Gold Stocks Remain Undervalued ( 2 )

While it is premature to identify the final stages of the bull market in precious metals, the circumstances for such a scenario are certainly present. Central banks have publicly declared their intention of creating unlimited amounts of liquidity for as long as is necessary to overcome the deflationary effects of the Great Recession of 2008-09. Chairman Ben Bernanke of the U.S. Federal Reserve has confirmed that short-term interest rates will not rise until 2015, if then.

No developed country has any interest in a strong currency; indeed some European nations such as Germany, Switzerland, Denmark and the Netherlands have negative interest rates on short-term debt in an effort to stem the flow of foreign capital.

Gold has risen every year for the last 12 years and seems likely to do so again this year. GLD and an ETF holding real-return (i.e. inflation protected) bonds have been the two asset classes with the best risk-adjusted performance over the last five years—through the worst equity bear market in 35 years and a 100% rebound in stock markets.

These two seemingly unrelated assets have in common a concern over the erosion of an investor’s capital in real terms, as both gold and real-return bonds effectively maintain their purchasing power in a period of inflation. The fact that inflation is relatively subdued at present does not mean it will not return. In fact, governments seem determined that it will, if only to enable them to reduce the real cost of the enormous amounts of debt they have incurred over the last few years.

Against that background, I am adding a new gold stock to the Canada Reports‘ recommended list this month—one which is very different from traditional mining companies in terms of its business model.

Franco-Nevada was a highly successful company in the latter part of the 20th century. It was eventually taken over by Newmont Mining and delisted. Then in December 2007 it was spun off from Newmont and relisted again. It no longer has founder Seymour Schulich at the helm but chairman Pierre Lassonde was a co-founder and, with CEO David Harquail, the management team ensures the formula remains unchanged from its previous successful model.

Based in Toronto, Franco-Nevada is a gold focused royalty and stream company with additional interests in platinum group metals and other resource assets. The majority of revenues are generated from high margin assets in North America. The portfolio provides exposure to some of the largest gold discoveries in the world.

Franco-Nevada has been amongst the best performing gold stocks in 2012 and for the last few years. FNV has gained 12.8% in the past month and shows a remarkable advance of 48% year-to-date. The one-year gain is 53.9% and over three years it’s ahead by 75%. Those numbers are even more remarkable when you consider how gold mining stocks generally have performed.

The principal reason for this outstanding performance goes back to its business model. As a royalty owner, the company receives between 0.5% to 5% of the value of all precious metals produced by the mines on which it has invested, without any exposure to rising costs or environmental liabilities. As the company says, its first dollar invested is its last dollar and it therefore enjoys very high profit margins (around 70%-75%).

Its diversified portfolio of mines are almost all located in politically stable jurisdictions in North and South America and Australia. This protects the company from too much exposure to unfavourable developments at any one property.

One of the advantages of the royalty model is that producers will often sell a royalty to help fund the development of a project. Thus Franco-Nevada has a constant stream of new mines coming on stream to provide growth.

In the second half of 2012, Franco-Nevada anticipates Barrick’s Hemlo western extension, Newmont’s Ahafo mine in Ghana, and Duketon’s Garden Well mine will begin producing royalty income. In the first quarter of 2013, Detour Gold’s Detour Lake project, on which Franco has a 2% royalty, will also begin production.

This stock offers a way to play the gold market without assuming the costs and risks of a traditional mining company. The dividend ($0.05 per month) offers some cash flow as a bonus.

Excerpted from October issue of the Canada Report. Gavin Graham is the president of Graham Investment Strategy and is a popular guest on radio and television business shows.

source: forbes.com

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