If you are looking for the best ideas for your portfolio you may want to consider some of Horizon Kinetics top stock picks. In its Q2 2019 investor letter – you can download a copy here – the firm discussed its investment thesis on Franco Nevada Corp (NYSE:FNV) stock. Franco Nevada Corp (NYSE:FNV) is a mining company.
In July 2019, Horizon Kinetics had released its Q2 2019 investor letter. Franco Nevada Corp (NYSE:FNV) stock has posted a return of 45.2% in the trailing one year period, outperforming the S&P 500 Index which returned 17.5% in the same period. On a year-to-date basis, Franco Nevada Corp (NYSE:FNV) stock has risen by 34.8%.
Let’s take a look at comments made by Horizon Kinetics about Franco Nevada Corp (NYSE:FNV) stock in the Q2 2019 investor letter.
“Franco-Nevada is a Canadian gold-focused royalty and streaming company, although it acquires royalties in other commodities as well, including silver, copper, oil and gas. It does not operate mines itself, but rather, collects royalties from mining companies or purchases future gold production at pre-arranged prices, in exchange for providing investment capital. Those prices represent a discounted present value of future years’ production, established by using an interest rate negotiated between the miner and Franco-Nevada. It can be startling to read that a typical contract might give Franco-Nevada the right to purchase gold at perhaps as low as one-third of current prices. It is clear both from per-ounce prices for new gold and silver contracts announced, as well as from the rate of book value expansion, that these are double-digit rates of interest, perhaps in the 12% to 15% range. The deep discount relative to current pricesis simply a reflection of the power of compounding over, say, a 20-year period or longer and brought forward to the present. Franco-Nevada earns that discount over time and is a consistent generator of return of equity (ROE).
This business model is unusually attractive. Royalty companies are among the highest-margin businesses of scale that exist, in that there is very little operating expense. General & Administrative expenses are only a few percent of revenue, and the contracts produce copious amounts of free cash flow, which are reinvested in additional royalty contracts or paid out as dividends – the company has increased its dividend every year since its initial public offering in 2007. The business model also requires little debt, thereby minimizing the financial risk. Since its inception, the shares have produced a total compound return of approximately 16% per annum even as gold prices have languished and gold mining companies have declined. Moreover, the company outperformed the S&P 500 by roughly a 4:1 margin during that time. This occurred despite a weak pricing environment for gold and silver.
The company is the beneficiary when its investees increase production, as well as when gold prices rise. However, it is not directly impacted by cost inflation, as the expenses are borne by the operators, not directly by Franco-Nevada. Similarly, the company is not encumbered with risks that are normally faced by mining companies, such as increased personnel costs, exploration and development expense, and mine reclamation or remediation. The latter is important, as these costs are difficult to predict and can be quite costly in severe cases.
In the past 10 years, the annual volume of gold-equivalent ounces the company has sold under royalty agreements has increased from 110.3 million ounces to 497.7 million ounces, or almost fivefold. Yet, of the 376 royalty properties that comprise its asset portfolio, only 107 are producing. The remaining properties may be thought of as a dormant asset. As such, there is an enormous amount of upside potential when these properties start production.
The primary attraction in Franco-Nevada pertains to the inherent optionality that its business offers, leveraged to a combination of higher gold prices and increased mining activity care of the dormant assets embedded in its royalty portfolio. The first pertains to appreciation in the price of precious metals, which typically are in greater demand during periods of U.S. dollar decline or political crisis. This provides the sort of countercyclicality or diversification element in portfolios that prompt many investors to favor gold or gold miners, yet without the opportunity cost – since gold does not produce income or earnings – or the business risk of a capital- intensive complex business. The second source of optionality is rooted in the probability that at least a portion of the properties that are not currently active will start producing gold/silver/oil/etc. at some point in the future.
Interestingly, the Franco-Nevada shares trade at a generally normal earnings multiple. However, the earnings are being produced by the active properties, which is to say that no value is being paid for the larger portion of the contract portfolio, which does not yet produce earnings. It is difficult to know whether this oversight – if it is an oversight – is due to the reticence of investors to pay for value to be received in an indeterminate time frame, or whether it is a function of the almost complete absence of royalty companies in ETFs. Considering that the number of dormant properties exceed currently active locations by a 2.5-to-1 ratio, the assumption that this optionality manifests into higher production appears reasonable.”
In Q1 2020, the number of bullish hedge fund positions on Franco Nevada Corp (NYSE:FNV) stock decreased by about 13% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t seem to agree with CME’s growth potential. Our calculations showed that Franco Nevada Corp (NYSE:FNV) isn’t ranked among the 30 most popular stocks among hedge funds.
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Video: Top 5 Stocks Among Hedge Funds
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Disclosure: None. This article is originally published at Insider Monkey.