Mining is risky. With a commodity output, they operate in an environment of perfect competition. It’s capital intensive and they don’t need to contend with depreciation alone, there’s also depletion. Pit walls can fall, people can get injured, and governments can penalize mines at will (nationalization, permitting, fines).
In a previous post I looked at Franco Nevada’s negative retained earnings and meager returns on capital invested. Given historic performance I thought it would be interesting to look at implied returns from prospective investments and the sensitivity of project failure.
Let’s say that Franco invests $250M in eight projects and the expected post-tax return is 4%. Well, what needs to go wrong to obliterate the return of the portfolio.
Well, this would do it:
1 project fails immediately
1 project fails at year eight
1 project fails at year ten
1 project ends two years early
What are the odds that this could happen? That’s an interesting question. It’s certainly higher than 5%. I imagine 50% is closer to reality. There’s also the impacts with grade issues and ramp up.
What is the purpose of a corporation? Let’s not get into the
stakeholder vs. shareholder debate. At the core, a corporation’s goal is to
increase its shareholder’s wealth. Otherwise, why start the corporation? I’d only start a company if I believed this investment would yield more
value (return) than a risk free asset. I’d want to be compensated for this risk as
well, hopefully earning a materially higher return than a riskless asset.
A corporation’s purpose, while simple, is easily convoluted
by countless factors. The owners of the corporation may not understand it in themselves.
I’m not Stanley Druckenmiller but I’m
no finance/business slouch either. After a couple
thousand hours of studying/working in finance, I
can honestly say that I’m only starting
to build a picture of what I consider to
be a “good” business. Why is this the case?
There’s so much noise.
A company’s price and fundamentals are so
detached. Who am I to say that a
company with zero earnings is a bad company? The
FANGs, they don’t earn much and yet
they are the best performing stocks in
the past decade. The fact that growth stocks don’t
trade on fundamentals makes it easier for
non-growth stocks to trade on the same basis. The market doesn’t hold them to account, don’t they see
I think Warren Buffet
has it right. The Berkshire Hathaway owner’s manual states that their goal “is
to maximize Berkshire’s average annual rate of gain in intrinsic business value
on a per-share basis.” This makes sense. If
I’ve got a dollar, I want to invest it in the area that’s going to
give me the most dollars in return. Berkshire
defines intrinsic value as the present value of future cash flows. They trade money. Trade 1 dollar for 1.08 dollars. Makes sense.
A $100 million investment with a $100 million NPV is subjecting
earned dollars to zero return. Now that doesn’t
make sense. Who would do that?
Well, as far as I can tell
Franco Nevada does this, and a whole-heck
of the mining industry.
Why do I say this? Well let’s take a look at the financial statements
for FNV for year end 2017.
Ok, so I’m a shareholder. How much money have I pumped into this company?
Wow! 6.5 Billion in total, the value has steadily marched higher over the past decade. Must be some good returns to justify this. Well, FNV has generated $836M in net income of the past ten years. That’s a pretty measly 1.88% on the contributed capital. Hmmmm.
But, but, they pay a
Yeah, they do. But it’s more than their net income.
So what does this really mean. Well FNV is paying out more than their making. Is this good business? Let’s keep issuing capital, take on some debt, and pay some dividends. More people see the dividend track record and subscribe. That’s an interesting cycle… sounds familiar. What’s the name for that?
Well, if you were a
shareholder between 2007 and 2016 it hasn’t
been good business. Earnings haven’t increased and the return on your equity
has been pretty lousy.
But who cares! The stock price is going up.
And a big reason for
that is steeper valuations from a PE perspective (note the chart above takes
out PE ratios over 100). In an environment where your competition is miners with a destructive track record for
capital allocation, you’re the best looking
girl at the bar.
Now I’m not saying
that the people that run FNV are bad miners. They just aren’t deploying capital
in a fashion that produces high returns. But
this begs the question, why are new players (triple flag, orion, osisko,
sandstorm) entering the business? With competition, prospective returns surely
aren’t going to go higher. The narrow margin of error may get pushed lower.
There’s also the question about why people own these stocks. I mean, it’s precious metals exposure and it’s certainly outperforming Barrick but common. Return on equity less than a LT treasuries. These are not risk free assets.