In an environment where the price of gold is high and rising, I make the case for a heavier weighting in favor of gold mining stocks.
Gold royalty and stream companies have been trading at significantly higher multiples than gold miners for nearly a decade, which some say is partly justified. After all, royalty and stream companies do not bear the costs of developing and operating mines.
Their business model is to purchase the right to current and future production from a mine for an upfront payment at a fixed price per ounce of metal delivered. Because these companies do not operate mines, their overhead costs are low, and because their royalty and stream agreements have been entered into at a fixed price, their profit margins and cash flow are assured even if the price of the gold is relatively low or falling, as it has been for most of the past decade.
Normally, royalty or stream agreements also benefit from the upside potential due to increases in either the life or production of a mine, which are not capped.
In August, after hovering around the same level for the past few years, the price of gold broke above $2,000 an ounce for the first time. In a high and rising gold price environment, gold miners’ profit margins and cash flow are seeing significant increases and investors should reflect this in their portfolios by placing a heavier weight on stocks. of gold miners versus stocks of gold royalty and stream companies.
But we are no longer in a low and depressed gold expense environment, are we? In a rising price environment for gold, such as the one we are in now, the calculus changes, although my argument for how to consider the valuations of both types of companies is unconvincing. While the profit margins and cash flow of royalty and stream companies continue to grow as the price of gold rises, the leverage to the price of gold declines given their costs. weaker fixed operating costs.
Conversely, margins and cash flow for producing companies are growing at a much faster rate relative to their higher inherent operating costs, laying the groundwork for explosive valuation growth. In Yamana’s case, each $100 per ounce increase in the price of gold represents a $100 million increase in annual EBITDA and a $70 million increase in cash flow from operating activities before net changes in working capital items.
