Trading/investing in/speculating on stocks
In my opinion, much of the return on commodities stocks will come from ‘speculating’ on commodity prices. The underlying companies are usually leveraged to the price of commodities. A 2X increase in the price of a commodity will usually lead to more than a 2X increase in operating profits of a mine. If the costs of a mine are 50% of the current commodity price, then a doubling in prices will increase mine profits three times.
A small part of the return will come from buying the dips and selling the rallies. (Because let’s face it- this is how most value investors make money. They aren’t always good at picking stocks.)
And a small part of the return will come from stock picking. But very few people are actually good at it. You know, there are hedge fund managers out there who don’t bother reading 10-Ks. And many of them invest in mining stocks without bothering to read some university textbooks on mine exploration and mine engineering. Some people think that it’s a good idea to go long ATPG, without understanding how PUDs can be manipulated.
There are two reasons why royalties can be very, very profitable. (But only by people who really, really know what they’re doing.)
Firstly, they are a way to rip off companies which are badly in need of financing. Companies in distress. Or junior mining companies where the CEOs do things that don’t make a lot of sense for its investors. And royalties offer the chance for due diligence, so it’s not as risky as investing in a stock where it’s really difficult to do due diligence. NI 43-101 is not perfect as geologists can do subtle things as using a favorable interpolation method (this can make a 20% difference).
And when dealing with junior miners, royalties offer added protection from the CEO doing awful things to its shareholders. The royalty holder is not affected by share dilution, overpaid CEOs, CEOs wasting money on promotion, excess overhead (e.g. liability insurance for insiders), takeunders, etc.
Secondly, they are leveraged to big increases in commodity prices. If a commodity price skyrockets, then naturally the mining company will want to do more exploration on its property and to expand production. The royalty holder benefits from all this without having to put up any capital. (Though not all royalties have this feature.) This is kind of like an out-of-the-money call option and sometimes people seriously underestimate its value.
On the other hand, sometimes there are downsides to mineral royalties. The mining company may try to underpay its royalties. (This happened to Terra Nova, which went to court.)
If a royalty is too large, it discourages mine expansion whereas a smaller one would not.
Examples of successful royalty strategies
Pierre Lassonde + Seymour Schulich / Franco-Nevada
Altius Minerals (ALS.TO)
Labrador Iron Ore Royalty Corporation (LIF.UN) – They don’t even do anything fancy. Most of the asset value is in their royalty, plus an equity stake in the mine covered by the royalty. On the other hand, this company was rather lucky as iron ore prices have skyrocketed.
Kevin McArthur / “Tip of the iceberg”
Kevin McArthur is the ex-CEO of Goldcorp and now runs Tahoe. He is interviewed by The Globe and Mail here. He seems to attribute his success to finding tip-of-iceberg opportunities. As I understand it, this means buying properties that have a lot of exploration potential. This probably comes in the form of extensions to the existing deposit.