Add-on Buy of My Favorite Bank

by Travis Johnson, Stock Gumshoe | September 26, 2012 9:57 am

OK, so that headline is a bit misleading — I don’t much like bank investments right now, with the possible exception of the TARP Warrants that continue to tempt me on some of the big US banks just because of the huge potential time value.

But one of the stocks I’ve held for quite a while (and have bought at higher prices) continues to slowly build up its banking business, and I just bought some more shares as the stock price slipped below 90% of (temporarily depressed, I think) book value.

That’s Sprott Resource Lending (SILU) — which is sort of like a business development company for natural resources firms (mostly miners). SILU does mezzanine lending and precious metals lending — supplying funding to miners who may be a year or two from production and need a capital infusion for construction or development, in exchange for a relatively steep interest rate (around 10%) and an equity kicker (shares or warrants that could be quite profitable if the project is successful). The anticipated annual return for their loans, if you include the equity kicker, is generally in the range of 14-20%. The loans are generally targeted to be between 1-4 years, though they’re thinking about doing longer-term loans to higher-quality borrowers as one possible way to expand their pipeline of deals.

The precious metals loans are not terribly different from what royalty or streaming companies are trying to do — they lend money up front to get cheaper gold in the future, with a minimum return that’s lower than the interest rates on regular loans (5% minimum for their first gold loan, for example). The anticipated gains from that part of their business are higher, but that depends on the gold price rising or at least staying high.

I’ve owned SILU for quite a while now, and suggested it to the Irregulars when it was substantially more expensive and just getting started — their conversion to a natural resource lender has been slower going than I (and they) anticipated, which has meant that their dividend has not grown as quickly as I would like. They are still in the process of offloading something like $50 million of distressed real estate assets from their days as a real estate investment firm (that was back when they were called Quest Capital, they did some resource lending back then, too, but were largely a real estate lender), and the resource loan book has not grown as quickly as I expected… but the number of new deals has grown, and several of their early loans have already been paid back early. They have also, particularly this year, taken a hit on their book value as the equity portion of their loans (those warrants and shares they get to sweeten the deal) have fallen in value with the weak performance of most junior resource companies.

I consider this a long-term bet on a great management team that has connections to make the best deals in the resource space, and I expect them to continue their steady growth in cash flow and dividend growth. The current dividend is six cents per year (paid quarterly), so it’s a current yield of a bit over 4%. I am compounding the dividends I earn, and will continue to do so with these new shares I’ve bought — but my current holding is now at a cost basis about 10% above where the shares are now, so I’ve also been too optimistic about how quickly things will turn.

They now anticipate clearing the remaining real estate by the first quarter of next year — which we take with a grain of salt given the fact that they’ve been wrong before, but they are focused on clearing their four remaining significant real estate assets from the books even though the prices are disappointing, believing that deploying that capital to resource loans will provide a better return. Thanks to the gold mine they recently foreclosed on, one property that’s under contract above carrying value, and some recoveries from legal action, they think their book value will quickly recover from the fact that they’re selling one major asset at less than their current carrying value (the hit to book value was last quarter, the positive compensating events have not yet hit the books). So I think that, absent any weakness in their warrant portfolio, the book value should generally grow over the next six months and may even pop back up by a few cents next quarter — and they are ambitiously trying to “run out of capital” by the end of the year as they deploy more of their cash to new loans.

This is a company that is set up to deploy cash flow to shareholders, and they are positioned well to be picky in choosing resource loans to make. They are certainly not risk-free, but they are cautious in making loans where they think the borrower has ample collateral and good prospects for repayment. I still like the idea of letting this management team lend money and generate a return for me, I expect the dividend to grow, and I think buying at a discount to book value will work out well over the long term. SILU has been in and out of my top ten holdings as the value has fluctuated, but it’s firmly back in that group now.

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