Exposure to gold serves as a hedge against volatility in a diversified portfolio, and Franco-Nevada Corporation (ticker: FNV) offers investors one of the safest ways to get that exposure.
Gold vs Bonds for Portfolio Protection
Gold and bonds often compete for the same slot in a portfolio. Traditional portfolios have much larger exposure to bonds, with little or no gold exposure.
Both asset classes can help to mitigate overall portfolio losses during a stock market crash. During periods of severe equity price contraction, gold and bonds usually preserve their value better stocks. In contrast, both gold and bonds generally struggle during periods of rising interest rates.
But from there, they have significant differences:
- Gold is more volatile than U.S. Treasuries and investment-grade corporate bonds. This can be a problem but also occasionally gives big opportunities.
- Gold holds its value through periods of inflation, while inflation can wipe away the returns of most bonds.
- Gold maintains universal purchasing power better than domestic bonds if your nation’s currency loses value compared to other currencies.
- Bonds are theoretically better for rare periods of deflation.
- Gold can do well during prolonged periods of low real interest rates, while bond returns tend not to be great in that environment.
- Gold has no credit risk, while bonds do.
Put simply, neither gold or bonds are significantly correlated with equities, which is why both are good to hold along with equities for diversification. And gold and bonds aren’t necessarily strongly correlated with each other, which means they can both have a role in a diversified portfolio.
Franco-Nevada: One of the Safest Gold Companies
Gold stores its value over decades and centuries, and little else.
Over short and intermediate periods of time it can be volatile, but over the long term it mostly just maintains its purchasing power. But then when you include storage, security, testing, shipping, management fees, and other costs associated with investing in gold in physical or paper form, all of that adds up. That’s why great companies generally outperform gold over time.
The next option is to invest in a company involved in gold production. That marries the capital-compounding advantages of a business with the hedging properties of gold. Unfortunately, gold miners have been very poor investments over time as group due to poor capital allocation system in the industry. In fact most of them have under-performed gold itself.
That leaves gold royalty and streaming companies like Franco-Nevada, which have historically been the best-performing way to invest in gold. Royalty and streaming companies are gold financiers; they give explorers and miners up front capital in exchange for gold streams and royalties in the future. Gold streams allow the financier to buy a certain amount ounces of gold from the mine once it’s in production for a very low cost, often below $400/ounce. Royalties on the other hand let the financier collect a percentage of net income from the mine.
Franco-Nevada is the largest gold streaming and royalty company. It collects streams and royalty from 51 active mines and has financed an additional 200+ mines that are in earlier stages of development.
Importantly, Franco-Nevada has vastly outperformed gold itself since its IPO about a decade ago:
Chart source: Google Finance
Every dollar invested in Franco-Nevada ten years ago would be worth $4.74 today. In comparison, every dollar invested in gold would be worth less than $1.61.
Likewise, Franco-Nevada has vastly outperformed gold miners as a group:
Chart source: Google Finance
Like gold miners, Franco-Nevada has levered exposure to gold. For a simple example, if it gets to pay $400/ounce for gold from its financed mines, and gold is at $1,200/ounce, then it makes $800/ounce in profit. If gold rises just 33% to $1,600/ounce, then Franco-Nevada makes $1,200/ounce in profit from the difference, and therefore their profit goes up 50%. The realty is more complex than that, but that’s roughly the way to think about it.
The difference is that Franco-Nevada is not quite as levered as gold miners. The cost per ounce for miners to profitably mine gold is often about $1,000/ounce, so the difference in gold price of a few hundred bucks below or over that number can result in huge profits or huge losses for the miner. Franco-Nevada’s costs are far lower, meaning that gold would have to drop to unheard of inflation-adjusted levels in order for Franco-Nevada to suffer losses, but they don’t have quite the explosive upside potential as many of the miners.
But that’s exactly what a lot of investors want from gold exposure. Franco-Nevada makes money and pays dividends even when gold goes down or stays flat for a while, but also strongly benefits when gold increases in price. The company is much more valuable now than gold was when it was over $1,800/ounce, and would be even more valuable if gold were to spike in price again.
The most important number for Franco-Nevada is their gold-equivalent ounces (GEO):
Franco-Nevada benefits from higher gold prices, but has no control over that. Instead, their ability to identify mining opportunities that will be productive in the future, and make profitable arrangements to give them up front capital to get started, is what they have control over and what allows them to outperform gold over time.
Over the past decade, Franco-Nevada has increased its GEOs from 100,000 to 500,000 ounces. Management expects to hit about 600,000 in 2022, and by then the United States will most likely have encountered a recession and other issues that could lead to a spike in the price of gold.
The company pays a relatively low 1.45% dividend yield, but has enjoyed strong growth. This is in comparison to gold ETFs that extract management fees.
Unlike many gold streaming and royalty companies, Franco-Nevada carries no long-term debt at all. In exchange, they tend to issue new shares each year to fund growth. Over the past decade, they have increased their number of shares outstanding by over 86%. However, prudent capital allocation from this share issuance has resulted in strong per-share gains in value. Book value per share, for example, increased from $14 in 2008 to $25 in 2018, even as the price of gold rose and fell in price.
Lastly, Franco-Nevada has taken advantage of this period of low oil and gas prices and financial trouble in the energy sector to make mineral right investments in that area as well. Specifically, in August 2018 Franco-Nevada announced an agreement with Continental Resources wherein Franco-Nevada will contribute $220 million in capital in the fourth quarter of 2018 to acquire oil and gas rights in the Texas/Oklahoma region, and is planning another $300 million investment spread over three years from 2019 to 2021.
Management expects their revenue from oil and gas investments to increase over the next several years from $50 million in 2017 to $120 million in 2022.
Risk Assessment and Final Thoughts
Franco-Nevada is not without risk.
If the prices of gold and silver fall to very low levels, many mines financed by Franco-Nevada would shut down due to not being profitable, and Franco-Nevada would temporarily lose the value from those assets until they start producing again. It would take extremely severe low prices in gold and silver for Franco-Nevada to be unprofitable, but moderate declines in price could reduce their profits.
In addition, due the strength of its business model and its complete lack of major debt, Franco-Nevada is highly-valued. The price-to-earnings ratio is not a good metric for this type of business, but the business trades for about 2.4x price-to-book. The dividend yield is low even with a high payout ratio, and the company primarily issues shares to fund new growth.
Despite its various advantages, Franco-Nevada needs to be looked at as a levered play on gold. There are more attractive opportunities for core portfolio growth, but Franco-Nevada serves as a profitable, low-risk, and low-cost hedge.
Fortunately, commodities are historically at a multi-decade low price point compared to the S&P 500.
GSCI/S&P 500 Ratio:
Chart Source: Incrementum AG
Even after recent gains in the yields of U.S. Treasuries, high-grade bond are still offering historically low interest rates. With stocks so highly-valued, bond yields so low, and diversified commodities historically cheap, investing in a diversified royalty and streaming company like Franco-Nevada makes a lot of sense for a small portion of a portfolio.
If gold, silver, oil, and gas stay where they are or even go quite a bit lower, Franco-Nevada still makes money and will likely increase its portfolio of streams and royalties over time. If precious metals increase in value during the next recession, Franco-Nevada will likely outperform further.
Overall, high-quality gold streaming and royalty companies offer a lot of advantages over gold and gold miners:
Chart Source: Franco-Nevada Corporation
As the largest gold streaming and royalty company, as well as being free of long-term debt, Franco-Nevada is a conservative portfolio hedge going forward for a portion of a diversified portfolio.
Disclosure: The author is long FNV and IAU.