years from now or 50 years from now these gold mining companies, these gold royalty companies get a royalty off of everything.
CK: Yeah, it is certainly a powerful business model. Before the call we were discussing some companies that you are also interested in. One that is very exciting for me to hear was Endeavour Mining. It is a company that we wrote up at Palisade Research a couple months ago. We wrote it up again last month and the stock has been performing quite well. They acquired True Gold just about a month and a half ago. Frank, talk to me about Endeavour and any other call it mid-tier mining companies that you are interested in right now.
FH: Well, there are a couple companies that we think will be taken out the way Claude Resources was taken out. There have been several acquisitions this past year, higher grade, small cap companies, particularly the higher grade. Clondex was one of the other ones that are listed in Toronto that has an asset in Nevada. Franco Nevada has a royalty on a particular company which gives it a good housekeeping seal, good quality management, and it is very high grade. When we look at our models it is worth $8 to $9 trading under $5.
The other one is Endeavour. Endeavour, at one time before it was focused on gold mining. I was a chairman of Endeavour so I know the company very well. Neil Woodyer has done a phenomenal job of building out that asset base. One of the— they call the smart beta, or factors we use to screen stocks is who has the highest cash flow return on their capital? We look at all the gold stocks and what is really interesting is Endeavour shows up in the top 20 highest cash flow returns on invested capital. With that we think that is one of these other companies as they get further along developing the most recent operations that they get to 900,000 ounces of gold. As they de-risk the mine development they become more and more attractive to be taken out. I think that Endeavour will be taken out. I think that Clondex will be taken out.
CK: Frank, many gold bugs are so focused on gold and the doom and gloom of every other sector in the world that they end up investing their entire portfolio in the sector. Right now that is certainly something that would pay off the last three months. But the four years before that it probably would have been quite detrimental to one’s portfolio. You have always been a proponent of proper balancing in a portfolio. You are not just invested in precious metals and mining stocks. In fact what we will talk about later is you launched an ETF last year called JETS. I want to transition a bit to the general markets. There is a lot of fear and concern about the Dow Jones and the US equities starting to top out. The Fed is maybe starting to get concerned internally that they have lost control. What do you think is going to happen in 2016, 2017 with the general equity market?
FH: Well, I think that the profit cycle has peaked and has been declining and everyone is resetting what their expectations are. What is going to be important is that the word now is negative interest rates. They are trying to spur this global economic activity and I think that in election year there is not much going to happen. But I do not think there is anything that has been really pervasively negative in a capital market. I think that the cash cows is where money is going to go, where there is Steady Eddie cash coming in, able to increase their dividend, buying back their stock. I will say services or products that people need.
That is one of the reasons why I create that Jets ETF. You need to fly to get across America. It is too long and business is about speed and alacrity. Right now we look there are two million people flying a day in America. With oil falling, these companies are huge cash cows. You are witnessing 88% increase in dividends last year and they are still traded at seven times earnings. But when companies like Branson’s company Atlantic, it was taken over at a 47% premium. I think that you are going to see more acquisitions and more money going into a re-rating of that particular industry where it is a cash cow.
CK: Well, since you started the Jets ETF, I do not have my numbers exact, but I think you are over $60M in assets under management. The airline sector has performed quite well since you started Jets. There has been a lot of profitability in the sector. Playing devil’s advocate here, we were just talking about the royalty companies performing so well because there are few employees for how much profit is coming in the airline business, by design has to have thousands and thousands of employees and lots of equipment, lots of logistics in place. Does any one of that concern you?
FH: Always especially when it is unionized and you get into those frictions. But coming back it is a need and I think that that industry is going to go through a re-rating. What has happened is that so often people like to quote Warren Buffet that he lost a lot of money in the airlines industry so he has gone into private jets and net jets. But I think it is very different because the CEO is like the CEO of American Airlines. He said, “Do not pay me in cash; pay me in stock,” and they are buying back millions of dollars worth of stock and they are increasing the dividend. We have several CEOs of these airlines that are now taking back stock in lieu of cash. I remember that being the technology industry with Steve Jobs and Oracle. I think those particular companies has spectacular performance because management really believed in the companies.
CK: You were speaking about cash cows as we transitioned into the Jets ETF. Can you name some ideas of either sectors or individual stocks you are looking at that are not metals and mining related?
FH: Microsoft is a massive cash cow. Its whole model of getting you to subscribe its methodology of getting revenue is only ballooning its cash by billions. Every month there is a billion dollars going into that bank account. I mean it is an incredible piece of machinery. They have been increasing their dividend, paying dividends, and it has become a need. Everyone has Microsoft to run the global economy and to run our domestic economy.
CK: Well, Frank, we began with gold. Palisade Radio is very focused on the resource sector so I want to come back to gold. What should investors be looking for in terms of pitfalls? Do you think there is anything at this point that could derail what seems to be a very new, very strong new trend that has developed not just in precious metals, but in quite a few of the commodities as a whole?
FH: Well, the big factor is when you look at gold there are two demand drivers: the fear trade and the love trade. The love trade is an important component and it relates to the rising GDP of China, India – affectionately known as Chindia – which has 40% of the world’s population that buy gold for love and for gift giving, for weddings, for graduation, etc. That is an important component.
Then there is the fear trade and the fear trade is what is dominating the market place today. That is whenever there are negative real interest rates, whatever the government pays you on a 10-year government bond, take away the monthly CPI number and you either get a positive rate of return or a negative. If we go back to September of 2011, a 10-year government bond was -3%. You have locked in a 3% loss every year for ten years quietly, and it was invisible because Fed funds was zero. Rates went positive by 200 basis points and the dollar ripped. What is happening this year it has gone negative because of the fear of global trade and particularly in an election year. I think the government is going to do everything to stimulate economic prosperity, and this is good for gold in particular because it is coming from negative rates.
CK: All right, Frank, well, thank you very much. I just want to say I am very jealous and envious of that background you have got behind you there. It is a beautiful setup, nice lighting. I am thinking I might need to set something up like that myself here.
CK: Well, once again, Frank Holmes. He is the CEO and Chief Investment Officer of U.S. Global Funds. All of our listeners can visit www.usfunds.com. Sign up for Frank Talk which is Frank’s blog. He is posting each and every week. Join the 40,000 other readers who are finding great content there. Frank, thank you for coming on the show.
FH: Thank you. Have a wonderful weekend.
Frank Holmes is the CEO and chief investment officer of U.S. Global Investors. Mr. Holmes purchased a controlling interest in U.S. Global Investors in 1989 and became the firm’s chief investment officer in 1999. In 2006, Mr. Holmes was selected mining fund manager of the year by the Mining Journal. He is also the co-author of The Goldwatcher: Demystifying Gold Investing. More than 30,000 subscribers follow his weekly commentary in the award-winning Investor Alert newsletter which is read in over 180 countries.