Investors seeking to diversify their portfolios into gold should consider Royal Gold (NASDAQ:RGLD) as the best way to invest in this precious metal, even though it might appear wildly over priced compared to gold miners such as Newmont Mining (NYSE:NEM) or Barrick Gold (NYSE:ABX).
As this chart shows, Royal Gold is trading at vastly higher valuations to these two gold mining giants, whether it is on a price to earnings, operating PE, or price to operating cash flow per share basis. However, as Warren Buffett said "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
I see three reasons Royal Gold is a great company trading at a fair price, and likely to generate far better future returns both compared to its peers, and the market as a whole, just as it has over the last 25 years.
1. Superior business model yields spectacular margins
The reason Royal Gold is one of my favorite gold stocks is because of its royalty streaming business models, which leads to some of the highest margins in the industry.
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Rather than investing billions of dollars into expensive mines, Royal Gold acts as an investor in mines, providing capital and getting royalty rights -- at substantial discounts -- from mining partners, which include large well-established companies like Newmont Mining and Barrick Gold.
In fact Royal Gold, which has invested in 37 producing properties, 23 development stage properties, and 141 exploration stage properties, has an average weighted gold cost of just $578 per ounce compared to an average price received of $1,201 per ounce in the fourth quarter of 2014. In addition, because its investments don't fund operating costs, rising gold mining costs don't eat into its margins as they do with traditional gold miners.
These cost benefits have allowed Royal to achieve gross margins of 55% in its most recent quarters, despite gold prices declining 15% in the last year.
2. Great growth potential
Because Royal Gold serves as an investor and financier of gold mines it can scale -- grow -- its business model quickly without spending large amounts of money on expensive equipment or overhead. For example, between mid-2009 and mid-2014, the company was able to increase its portfolio of investments from 119 to 201 while increasing its employee count from just 18 to 20.
Meanwhile, Newmont Mining has 13,700 employees, meaning each Royal Gold employee generates 24.5 times as much sales per employee as those at Newmont.
Royal Gold has $1.15 billion in potential liquidity to invest in new mining projects, which it typically uses to target mines with long life expectancies, operated by large, proven gold miners, in politically stable countries such as the US, Canada, Mexico, and Chile. In fact 92% of its gold production comes from these four countries.
Over the next five years, Wall Street analysts expect Royal Gold's superior business model to achieve better growth than these larger miners, with 18.5% EPS growth compared to 13.4% for Barrick and a 34.4% decline for Newmont.
While investors should never build an investment thesis based solely on educated estimates of analysts, in this case I agree that Royal Gold -- thanks to its superior lower cost investment focused business model -- is likely to prove one of the fastest growing gold companies, even if gold prices remain suppressed.
3. Superior dividend growth
Numerous studies have shown that stocks with consistently strong dividend growth make the best long-term equities. As the above image shows, Royal Gold's dividend growth track record is indeed impressive, even more so when compared with the severe dividend cuts from miners like Newmont Mining or Barrick Gold.
Of course a fast growing dividend isn't any good if it's not sustainable. With a free cash flow dividend payout ratio of just 62% I think the likelihood of Royal Gold's dividend growth being sustainable and likely to continue for several more years is quiet good, especially if gold prices recover.
Takeaway: Paying for quality is the best choice when investing in gold stocks
Despite its high valuations, I believe Royal Gold to be one of the best gold stocks you can buy today. Its highly scalable royalty streaming business model minimizes capital costs while maximizing profits -- especially during times of depressed gold prices when it can exact better terms from distressed gold miners. When combined with its large liquidity to fund growth and superior dividend growth track record, these factors make Royal Gold one of the best gold stocks to own over the next few years as well as increasing its likelihood of beating the market overall.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.