WPM - Ride The Royalty Ripple To Riches Like Charlie Munger

2023-10-06 07:35:00 ET

Summary

• Charlie Munger passively made a fortune with his $1,000 oil royalty investment in 1962.
• Royalty interests are an unstoppable force for inflation-beating passive income.
• Each royalty firm has a unique treasure chest waiting to be unlocked.
• Join us on an interesting journey as we unveil a few cash machines, helping you pick the perfect gem.

Co-authored with "Hidden Opportunities."

Introduction to Royalties

In 1962, Charlie Munger made a slightly unconventional investment after meeting Al Marshall during a husband-and-wife golf tournament. When Mr. Marshall explained his plan to bid at a local oil royalty auction, the Vice Chairman of Berkshire Hathaway Inc. ( BRK.A , BRK.B ) joined him and took care of the legal and financial elements of the setup. Both put in an investment of $1,000 each and cashed in large royalty checks for decades. In 2010, Mr. Munger revealed that he received $70,000-$100,000 annually from that royalty investment and easily made millions over sixty years.

This is the power of royalties; they pay handsomely for as long as the underlying asset has tangible value. Hydrocarbons will be increasingly relevant for decades, making energy royalties a lucrative investment for income seekers.

Mineral royalty investments are an excellent way to tap into the stickiness of hydrocarbon demand. They offer substantial benefits for your overall financial well-being in the form of the following:

1. Passive Income - Royalty investments are designed to make regular distributions. So every day they are in business, you receive your cut of the profits.

2. Portfolio Diversification - Royalties are disconnected from the stock market gyrations because they correlate more strongly with the associated supply-demand situation. As such, they provide much-needed diversification for a healthy financial posture.

3. Tax Benefits - Royalty trusts are typically designed to pay pass-through income to investors tax-efficiently. Investors may benefit from tax-advantaged treatment of distributions, which generally are more favorable than traditional dividend income.

4. Minimal Operational Risks - Royalty firms typically have a very thin workforce, primarily for administrative tasks. As such, there is no dependency on the labor market or the requirement to retain top talent or incentives to improve workforce productivity. The company's well-being is generally disconnected from the internal operations and strongly correlated with the leaseholds and customer operations. There is also no capital expense involved in these businesses.

Energy Royalties Pay Big Dividends

Energy independence is a hot topic and an active pursuit by leading economies. Energy is the lifeblood of a growing economy, and we will need more of it to sustain the ever-increasing world population. Despite the increasing popularity of renewables like wind and solar energy, projections from every credible energy research agency reveal that hydrocarbons will continue to supply the lion's share of the global energy mix for the foreseeable future.

As the world increasingly hunts for energy, more sources are needed to meet the demand. Hence, we will see many new sources introduced, and some may grow fast to acquire a significant share of the energy mix. But that doesn't mean today's hydrocarbon sources are going away. In fact, the energy-hungry world stemming from the growing global population will ensure we will be consuming more oil and gas in 2050 than we do today.

In addition to the above benefits of royalty investments, those in the energy sector offer two additional advantages.

1. The Best Inflation Hedge - Energy royalties tend to be an effective hedge against inflation because energy prices often rise with inflation. Moreover, royalty interests have zero capital requirements, insulating them from inflationary cost pressures. As the cost of living increases, the royalties paid to investors rise, helping to preserve the real value of income over time.

2. High Insider Ownership - Generally, firms owning royalty interests are structured as partnerships, and the general partners will have a significant ownership interest in the company to enjoy the passive income from these cash machines. This ensures continued alignment of the business pursuits with our interests and keeps that cash machine running.

Our Investing Group recently reviewed four energy royalty firms - Dorchester Minerals ( DMLP ), Black Stone Minerals ( BSM ), Kimbell Royalty Partners ( KRP ), and Viper Energy Partners ( VNOM ). The royalty firms in our list have blown the S&P 500 (SP500) out of the water in the past three years as global economies recovered from the COVID-19 pandemic.

Since their revenues and operating profits vary with the price and volume of commodities extracted by their customers, these investments will pay variable dividends to shareholders. These firms offer up to 11% yields, reflecting a solid stream of passive income from sticky global energy demand.

Not all energy royalty companies are equal. They have varying proportions of royalty income from Crude Oil, Natural Gas, and NGLs.

• DMLP's estimated $0.75-$0.8 quarterly distribution annualizes to a ~11% yield. The firm has no IDR (Incentive Distribution Rights), and the General Partner distributions are capped to a maximum of 4% of the net cash generated by the firm's activities, while limited partners (regular shareholders) receive 96%.
• If BSM maintains its most recent $0.48/share quarterly distribution, which is at a record level for the company since its inception, it would represent an 11% annualized yield.
• Annualizing KRP's most recent $0.39/share dividend, we estimate a 10.1% yield. Still, we expect the distribution in upcoming quarters to be higher as newly acquired royalty assets will begin transitioning their earnings to KRP.
• VNOM is committed to returning 75% of the Cash Available for Distribution to shareholders through regular and special payments. The company increased the quarterly base distribution to $0.27/share and declared $0.09/share in variable distributions for Q2. As such, annualizing the total Q2 base-plus-variable distribution of $0.36/share calculates to a 5.2% yield.

Some have a finite asset durability, while others regularly acquire to maintain or grow their royalty base. Some pay out most of their royalty income as distributions, while others retain a healthy chunk of the profits for corporate activities, acquisitions, and other shareholder enhancement initiatives. Customer base concentration/diversification is also a critical consideration to ensure the sustainability and safety of those cash dividends.

Royalties From Other Industries

While energy is a highly lucrative sector for high-yield royalty income, other industries don't fall short in their ability to return profits to shareholders. Some notable industries that can be valuable royalty plays are:

1. Biopharma and Biotech

These companies spend billions of dollars and years researching and developing new drugs and treatments. Once approved, these drugs have exclusivity and patent protection, providing a solid moat to generate profits for years (if not decades).

Clinical trials are expensive, and their outcome is never guaranteed. They are literally a black box - no one, including company insiders, knows the outcome before the data is available. As such, smaller pharma companies with a thin product pipeline can be a high-risk investment.

Larger, more established pharma companies like Johnson & Johnson ( JNJ ), Merck (MRK), Novartis ( NVS ), Roche ( RHHBY ), and Takeda ( TAK ) have a better-established process to pursue clinical trials and seek regulatory approval for their drugs and treatments. Moreover, they have more robust pipelines and an attractive portfolio of approved and commercial drugs that generate proceeds to support dividends to shareholders.

Royalty Pharma ( RPRX ) and XOMA ( XOMA ) are notable ways to generate dividend income from the lucrative royalties of commercial drugs and treatments through partnerships with larger firms. Our Investing Group recently discussed the ~9% yielding opportunity with XOMA preferred shares, as the company currently has two commercial drugs in its royalty asset portfolio.

2. Technology

Technology is a highly sought-after sector with massive growth prospects. But even this industry has notable royalty opportunities that can benefit income investors. Some firms develop innovative designs and license their intellectual property to other companies for a fee.

You may have seen those Dolby ( DLB ) Atmos logos on laptops, smartphones, and other devices manufactured by giants like Apple ( AAPL ) and Samsung ( SSNLF ). Every such appliance sold puts some dollars into Dolby's coffers for no additional effort on the company's part. In FY 2022, 93% of Dolby's revenues came from licensing its intellectual property to partners, and the company has paid growing dividends to shareholders since 2014, currently yielding 1.3%.

Qualcomm ( QCOM ) is an industry leader in 5G chips, with over 150 5G licensing agreements with equipment designers and manufacturers. QCOM's designs are among the most widely licensed in the industry through multiyear patent license agreements with every major handset manufacturer. The company has been doing this for 30+ years and currently cashes in 3.25% of the net selling price of branded handsets employing its design. 16% of Qualcomm's top line in FY 2022 came from licensing its chip designs to other technology companies, and the company has been an annual dividend grower since 2003, currently offering 2.9%.

3. Natural Resources

In addition to the above-mentioned sectors, investors can seek royalty income from other non-energy minerals like gold, lithium, and other natural resources. Companies like Franco-Nevada Corporation ( FNV ), Wheaton Precious Metals Corp. ( WPM ), and Royal Gold ( RGLD ) offer growing dividends from underlying royalty interests in gold, a popular inflation hedge and portfolio diversifier.

Conclusion

Royalties are an excellent source of passive income. Although they come from varied sources, several provide solid inflation protection and offer the potential for growing income over time. This article briefly discusses the potential for royalty income from energy, pharmaceutical, technology, and natural resources.

As with every other security in the financial market, it is critical to not overpay for royalties. Our Investing Group recently discussed four hydrocarbon royalties in detail with up to 11% annual yields, and we are bullish on this sector for our income needs. Energy royalties are attractively priced in this market amidst fears of recessions and oil demand shocks.

The energy royalty sector in U.S. oil and gas is highly fragmented, and soaring energy demand will likely bring up several consolidations. These royalties present high-margin income opportunities, making them terrific long-term holds for perpetual income generation for investors comfortable with some income variability. With such names in your portfolio, the next time you see or hear about high gas prices at the pump, you can relax knowing you will receive a healthy cut.

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