As the era of free money driven by central bank interest rate cuts and bond buying comes to an end, markets are entering into a new phase of turmoil. The expectation of four interest rate increases in 2022 as the Fed fights the inflation that has lifted growth in the consumer price index to 7%, the highest in nearly forty years, was barely imaginable a year ago. Equally unimaginable was the prospect of the largest act of military aggression in Europe since World War II, as Russia launches attacks on Ukraine, adding to an uncertain outlook.
In the face of the surge in long-term real interest rates in anticipation of monetary tightening, there has been a repricing of long-dated assets that once supercharged the American stock market. The impact has been dramatic for the many stocks and, more importantly, cryptocurrencies, supporting gold’s status as an inflation hedge and defensive asset. In a recent research article, Goldman Sachs noted that “divergence between gold and real rates is common when higher rates might become a risk to real economic activity, raising the probability of recession and demand for defensive assets. Historically, gold tends to increase during rate hiking cycles, particularly when U.S. growth starts to decelerate and EM dollar purchasing power holds firm…”
In 2020, we observed the largest one-year debt surge since World War II, with global debt rising to US$226T. Debt was elevated going into the crisis, but now governments must navigate a world of record-high public and private debt levels, new virus mutations, and rising inflation. High levels of indebtedness and the collapse in growth in emerging markets make the global economy particularly sensitive to changes in monetary policy, but tightening money supply may not be enough.
Across the market, margins are being impacted by slowing economies, decreasing revenues, and higher costs as real wage inflation becomes widespread. Increased commodity prices, in a tight and volatile market, further increase input costs across industries. Geopolitical turmoil is coupled with an uncertain market outlook; at the time of writing (February 2022), the Russian military has launched massive attacks on Ukraine, and tensions remain high in Taiwan. Signs of a tightening and more costly labour market, rising costs and margin compression have become more prevalent over the last six to nine months and will be a focus in this earnings cycle, as the sector reports fourth quarter results and sets guidance for 2022.
Increased commodity prices, in a tight and volatile market, further increase input costs across industries
Faced with looming economic and geopolitical storm clouds and a constructive outlook for gold, gold-focused streaming and royalty companies offer a strikingly attractive investment vehicle to gain exposure to gold – particularly the larger, dividend-paying, cash-generating businesses in the sector that offer diverse, cash-yielding, high-margin exposure to gold. There are several specific facets of the streaming and royalty business model that make it a durable proposition to withstand a tumultuous future for the markets. Streaming and royalty businesses are high-margin businesses by design, while also being inflation-resistant, diversified, scalable, and built to deliver and endure throughout commodity cycles.
Crucially, the royalty and streaming sector does not experience margin compression during periods of real price inflation but does benefit from increases in the commodity prices that may accompany such economic forces. They are also insulated from direct operating and capital cost increases by virtue of limiting exposure to revenue from operating mines. This structure allows the sector to deliver high, stable, and predictable margins for investors, as well as a consistent dividend. To put the precious metals royalty space into context, in the last 15 years the price of physical gold is up approximately 175%, the GDX Gold Miners index is down 6%, the GDXJ Junior Gold Miners index is down approximately 40% and a basket of senior streaming and royalty companies is up approximately 300% at the time of writing. Put simply, the royalty model has demonstrated that it can capture the leverage to the gold price just like a gold producer, while avoiding the trend of negative gearing due to cost pressures, periodic pro-cyclical capital allocation missteps amongst the miners and other external forces.
The majority of mid-cap gold companies will source revenues from two to five mines, typically located in one to three countries, and may be progressing a development project or two in addition to a handful of exploration projects (if they have sufficient capital to do so). Comparatively, streaming and royalty companies are typically highly diversified and, therefore, unlike the aforementioned gold companies, revenues can be generated from dozens of mines while also providing exposure to optionality and growth from development and exploration stage projects across the globe, in addition to the ongoing mine life extension operating mines typically deliver. With varying responses to COVID-19 globally, and pockets of escalating geopolitical turmoil, diversity reduces risk to short, medium, and long-term cashflows.
The scalability in the streaming and royalty business model comes from the inelasticity between employee head count compared to production, sales and cash flow. For example, a typical large mining company may have tens of thousands of people across operations with sizeable corporate offices. This figure typically increases as production and portfolio complexity increases, as additional staff are required for new mines, expansion projects or associated regulatory and administrative support functions. A streaming and royalty company can add significant scale to its portfolio of investments without needing to increase head count given that streams and royalties are passive investments.
In a cyclical market, we believe that a portfolio with a duration that provides exposure to multiple price cycles and can withstand periods of lower commodity prices represents a source of tremendous optionality. Base metal and platinum group mines, from which we stream gold and/or silver byproducts, typically have a life of mine that is multiples longer than that of a primary gold mine. For this reason, streaming and royalty companies often have longer asset lives than their gold mining peers due to their gold and silver exposure being byproducts from non-precious mines.
The many attractive attributes of the business model described here is what drew us nearly six years ago to embark upon building Triple Flag from scratch into the substantial business it is today. We believed then, as we do now, that a gold-focused streaming and royalty company is ideally positioned to capture the opportunities and effectively insulate investors from the risks presented by this volatile market, while offering the mining sector access to much needed enabling financing for future growth. We believe that the opportunity set ahead, particularly in this age of volatility and energy transition that requires significant future investment into new mines to deliver the projected metal supply required, presents perhaps a generational opportunity for sophisticated resource finance providers. This, in turn, will create good investment return potential for our investors via new precious metals streams and
royalties.
