When Greg McCoach Picks Mining Stocks, It’s Location, Location, Location

The Gold Report: When we last spoke in February, you were predicting a new round of quantitative easing (QE), which we’ve been seeing the last few weeks. Where do you think this is all going to end up?

Greg McCoach: The latest QE3 is open-ended, allowing the Federal Reserve to create money every month, indefinitely. QE3 was announced just a few weeks ago and already there is talk about QE4. So, in my opinion, this is the death spiral of the U.S. dollar.

The same thing is going on in Europe and Japan. It’s very troubling and, in my opinion, totally unsustainable. But, trying to predict a timeline for the ultimate demise is almost impossible. This stuff could last another couple of years. Adding in the derivative problems on top of all this debt, it’s just sheer insanity. So, where is gold going? It’s going way higher because this is the ultimate dynamic that will guide the investment world for the coming years.

TGR: Is there any realistic solution, or are they just getting us deeper into the hole, and ultimately everything is just going to cave in on top of us?
“At some point I know gold and silver prices are going to go way higher than where they are now.”GM: The days of being able to fix this are long past. I had a chance conversation with a U.S. senator and, when I asked him about the debts and deficit spending, he admitted that everybody in Washington and New York knows that there’s no possible way to pay this back. So, essentially all the politicians are hoping it doesn’t blow up on their watch.

I’m a student of history, which shows that no government that has taken on a fiat currency has gotten past the 41-year mark before it ended in inflationary panic and disaster. The U.S. dollar is now going into its 42nd year as a fiat currency and breaking the record. We’re right on the cusp of what history says is totally unsustainable and will eventually collapse.

Then there is the derivative problem on top of the debt. There’s no historical record of derivatives because they were created in the 1980s for large financial institutions to manage big risks. Unfortunately, the greed in the system overtook them, with everyone trying to make incredibly large returns. Now we have the derivative liability tracking through the world system.

TGR: Hardly anyone is even talking or worrying about derivatives at this time.

GM: Derivatives are the gigantic pink elephant in the room that no one wants to admit is there. As an example, the sovereign debt of Europe is $70 trillion. The derivative liability, that means the unsecured liability that’s associated with that debt, exceeds $700 trillion. It’s a ridiculous number. When we’re talking about trillion-dollar deficits and derivative problems in the hundreds of trillions, it just shows that there’s no possible way this can be fixed.

TGR: Another thing that is looming is the fiscal cliff that we’ll face in a few months. What do you think will happen there?

GM: I think the pressure on Congress to do something is critical. John Mauldin, a very bright economist who writes a newsletter, recently spoke at a conference I attended. He stated that if the U.S. Congress doesn’t deal with the deficit problem in the first six months of next year, it’s over. He said he would go from being an optimist about America to becoming a pessimist and that we’ll go into this death spiral, as he refers to it, of not being able to pay our debt or interest on it. But, he believes that Congress is going to do something.

I’m very pessimistic about that, though I’m more of a pragmatic optimist. I don’t see how Republicans and Democrats, who are so deeply divided, can handle the amount of deficit spending that would have to be cut out of the budget and how badly taxes would need to be raised just to try to have a chance of warding off what’s coming. The chances of that happening, in my opinion, are zero.

So, the fiscal cliff is coming. He and I believe that if we’re going to do the right thing, we have to go far beyond what the fiscal cliff is talking about. The way it’s set up right now, only about 5% will be cut from spending next year. That’s nothing. We have to do far more than that. Everybody’s going to have to pay more taxes and government spending will have to be drastically reduced, or we go into the death spiral. That’ll be very good for precious metals’ prices, but it’s a very sad commentary on where we’ll be in this world.

TGR: Do you think the recent prediction by Merrill Lynch for $2,400/ounce (oz) gold by 2014 indicates that the investment establishment is starting to see the light and realizes the dire situation, and that gold is going to have to go higher?

GM: The mainstream media, which has always been slanted against gold, is starting to acknowledge this. For them to make a positive comment about gold is really just a fraction of what’s probably coming. At some point I know gold and silver prices are going to go way higher than where they are now. When I tell people that they should be buying precious metals, they say, “Isn’t the price too high?” No, it’s dirt cheap compared to where it’s going.

After the elections, I think we’ll see gold and silver prices press for a new high. As currencies eventually collapse, it’s going to affect the whole world, and metals prices are going to go parabolic. People are always trying to guess how high that could be. The only justifiable rationale that I can give is to take how many ounces exist in the world aboveground today compared to how much fiat currency exists worldwide, and how many ounces of gold would be required to cover all that paper money? Well, my calculation comes out to about $19,750/oz, and that’s probably conservative.
“We have to focus on the best areas of the best jurisdictions that have existing and rational mining laws.”I think gold could hit at least that number when it goes parabolic, based on all the emotional craziness that would be going on at that point. The rush into precious metals would be one for the record books. You would have oceans of fiat money that were suddenly trying to find some form of safety. Gold, which has always been the safe-haven asset, is a tiny little market and couldn’t receive it. That’s why it will drive these prices into the stratosphere.

I can’t tell you when all this is going to happen and I could be wrong, but the precious metals bull market could continue for quite some time before we get to those parabolic moves. We might be at the end of that cycle right now and precious metals prices could start to go parabolic within the next few months or year.

TGR: So, when do you think the mining stocks are going to start benefiting from the higher metals prices and where should they be going?

GM: There’s been a real disconnect. The high gold and silver prices have enabled producing mining companies to make money hand over fist, but their lack of market performance relative to metal prices has been troublesome. In the nearly 14 years I’ve been doing this, I can’t remember a more difficult period for the junior mining stocks than the last few years. In August and September, the volume on the Toronto Stock Exchange started doubling and things were looking really good. I was expecting a favorable recovery this fall with higher metals prices, but our mining stocks are still really fragile, maybe because of the election.

TGR: There have been some setbacks recently with geopolitical issues affecting mining companies in certain areas. How is this influencing your investment recommendations and where should investors be focusing or avoiding at this time?

GM: It’s becoming more and more complicated. Some governments around the world are acting like extortionists. They see a profitable mining company in their country and say, “We own your asset now, goodbye and good luck.” This is a nightmare for investors. More and more countries are getting greedy and not wanting to allow mining in their countries unless they get an unfair portion of the profit, or they’re just outright nationalizing these mines. That trend is definitely on the rise.
“I’m looking at companies that can still deliver a big upside, yet have cash flow so they don’t have to be constantly going back to the market to do financings, which dilutes current shareholders.”What that means for junior mining stock investors is that we have to focus on the best areas of the best jurisdictions that have existing and rational mining laws. That was the topic of my talk at the Toronto Cambridge House Investment Conference. I think it’s so important that I wanted to highlight this issue and show people just how critical it is to invest in the right areas of the best jurisdictions. I’m not just talking about the best countries, but the best areas within those countries or jurisdictions.

TGR: Do you want to talk about some of the companies that you like?

GM: I divide my recommendations into exploration, development, production and permitting situations. In the first eight years, we had great success with exploration stories and a few development stories. Now I’m more oriented toward a combination in the portfolio, but looking more at companies that have cash flow. Because of the volatile nature of our markets, I’m looking at companies that can still deliver a big upside, yet have cash flow so they don’t have to be constantly going back to the market to do financings, which dilutes current shareholders.

I like a company called SilverCrest Mines Inc. (SVL:TSX.V; SVLC:NYSE.MKT), located in one of the best areas of Mexico. There are certain areas of Mexico I don’t like, but this is in a good area. The company is currently working through all the startup bugs, but it’s banking money hand-over-fist, with over $35 million (M) cash and growing every month. It’s using that cash flow to find more ounces around its mine site.

SilverCrest also made a new discovery in another location in Mexico that’s looking very promising. The stock price was around $1.65/share over the summer and it’s at $2.39/share now. That shows it’s in a quality mining spot and is a company to watch. I think the stock will break out to a new all-time high along with silver prices. That should take SilverCrest to a $6–8/share buyout by a midtier company. I’m very bullish on SilverCrest right now.

TGR: How about other ones in Mexico or South America?

GM: Orko Silver Corp. (OK:TSX.V) is still looking very good. It has decent share structure with an NI-43-101-compliant resource in a very good part of Mexico and a new super-pit design with quite a silver asset that’s economic. I think Orko will be taken out as well.

In South America, on the exploration side, I like a company called Tinka Resources Ltd. (TK:TSX.V; TLD:FSE; TKRFF:OTCPK), which is currently drilling some very large, very high-grade base-metal anomalies: silver, lead and zinc. Originally, the company had 20 million ounces (Moz) silver in an NI-43-101-compliant resource that it has built further. In addition, it has found some other very high-grade lead and zinc resources. We’re hoping that this drilling really breaks open the understanding of these areas. This is on a major trend in central Peru going down into Chile that is known to host large volcanic massive sulfide (VMS) deposits, which are known to be very high-grade and highly profitable. I’ve been following the story for quite some time and I like what I’m seeing there. Drilling is currently underway and it should get some assays that could really move this story forward. Tinka is one to watch right now.

TGR: OK. Any other ones there?

GM: I’m going to be taking a trip to South America this winter to look around at some new projects. There are so many areas that I need to check out. If I really like something on paper, I try to visit the site before I make a recommendation. Once you get on site, there are always a lot of new questions that you didn’t realize you needed to ask when you saw everything on paper. So, it’s very important to do these site visits.

I really like Chile as a country that’s moving toward liberty and freedom. Mining law is well established in Chile. I think that’s a good area for investors to look at; Chile has some very big deposits of copper and gold.

I like central and southern Peru because the local people know mining and the mining law in those areas is very well established. That compares to northern Peru, where nationalization is going on. Just because I like a country doesn’t mean I like all areas of that country.

I like the Yukon where there are going to be a lot of big gold, silver and base metal discoveries. Right now we’re focused on the White Gold camp and what ATAC Resources Ltd. (ATC:TSX.V) is doing. The White Gold camp is going to have a lot of big new gold discoveries in the coming years. It will take time and there are infrastructure issues. Investors need to be patient. It’s going to take a lot of money because the lack of infrastructure makes for very expensive exploration. There is no problem getting permits and building mines, but you can’t get to them very easily and that gets very costly. For a junior mining company with no cash flow, that means you have to keep going back to the trough to raise money. If you don’t hit early on, it can get painful for the investor.

TGR: So, what other companies do you like in Canada?

GM: I like Ethos Gold Corp. (ECC:TSX.V; ETHOF:OTCQX). It hit high-grade narrow-vein gold drilling this summer, but it was not the bulk-tonnage targets it would like. It only drilled 60 holes. Kaminak Gold Corp. (KAM:TSX.V), which I also like, has had great success up there and drilled over 400 holes this summer. I also like a new discovery up there called Comstock Metals Ltd. (CSL:TSX.V), still in very early days. I think there are a lot of things that could happen in the Yukon, but it’s going to take time.

TGR: Any thoughts on Explor Resources Inc. (EXS:TSX.V; EXSFF:OTCQX)?

GM: Explor Resources is a company that’s in a great area. All the infrastructure is right there. It got a lot of attention over the last three years from investors and mining companies. Expectations were high to find a big high-grade gold deposit. So far, it’s hit on a lot of very expensive deep drill holes. For a junior mining company without a deep-pocket partner, this has gotten very expensive. Lately the company has had some of its best drill results. It hit 35 meters of 8 grams/ton gold, which is very good. Had it hit that years ago, when it only had 65 or 85M shares outstanding, it would’ve been a multi-dollar stock. Now, in this tough market, we have these great drill results but there are 160M shares out and it needs more money again. Timing is everything in these deals.

I do think Explor will do well because it will be coming out in late November or early December with around a 1.5 Moz NI 43-101 resource calculation, which should be a bankable asset. The rest of the assays on further drilling will be coming out later this fall and will be calculated in another NI 43-101 resource sometime in April/May 2013. I think that will be around 2.2 Moz. That’s a significant resource and the majors have to pay attention because it’s located just 10–15 minutes outside of Timmins, in an area with infrastructure, that doesn’t cost a lot to build a mine and has no permitting issues.

I do think that, ultimately, Explor will perform well. The stock is around $0.15/share today, after hitting a low of $0.12/share during the summer. As these NI 43-101 numbers come out, this stock will get back to a more respectable level and eventually will be joint ventured or possibly taken out by a bigger entity.

TGR: Definitely one to keep an eye on. So, are there any other ones you want to mention?

GM: Up in the Northwest Territories, Canadian Zinc Corporation (CZN:TSX; CZICF:OTCQB) has a mine that was built by the Hunt brothers in the late 1980s, with very high grades but not a lot of infrastructure. It looks like it’s getting a permit right now. If that comes through, I think the stock revalues from $0.39/share currently, to more like $2–3/share. Then it’s a development story with about a year and a half to two years to production. Sprott Asset Management is one of the biggest shareholders. If you believe that silver prices are going higher, here’s an operational mine that could be in production with very high-grade ore by 2014 or 2015. So, I like that one as well.

TGR: What should people be doing now to protect themselves and profit from what you expect is ahead?

GM: If you want to make money and not lose money, number one, you have to get out of U.S. dollars. If you hold U.S. dollars in a U.S. bank account, work for U.S. dollars at your job, or you’re hoping to retire in U.S. dollars, you’re going to be in trouble. This is what’s coming. This deficit issue is beyond sustainable. At some point it means collapse and devaluation of our currency.

TGR: We’ve never had it in this country, so that would be a real shock to people.

GM: A big shock. The only way to protect yourself, that I see, is to own physical gold and silver as the ultimate form of money, and take possession of precious metals, whether it’s American Eagles or Silver Eagles for Americans or Canadian Maple Leaf coins for Canadians. Don’t let other people store them for you or get involved with certificates, pooled accounts or ETFs, because they only have to keep a small percentage of the actual money they receive in the metal that they say they’re buying for you. When these metal prices go parabolic, how can they deliver to you if they don’t own the actual metals? That’s going to be a big surprise to people.

On top of that you’ve got to own the precious metal mining stocks, with their big upside leverage potential. Aside from that, my subscribers know that I’m very oriented toward preparedness. Get some food storage together. Our system works on a just-in-time three-day inventory system. If, for whatever reason, there’s a disturbance to that three-day delivery system, the shelves are empty. Get some canned goods and freeze-dried foods that last for a long time. It’s just a smart way to look at life, regardless of how you feel.

On a positive note, once we learn our lesson and the people keep the politicians accountable and don’t let them abuse a fiat currency as we have the last 40 years, I do believe that good things can happen again with a new age of prosperity that has never been seen in this world. So, that’s my positive note, after talking about the difficult times we’ll have to get through first.

TGR: We appreciate your thoughts today, Greg, and the next time we talk, we’ll know a lot more about how all this has turned out.

GM: Glad to be with you.

Greg McCoach is an entrepreneur who has successfully started and run several businesses in the past 23 years. For the last nine years, he has been involved with the precious metals industry as a bullion dealer, investor and newsletter writer (Mining Speculator and The Insider Alert). McCoach is also the president of AmeriGold, a gold bullion dealer. He writes a weekly column for Gold World.

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1) Zig Lambo of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: SilverCrest Mines Inc., Tinka Resources Ltd., Ethos Gold Corp., Comstock Metals Ltd., Orko Silver Corp. and Explor Resources Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise. ( Companies Mentioned: ATC:TSX.V, CZN:TSX; CZICF:OTCQB, CSL:TSX.V, ECC:TSX.V; ETHOF:OTCQX, EXS:TSX.V; EXSFF:OTCQX, KAM:TSX.V, OK:TSX.V, SVL:TSX.V; SVLC:NYSE.MKT, TK:TSX.V; TLD:FSE; TKRFF:OTCPK, )

John Kaiser: Gold as a Positive Economic Indicator

The Gold Report: Gold prices reached historic highs during the last quarter. However, in a recent Kaiser Bottom-Fish newsletter, you showed the Toronto Stock Exchange Venture (TSX.V) listings since February have had dramatically more down than up days. Is this a correction or a long-term trend?

John Kaiser: What we have seen is a negative response by ordinary investors to a deteriorating economic outlook for the United States and the world, which we might call a correction of expectations. But what worries me about a long-term trend is the growing prevalence of volatility-based profit harvesting, high-frequency and algorithmic trading paired with the elimination of the downtick rule for short selling, which allows traders to push markets down or up at will and in the process destroy perceptions of value in the market. This has been particularly intense in the junior resource sector, which the TSX.V is dominated by, because these companies, generally, do not have revenues and cash flow, the usual measures by which value is assigned.

It is very difficult to develop a visualization of what a venture project is all about, what it could become and turn that into a market valuation that enables the company to finance its projects at minimal dilution to existing shareholders. It is much easier to pound the order book, fill it with sells and completely undermine the perception of the people who have been investing for value. The bottom line is that we have seen a withdrawal of value-style investors from this market, both at the retail and sophisticated levels. As an example of how significant this has been, during February, the Venture Exchange averaged $310 million (M) worth of trading per day. By October, the average value traded had plunged to $94M per day.

TGR: Are you saying that the difference is not because of the fundamentals of the stocks and the companies behind them that are on the TSX.V, but because the rules have changed and people are playing around the volatility?

JK: It is a combination of the two. We had a surprise recovery in the resource sector in 2009 and 2010, facilitated by U.S. quantitative easing and China’s stimulus program that injected $600 billion into infrastructure development. Coupled with strategic Chinese stockpiling, that helped pull up raw material prices from the end-of-2008 lows. But the Fukushima nuclear disaster with its supply chain interruptions and the emergence of the Tea Party as a major force in the debt ceiling debate conspired to make the world very concerned that the creeping recovery is going to tip back into the garbage can. That has stalled the post-crash recovery in raw material prices, leading investors to price in the possibility of the global economy descending into a 1930s-style depression. Contrary to the beliefs of many goldbugs, a depression would also be negative for gold and silver prices.

TGR: In addition to some of these short-term trends, you have talked about the possibility that the United States is moving away from its power position. Europe and America are descending while China and India are ascending. Do most people see this? And is this impacting the stock market?

JK: The “declinist view” says that the U.S. economy and its military power are in a long-term downtrend. In at least economic terms, this is supported by gross domestic product (GDP) statistics. In 2000, the U.S. GDP was 32% of global GDP while China’s was about 5%. Since then, American GDP has sunk to about 22% while China’s sits at just under 10%. At the same time, we have seen America’s share of total military expenditures rise from about 40% to 43%, where it seems to be going sideways. The U.S. is carrying an unsustainable burden of the cost of keeping the global peace. With America’s share of global GDP in long-term decline, the ability to fund almost single-handedly a global military force is not sustainable.

TGR: Based on that, what is your prediction for the final quarter of 2011?

JK: What I have described is a long-term trend that is underway. Right now, we are in the throes of sorting out what is going on with the Eurozone. Europe is in danger of imploding upon itself. It needs to stabilize its financial situation. At the same time, we need to see some signs that the American economy is rebounding. Employment statistics are going to be important. After losing nearly 6 million manufacturing jobs between 2001 and the end of 2009, some 303,000 manufacturing jobs have been created since 2010. This trend stalled earlier this year because of the Japanese supply chain disruption and concern that the political quagmire will result in consumer demand destruction. We need manufacturing capacity to come back to the U.S. in order to support the growing service job economy. The uncertainty about the growth of real jobs could result in a very volatile market during the last couple months of this year.

Wall Street sees down as easier than up, so the tendency is to lean on the market and pressure it down. A big tax loss selling window is going to emerge soon. We may even see a bottom-fishing window open up. My concern is that shareholders who understand why they own quality stocks will be reluctant to sell at the bottom after enduring what amounted to a nearly yearlong slow motion crash. On the other hand, low quality stocks will probably be sold ruthlessly. That means poor liquidity in the better stocks, but very high liquidity at very cheap prices in the stocks that do not have staying power. We may, in fact, see an icicle-type formation where prices dip down because there has been lots of selling into the bids without significant replacement by new bids. Too many investors remember how unwise it was to catch half-price bargains in the fall of 2008 that turned out be falling knives and anvils. When people finally go looking for quality stocks at depressed prices this December, they will find little available. As they start to reach for stocks, prices will spike upward and kick off Q112 with a strong uptrend.

TGR: In an environment like this, what is the best way for an investor to protect wealth or maybe even profit?

JK: My area of specialty is the resource sector, both the mining companies and the resource exploration and development companies. If you accept my belief that the strength in gold and silver prices reflect anxiety about the relative decline of the United States as both an economic and military power, which I see manifested in the fact that the value of all the aboveground gold and silver has risen to 12% and 3% of global GDP, respectively, from the 4% and 0.5% levels that prevailed a decade ago when America was indisputably triumphant, we will see prices head modestly higher from current levels over the next five years.

That is very significant for the gold and resource producers and juniors because they are pricing a bubble-type perception, namely that gold is going to go back to $1,000/ounce (oz) and that silver is going to go back below $15/oz, prices that could make many of these companies unprofitable. That is the reason we are seeing very low cash-flow multiples similar to what we often see in industrial mineral-type companies. So the big bet here is that we will witness an inflection when people start to accept that the current gold and silver prices are the new reality, which will result in an upward repricing of anywhere from 100–300% for gold and silver companies.

One strategy is to look at the solid, cash flow-positive silver and gold producers right now, and take a position in them. A secondary strategy would be to look at the gold and silver ounce-in-the-ground development companies, which are trading at valuations considerably lower than what you get by plugging current metal prices into the discounted cash-flow valuation model.

TGR: What would be some examples of companies that fit either the cash-flow positive or the development company trading at a lower-valuation model?

JK: Fortuna Silver Mines Inc. (FVI:TSX; FSM:NYSE; FVI:Lima Exchange) has a mix of silver and base metal production. It would benefit considerably if people expect the current cash flow to be sustainable over the next few years.

TGR: It looks like it is trading at $6.58 right now. It has been as high as $7.22.

JK: Right now, Fortuna is being priced at roughly a very conservative six-times multiple of 2012 cash flow based on forecast production and the current $34/oz silver price. The reason it is so low is that people do not think the cash flow is sustainable. That can be either because they think a mine will encounter a problem and cease production or because they expect the commodity price to go down substantially.

So far, Fortuna has not disappointed us with production from Caylloma, but we do need to see production ramp up for San Jose to proceed next year as expected. But a lowish 5–7 multiple for next year’s forecast production at current silver prices seems to be the norm for primary silver producers. To help my readers better understand the situation, I have created a couple of graphics based on our production and cash-flow forecast for Fortuna. The annual production and price target chart shows the impact San Jose coming on stream will have on silver production over the next four years. In 2012, San Jose will add 1.7–1.9 million ounces (Moz) from Caylloma, growing overall silver production to 5 Moz annually by 2015. The chart shows the stock price that would result at a 10 times cash-flow multiple at different average silver prices for 2012.

As you can see, the current $6.58 stock price is not far from the $7.01 price target that corresponds with a $20/oz silver price and a 10 times cash-flow multiple. But if we apply the current $34.64/oz silver price, the stock price jumps to $11.20 at a 10 times multiple. At $50/oz silver, the price target jumps to $15.59. You can also see what happens at more optimistic silver prices such as $75 and $100. A five times cash-flow multiple is too conservative for a precious metals producer such as Fortuna whose silver production at $20/oz silver is 60% of revenue.

Once there is acceptance that silver prices are not going back to the bad old days, you could see a 15:1-type multiple emerge. It is hard to predict what sort of cash-flow multiple the market will eventually settle on during these volatile times, but the second Fortuna chart helps me see the price target for Fortuna during 2012 at various average silver prices and cash-flow multiples.

For example, suppose you think, like I do, that silver could average $50/oz in 2012 and silver producers attract a 15 times multiple. Slide that vertical silver bar reflecting the current silver price over to $50/oz, and move up to the green line corresponding with a 15 multiple and you get a price target just short of $25/share for Fortuna. It should be obvious that the market is biased toward a pessimistic scenario where silver crashes back to $20/oz. Keep in mind that this cash-flow-based valuation metric assumes that higher silver prices are not due to substantial cost inflation or U.S. dollar exchange rate declines, which would gobble up any gains in silver revenues caused by price increases.

The primary silver producers are companies that did all the heavy lifting in the past few years, putting their silver deposits into production. They are now getting an enormous amount of cash flow, but are not being priced as if this cash flow will be sustainable over the life of the mine. So, the big bet is whether current silver prices are sustainable over the next five years. I am arguing that they are sustainable and we will see a valuation paradigm shift where these low cash-flow multiples of 5:1 will jump up to a 10:1 or 15:1 ratio. What will follow is an aggressive development of more silver production absent the concern that capital expenditures will end up being lost because silver prices collapse.

TGR: Could a shift to 10:1 pricing boost all silver producers?

JK: If the silver price proves to be sustainable, we could see the stocks all undergo significant gains as they adjust to this new paradigm, as is evident in the Upside Potential chart for the 15 primary silver producers we track. The one apparent exception is Aurcana Corporation (AUN:TSX.V), which looks weak because in 2012 its Shafter mine will add only 900,000 silver ounces to the existing 1 Moz production from La Negra. But Shafter is forecast to hit 3 Moz in 2013, bringing total production to 4.8 Moz in 2015. So Aurcana might be the laggard to watch for those speculators who prefer to react to the inflection rather than anticipate it.

TGR: On the gold side, you pointed out in a recent article that the inflation-adjusted equivalent of the post-1980s bubble of $400/oz would be $1,032/oz and that $1,800/oz gold represents a 74% real gain. What are you predicting is going to be the new normal for gold?

JK: Much of the discussion about gold treats it as an inflation hedge. We can argue that the big move during the 1980s was a slingshot effect that allowed gold to catch up for decades of inflation while its dollar price was artificially fixed. Goldbugs today will argue that the “real price gain” I am observing is just an anticipation of the inflation that will come once the world’s debt problems are monetized. If they are correct, then it explains why there is such muted interest in gold equities despite record gold prices. Whatever profits are present today will vanish tomorrow when costs undergo an inflation big bang. But I think there is a different reason for this “real price gain” to be present, and it is not bad for gold equities, at least not in the medium-term future.

Rather than relate the value of the existing gold stock to measures such as the money supply, I look at gold’s value as a function of global GDP. Given that GDP represents the total value of exchanged goods and services whose turnover one can assume created wealth while gold just sits there growing incrementally while accomplishing very little, you might wonder what the connection would be between wealth creation and the value of the gold stock. This chart graphs the annual value of the aboveground gold stock based on the average annual gold price as a percentage of nominal global GDP expressed in U.S. dollars at the average currency exchange rates prevailing each year.

That description is a mouthful, but I find the graph fascinating because it shows a massive spike to an $850/oz gold peak of 26% in 1980 when it looked very much like America was losing it on the global stage, plunging to a low of 4% in 2001 when it looked like the world was America’s oyster. Since then, we see a gradual increase to a peak of 15% in 2011, but still well short of the 1980 peak of 26%. We see a similar pattern with the aboveground silver stock.

Note that during the past 30 years miners added 2.2 billion ounces (Boz) gold to the 3.2 Boz that existed in 1980, and 17 Boz silver to the 30 Boz that existed then. This graph includes the value of that additional gold and silver.

The possible meaning of this trend begins to take shape when we look at another chart that plots the American and Chinese GDP as a percentage of global GDP, along with plots of each nation’s military expenditures as percentages of global military expenditures. America’s GDP percentage has declined from 32% in 2000 to its current level of 22%, while China’s has grown from 4% to nearly 10%. At the same time we see America’s military spending stuck at about 43% of global spending, while China’s share has nearly doubled to just over 7%, a trend that closely tracks the growth of its GDP. Given political efforts to contain government spending, and the fact that military spending is the single biggest item in the spending budget, an obvious question is what exactly does this overwhelmingly high percentage of global military spending accomplish, and do American taxpayers proportionately benefit? Regardless of the answer, what happens if these inversely related American and Chinese GDP percentage trends continue along their trajectories?

In my view, the expansion of the value of the aboveground gold and silver as percentages of global GDP reflect growing international uneasiness about the next two decades during which America and China respectively become relatively weaker and stronger on the global stage. The real price increases we have seen in gold and silver reflect this growing structural uncertainty rather than fear about hyper-inflation and fiat currency collapse. And short of a catastrophic global economic collapse that causes China to implode worse than the United States, I do not see anything on the horizon to make this anxiety diminish.

So let’s assume that, rather than an escalation of anxiety such as we saw in 1980, we are stuck with persistent medium-level anxiety that, for argument’s sake, stabilizes at a level where the value of the gold stock is 10% of GDP and in the case of silver 3%. These are levels less than half the peak percentages of 26% and 14% achieved for gold at $850/oz and silver at $50/oz in 1980. If we accept the global economic growth projected by the International Monetary Fund and gold production increases over the next five years along the lines projected by CMP or GFMS, then at a 10% “anxiety” percentage of GDP I can see the gold price trading in a range of $1,400–1,700/oz during the next five years. In the case of silver at 3% of GDP I see a range of $45–60 which is even better than the current $34 price.

I am confident that these new levels are the new reality, which means that this 50–70% real gain that we see in the price of gold represents a lot of potential profit to be harvested by putting into production deposits that three years ago would not have been economic. This is good news for producers and ounce-in-the-ground projects that have a significant profit margin to be captured if they are put into production and can sell their gold at prices of $1,500–2,000/oz over the next five years.

TGR: So if we assume $1,500–2,000/oz gold prices, what are some of the juniors that could profit in the next year or so?

JK: One that has been an ongoing recommendation is Spanish Mountain Gold Ltd. (SPA:TSX.V), which was formerly Skygold Ventures. It trades at about $0.80 right now. At a gold price of about $1,750/oz, it has a potential value of just under $2/share when I run the parameters published in the junior’s 2010 preliminary economic assessment through a discounted cash-flow model at a 10% discount rate. At a gold price of $1,100/oz, Spanish Mountain is worthless. So this is an example of a large-tonnage, low-grade deposit, which at the prices from a few years ago is basically dead in the water.

But at the $1,750 level, it’s potentially a $1.50–2 stock. If gold ends up at $2,500/oz, I could see Spanish Mountain being worth $4, but only if such a gold price rise is not accompanied by capital and operating cost escalation. I certainly do not rule out a spike toward $3,000/oz over the next few years—$3,300/oz right now would be the equivalent to $850/oz in 1980 if we take gold’s value as 26% of GDP as the bubble limit. Although unsustainable, such a move would create a tidal wave of interest in the sector. It would trigger a gold price valuation paradigm switch for gold equities similar to what I am predicting for silver. People would start taking the current prices seriously and plug them into their cash-flow models instead of using $1,100/oz 3-year trailing averages for gold projects.

Instead of suspiciously viewing today’s gold prices as a trend that will end terribly, people need to look back at a long-term gold chart from the early 1970s when the price went from $35/oz to $850/oz. Yes, that was a hyperbolic chart and it still stalled out. But gold stalled out at $400/oz and stabilized there. And that was a huge, 500% real increase. So we had 30 years of gold production where all this fruit that had previously been very high in the trees was suddenly turned into low-hanging fruit that the mining industry systematically harvested and added 2 Boz to the 3.2 Boz that existed in 1980. What we are witnessing now is on a somewhat smaller scale, but if you use this measure of the gold value as a percentage of global GDP, then the current percentage of about 12% is still halfway from a bubble limit where it starts becoming too much of a self-fulfilling phenomenon that has to burn out and crash back.

TGR: So what about a hybrid company? You have written about Geologix Explorations Inc. (GIX:TSX). It is trading at $0.28 now. Is that factoring in higher metals prices? Where could that go?

JK: Geologix is copper and gold. An important message I am trying to send to my audience is that gold is not inversely related to economic strength anymore. It is not a hedge against the world economy collapsing, which normally means what is good for copper is bad for gold, a reason miners who understand the meaning of “hedge” like copper-gold mines. The real price strength of both copper and gold is now twinned.

Because Geologix is still perceived as more of a potential copper producer than a gold producer, when copper prices retreated earlier this year, the stock followed. While we can argue into the wee hours whether or not my analysis of the factors driving the gold price is correct, few will dispute that strength in copper is a function of expectations that the global economy will continue to undergo growth rather than go back into a major recession.

If you are inclined to believe that the global economy is more resilient than most people think, but still lean toward the notion that what is good for people in general is bad for the gold price, then a copper-gold project such as Geologix’s Tepal project in Mexico merits attention. I have run discounted cash-flow models of Tepal based on the preliminary economic assessment parameters presented by Geologix in April 2011 in which I assume a pessimistic scenario of $2/pound (lb) copper and the optimistic scenario of the current $3.50 price. At the current $1,750/oz gold price, the model shows a price target of only $0.67 using a 10% discount rate, but at $3.50/lb copper the target jumps to $2.03. At $1,400/oz gold and $2/lb copper, Tepal is dead, an outcome the market already seems to be pricing into the stock at $0.29. But if copper stays at $3.50/lb and gold soars to $2,500/oz, the Geologix price target blossoms to $3.50. Geologix is thus a good example of a leveraged play on my theory that gold’s strength is linked to a growing economy rather than a faltering one.
TGR: Any other good examples of how the rerating of gold prices into stock prices could impact companies you are following?

JK: One of my newer picks is a company called Probe Mines Ltd. (PRB:TSX.V). A year and a half ago, it was pretty much just limping along on the basis of a small claim it had in the McFauld’s Lake area of Ontario where it covered a fraction of a chromium deposit. But since then it has made a brand-new gold discovery in the Borden Lake area of Ontario, and it just published an Inferred resource of over 4 Moz at a fairly low grade of about 0.7 grams/ton. At current prices, this represents about $40/ton. It is one of these large, disseminated gold systems that will be amenable to open-pit mining, a similar concept to Spanish Mountain. Probe has not yet done the economic scoping studies needed to identify operating and capital costs, the key to evaluating the impact of the current gold price on undeveloped gold deposits. Here is an opportunity to benefit from comparing similar deposits such as, say, Brett Resources Inc. (BBR:TSX.V) and its Hammond Reef deposit that Osisko Mining Corp. (OSK:TSX) bought for about $500M while gold had a lower price than today. Probe’s total valuation is only about $187M based on 80M shares fully diluted. With expansion drilling underway there is potential to get a stock price boost from the discovery of additional ounces, not just growing confidence in the current gold price and optimism about mining costs at Borden Lake.

TGR: How high do you think it can go?

JK: In the short term, I would expect $3–4 if it delivers its preliminary economic assessment by the end of Q112 and the numbers are similar to Brett’s Hammond Reef, if not better, but if the exploration drilling establishes similar mineralization along the fold of this belt where no real work has ever been done in the past, it could end up boosting this resource to a 5–10 Moz system. At that level, it starts becoming interesting to a major. Then we could see this stock flirt with a $5–10 range. Plus, it was financed earlier this year to the tune of $25M, and again a week ago for $15M, so there is no need to worry about financing dilution risk in the near term. And the Black Creek chromium asset could be a target for Cliffs Natural Resources Inc. (CLF:NYSE), which is developing its Big Daddy chromite project in Ontario. That could give this company another injection of capital without having to undergo equity dilution.

TGR: You mentioned that you now see gold as positive toward economic development, not inverse to economic health. Do you think that higher gold prices are driven by goldbugs or by investors who are looking to profit?

JK: It is my view that goldbugs are a minority. I believe the buying is by investors who are simply hedging some of the wealth, higher net worth people who are putting a portion, maybe 5%, of their wealth into gold. They have the most to lose if the world becomes unstable, and currencies fall apart relative to each other. They don’t need that 5% of their wealth that they are stashing in gold. A similar thing is happening with silver, except it is driven by people in emerging nations where they cannot really afford a 1 oz gold coin and they don’t trust their governments, so they are using silver to store accumulated wealth. Therefore, a lot of silver, which primarily was fabricated into industrial applications, is now being pulled out of those applications by the high price and being redistributed as a very dispersed asset class. It is not going to come back into the system quickly, just as I don’t think the gold overhang is going to come back because investors decide to grab a profit and run. Frankly, I think gold and silver ownership will be quite boring in profit or loss terms during the next year, which is very good for gold and silver equities.

TGR: Thank you, John, for your insights.

John Kaiser, a mining analyst with over 25 years of experience, is editor of Kaiser Research Online. He specializes in high-risk speculative Canadian securities and the resource sector is the primary focus for an investment approach he developed that combines his “bottom-fishing strategy” with his “rational speculation model.” Kaiser began work in January 1983 as a research assistant with Continental Carlisle Douglas, a Vancouver brokerage firm that specialized in Vancouver Stock Exchange listed securities. In 1989 he moved to Pacific International Securities Inc., where he was research director until April 1994 when he moved to the United States with his family. He launched the Kaiser Bottom-Fishing Report (now Kaiser Research Online) as an independent publication in October 1994 and developed it into an online commentary and information portal. He has written extensively about the junior resource sector, is frequently quoted by the media, and is a regular speaker at investment conferences. Since 2008 he has developed a focus on security of supply issues and how they relate to critical metals such as rare earths.

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1) JT Long of The Gold Report conducted this interview. She personally and/or her family owns shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Geologix Explorations Inc., Fortuna Silver Mines Inc.
3) John Kaiser: I personally and/or my family own shares of the following companies mentioned in this interview: Geologix Explorations Inc, Spanish Mountain Gold Ltd. I personally and/or my family am paid by the following companies mentioned in this interview: None.


Geordie Mark: Global Demand for Iron Ore on Rise

Source: Brian Sylvester of The Gold Report 04/27/2011

How long until the window on rising iron-ore prices closes? Global demand is driving prices higher and shipping costs are at historic lows. But only companies poised to get into production quickly will be able to capitalize. In this exclusive interview with The Gold Report, Geordie Mark, an analyst with Haywood Securities in Vancouver, picks the companies that are ready to profit and those that are likely to get picked off by competitors.

The Gold Report: BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF), one of the world’s largest suppliers of iron ore, recently submitted an environmental review for a proposed $48 billion expansion of the Port Headland Harbor in Western Australia to accommodate the doubling of iron ore production from its Pilbara operation. When a company’s willing to spend $48 billion at one operation, what does that tell us about the long-term fundamentals about the iron ore business and, ultimately, the steel business?

Geordie Mark: The thesis there is one of global growth in steel demand resulting from continued industrialization from advancing economies, particularly China. At the moment, China produces somewhere near 45% of the world’s steel.

On the back of that, India is continuing to grow its internal steel production at greater than world average rates. So, 37% of the world’s population, which includes only China and India, has significant growth in its underlying steel consumption and demand.

If you take a step back, these countries are both in the juvenile stages of their steel use. They still have a long way to go in ramping up their countrywide infrastructure requirements. This trend is expected to continue for a number of years, if not decades.

TGR: Investors commonly think of China and India as the primary drivers behind steel demand. However, I have a November 2010 report from UBS, which estimates that steel consumption this year will rise by 4.5% in Europe, 4.5% in Russia and 5% in Brazil—a little bit more than India and China. The growth forecast gets even more bullish in 2012. Are Haywood’s numbers similarly robust in countries outside of China and India?

GM: I would have to agree. China is obviously the main source of growth due to its size. For example, China’s steel consumption is roughly eight times that of the U.S. But we are seeing significant growth from other countries, too. There are significant growth projections coming out of Europe, Russia and Brazil. The World Steel Association estimates global growth this year at 5.9% and 6% for 2012.

TGR: All that competition for iron ore is driving up the cost. China’s imports of iron ore in the first quarter rose almost 15% to about 177 million tons (Mt). Meanwhile, the average import price was $156.50/ton in the first quarter, about 60% higher than in the year-early period. What are some ways to play this remarkable growth?

GM: To play the growth, investors could look to companies that are either entering into production or can enter production in this period of high prices, which we believe will be about five years. In the short term that could include companies entering into production this year in order to get near-term cash flow and strong margins. An example is Labrador Iron Mines (TSX:LIM). We expect Labrador to start production within about a month’s time from a direct-shipping style operation.

Investors could also find growth in development-stage companies that could go into production within the window of high prices. For example, Northland Resources S.A. (TSX:NAU) has a project it anticipates it will start mining in late 2012 for high-quality iron ore concentrate product.

TGR: What’s your prediction for prices a year out from now?

GM: This year we are forecasting an average price of around $139.50/tonne for 62% Fe iron ore FOB Brazil. Next year, we forecast about $124/tonne.

TGR: Why are the prices going down?

GM: We have taken a conservative approach to building our forward commodity price curve given known supply growth, as well as uncertainty surrounding seaborne transport rates. Furthermore, concordantly, the commodity has witnessed elevated pricing volatility whereby about a year ago, the industry came off an annual benchmark approach where the Big Three, that’s Vale S.A. (NYSE:VALE), Rio Tinto (NYSE:RIO; ASX:RIO) and BHP, negotiated with steel producers on an annual basis to fix prices. The rotation of the mechanics of commodity pricing within this industry was a result of the underlying demand-driven environment, which now places the iron ore producers with a lot more say in negotiations.

World iron ore pricing rotated out of an annual benchmark into quarterly indexing and a greater reliance on the spot price markets. In the last first quarter and second quarter price negotiations, we have increases in prices for the Big Three, but as stated earlier we will also see greater volatility in the spot market relating to seasonal events and any fundamental policy changes out of China and other growth steel producers. Since we do see greater potential for volatility in the market going forward, we’re resting on the conservative side for pricing.

TGR: The value of companies with iron ore assets or projects increased by an average of 400% between October 2005 and October 2010, whereas the value of metallurgical coal companies increased 34% during that same time, according to the UBS report. Steel companies were up 12% during that period. Part of that value creation is because steel companies have gone upstream and bought iron ore juniors to control the cost of supply. Do you expect that trend to continue?

GM: I would say the valuation metrics driving steel companies and companies with iron ore assets differ appreciably given that the steel companies work on operating margins and output growth, whereas companies with iron ore assets and projects have moved up because they’re increasing the underlying resource base, lowering apparent risk by moving through development or entering production in a market with elevated commodity prices.

We do see vertical integration being a very significant component going forward for the steel producers. Steel producers want to hedge away from the Big Three. These companies want to be independent and integrate their cost management into locking up some of their iron ore at cost. Such integration enables steel companies to be more competitive when selling steel. We believe that there is likely to be continued vertical integration in the sector as steel producers lockup supply and protect the underlying cost base.

TGR: One example of that was when Cliffs Natural Resources Inc. (NYSE:CLF) bought Consolidated Thompson Iron Mines Ltd. (TSX:CLM)

GM: That’s exactly right. Cliffs and Consolidated Thompson have a lot of operational synergies in the Labrador Trough. Cliffs was able to pay a good price for Consolidated Thompson. The Canadian operations had operational synergies, so that arrangement worked for Cliffs.

Another example of vertical integration would be Tata Steel Ltd. (LSE:TTST; Grey Market:TATLY) forming a joint venture with New New Millennium Capital Corp. (TSX.V:NML) on a direct-shipping ore project in the Schefferville-Labrador Trough, as well as participating in a bankable feasibility study on New Millennium’s large taconite deposits near Schefferville.

There is good vertical integration potential in the sector, particularly within areas that have existing infrastructure or reasonable assurance in terms of asset ownership. Canada is a very good home for such activity.

TGR: You recently revised your price target on Alderon Resource Corp. (TSX.V:ADV; OTCQX:ALDFF) from $3.90 to $5.80 after it published a resource estimate on its Kami iron ore project in Labrador. Was it the size of the estimate that made you revise your target?

GM: We were pleasantly surprised by the resource estimate. Alderon reported an Indicated iron ore resource of 490 (Mt), plus an inferred resource of 118 Mt. Just today, the company brought out some drill-hole results on North Rose, which is outside the defined resources, and looks as though it has potential to add resources. Alderon did surprise on the upside and we give it some more credit on that basis.

TGR: What were your thoughts after visiting the property and meeting management?

GM: My take is that the management is made up of very strong group, and this is married with a very strong board. A significant component of the current board is that many were also on the board of Consolidated Thompson during its pre-production stages.

In terms of the property, it’s all location, location, location for infrastructure. The Kami property is within 15 miles of four operating mines with four options to get to a public rail system. Those components work well together for this project.

TGR: Would those factors make it a takeover target?

GM: It has potential. The main other component is that it is independently owned. There are no steel producers involved in the company at the moment. Its largest shareholder is Altius Minerals Corporation (TSX.V:ALS) because it originally held the property. I definitely think Alderon could be a potential takeout candidate in the long term.

TGR: Are there some other promising juniors that you follow?

GM: Another independent iron ore company in that same mining area is Champion Minerals Inc. (TSX:CHM). It has a portfolio of projects with around 1.5 billion tons of NI 43-101 compliant resources. Its flagship project, Fire Lake North, is not too far away from ArcelorMittal (NYSE:MT) existing Fire Lake Mine. Champion potentially still needs a little more infrastructure to come into play, but it has a very good portfolio of assets going forward. We have a target of $4.20 for Champion stock. Recently, it was trading at about C$2.38.

TGR: Any other juniors in the Labrador Trough there?

GM: I mentioned Labrador Iron Mines, which is entering production this year. It probably will produce just less than 1.5 Mt. of 62% direct shipping iron ore style product.

TGR: Who are the major shareholders in that play?

GM: The main shareholder is Anglesey Mining Plc. (LYSE:AYM). The second major shareholder is Passport Capital.

There is also New Millennium Capital Corp., which has a joint-venture project with Tata Steel, its largest shareholder.

TGR: Given Tata’s large stake in New Millennium, it’s probably not a takeover target. But are Champion and Labrador?

GM: Alderon, Champion and Labrador all have the potential to be taken out.

We are also looking at Northland Resources being one of the next producers, although it isn’t in the Labrador Trough.

TGR: Where is that project located?

GM: It has two projects. Its flagship is the Kaunisvaara project in Sweden, which is fully permitted for production, and is in development at the moment.

Sweden has a long history of iron ore mining. This project would export out of Norway, and would probably be predominately selling to a European market. The project is expected to output a very high-quality product at around 69% Fe, and we think the company could fetch a good premium for the product.

TGR: What can investors expect in the iron ore market in the near term?

GM: Growth should continue to emanate out of China and India, and bolstered recovery is taking hold in Europe, particularly Eastern Europe, and North America. Another feature to look at is the cost of seaborne freight. There have been continuous lows in the market for seaborne freight because of surplus capacity that should continue for a number of years. Demand growth and lower transportation rates provide fantastic opportunities for pricing protection to moderate operating margins for projects entering production or at the development stage.

TGR: Thanks for your time, Geordie.

Dr. Geordie Mark, a research analyst with Haywood Securities, focuses on uranium companies involved in exploration, development and production. He joined Haywood from the junior exploration sector, where he was vice president of exploration for Cash Minerals, which concentrated on uranium and iron oxide-copper-gold targets across Canada. Prior to joining the exploration industry, Mark lectured in economic geology at Monash University, Australia, and served as an industry consultant. He completed his Ph.D. in geology in 1998 at James Cook University’s Economic Geology Research Unit in Australia, specializing in aqueous geochemistry and igneous petrology applied to ore-forming systems.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.

1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Alderon.
3) Geordie Mark: I personally own shares of the following companies mentioned in this interview: Northland Resources. Haywood Securities, Inc. has reviewed lead projects of Alderon Resource Corp. and Champion Minerals Inc. and a portion of the expenses for this travel have been reimbursed by the issuer. Haywood Securities Inc. or an Affiliate has managed or co-managed or participated as selling group in a public offering of securities for Alderon Resource Corp. and Champion Minerals Inc. in the past 12 months.

Steve Palmer: Rare Earth Opportunities

Source: Tim McLaughlin and Karen Roche of The Gold Report 04/09/2010

New technologies are pushing up the demand for rare earths. Steve Palmer, president and CEO of AlphaNorth Asset Management, says the rare earth space is currently his favorite place to invest in the resource sector. In this exclusive interview with The Gold Report, Steve also talks about where he sees the markets headed in 2010, and shares how he tries to limit the downside when investing.

The Gold Report: Your fund finished 2009 with gains of about 160%. What’s the outlook for 2010?

Steve Palmer: It’s unrealistic to expect a repeat of 2009 this year. However, we’re seeing many attractive opportunities still and we’re optimistic that 2010 will also be a strong performance year.

TGR: Can you talk about some of the attractive opportunities you’re looking at?

SP: We buy a lot of private placements. We like to get in on situations that have minimal downside with lots of leverage to the upside. When we buy a private placement, we usually get a half or a full warrant, and if the company executes on the business plan we can have significant gains. We’re still seeing lots of attractive private placements.

TGR: And you think that there are still some of those opportunities at this point?

SP: I’m trying to focus my new investments a little bit more away from the resource space. Our fund is relatively balanced between resources and other sectors. The “other” would include technology, special situations and biotech, mostly. Given the strong returns that the resource sector has had in the last year versus some of the other sectors, I just prefer looking at the other sectors at this stage.

I’m not implying that we’re not making any new investments in resource companies. I have just kind of skewed my interest level to the non-resource sectors at the moment.

TGR: Why have you chosen biotech as opposed to several other sectors? What’s unique about this sector that you see upside potential?

SP: In the small cap space in Canada, outside of resources and technology, there are not many opportunities in the other sectors such as financial, telecom, real estate, etc. I prefer companies that have more return potential than a typical financial company would have. The high-return potential is usually in some of the technology names and biotech. The resources obviously have big potential, too. Of sectors in the middle, there are not that many names in those sectors, and they typically don’t have the same return profile.

TGR: Are you restricting all your investments to Canadian-based small caps?

SP: Not all of them are Canadian-based. The majority are. There are enough companies in Canada to look at without having to look at other countries.

TGR: In your February commentary for your fund’s investors, you said you thought it was unlikely that equities would be able to make any significant gains over the summer months. There was a bit of a pullback in late January/early-February. Do you expect that to happen again in the near term?

SP: It’s quite possible that a pullback like that would happen sometime in the summer or late in the spring. Summer’s generally not a good time for small caps. Some people use the saying, “sell in May and go away.” It didn’t apply last year, but it may this year.

TGR: If there was that sort of a pullback, do you think things would start to pick up again in the fall?

SP: If there was a pullback I would be a buyer.

TGR: Do you see it as a summer doldrums sort of thing?

SP: It could be a little worse than summer doldrums. The markets have been quite strong over the last 12 to 16 months, so it wouldn’t be unusual to have a 10% or 15% setback.

We could go higher in terms of the TSX before there is a meaningful correction. It’s at 12,100 right now. Last year it was up 35%. It’s up 3% or 4% so far this year. It could go to 13,000. I only say 13,000 because I do some technical work and to me that would be a strong resistance level and right now we have a lot of positive momentum in the markets. We could see for the next couple of months the Canadian markets continue to go up, but I think they’d be hard pressed to go much farther than 13,000 this year.

TGR: So you’re thinking it won’t hold that 13,000 level if we get to that point?

SP: Correct. Because with the 35% return last year and another strong year this year, the odds are against it going higher than that in 2010.

TGR: Do you see any scenarios that it might move beyond that 13,000 level?

SP: Move beyond? I don’t know. There are lots of things that unfold that we can’t foresee. We have another nine months to go. Most of the news on the economic front has been fairly positive over the last few months. It’s not always going to be positive.

TGR: We talked earlier about some of your moves to more biotech and technology companies. In your January 2010 fund review, you said your current bias was toward non-resource companies. Can you highlight for our readers the reasons that you felt it was necessary to rebalance the portfolio?

SP: The relative weighting of resources in the portfolio actually hasn’t come down that much. In March, we had a couple of resource names that had very significant price appreciation, which is kind of making it difficult to reduce the resource weighting.

TGR: Is that a problem?

SP: Well, it’s a good problem to have. We had Cline Mining Corp. (TSX:CMK) go from $.30 to $1.75 in the last two months. This contributed to the increase in our resource weighting. One I’ve mentioned before is Colossus Minerals Inc. (TSX:CSI), which has been very strong lately also. We have a sizeable position in both of those companies. Even though our new investments have been more in the non-resource side, our existing investments are more than making up for that. So the relative weighting hasn’t really changed that much, which is fine.

TGR: When you’re looking at resource companies, do you look primarily at Canadian resource companies?

SP: Yes, primarily Canadian. The TSX is the primary exchange for resource companies in the world. The TSX Venture [index] for the juniors and the TSX composite as the broader index. When I do look at the resources, I have a bias to some of the more obscure areas like the rare earth space. That’s probably my favorite place to invest in the resource sector at the moment.

TGR: That seems to be a hot topic for many people. What caused you to look at rare earths and where do you see the primary opportunities there?

SP: There’s a very strong demand for rare earths in all the new technology, whether it’s related to solar, wind, batteries and so on. China produces the majority of the rare earths. China recently put some restrictions on what they export. The rest of the world has to scramble now to ensure that they have supply because China will likely put further restrictions on exporting their rare earths in coming years. There’s a huge demand for them and the price has gone up fairly substantially for many of these rare metals.

There are not that many companies that have rare earth assets. I see the opportunity for significant gains in that space. It’s similar to uranium several years ago. There was an investment thesis being made about all the nuclear reactors being built and how much uranium demand there was going to be and there wasn’t enough of it around. All these companies started up with uranium exploration projects and assets. Before they imploded in 2008, there were well over 100 juniors pursuing uranium assets.

If you look at the rare earth space, you have a similar thesis in terms of fundamentals, yet there’s nowhere near that many companies with rare earth assets. I have only 17 companies on my watch list in the rare earth space.

There have been several uranium companies that have refocused and now they’re rare earth companies.

TGR: In another interview we did recently, it was suggested that those who come to the market first with rare earths will quickly satisfy most of the demand. Consequently, the real key in investing in the sector is investing in one rare earth property and in one that can be brought into production quickly. Do you have the same observation?

SP: That’s partly true, but the demand is growing fairly significantly. China produces more than 80% of the world’s rare earths. If they shut that off to export, we would have to find a lot of rare earth production outside of China to make up for that.

TGR: Do you see that mostly coming from Canadian companies?

SP: Primarily Canadian companies. Not necessarily with a Canadian rare earth asset, but many of the junior rare earth companies are listed in Canada.

TGR: Do you have anybody in particular?

SP: My favorite one is Stans Energy Corp. (TSX.V:RUU). Their asset is in Kyrgyzstan. I like that one because they’ve acquired a property that has a proven resource of rare earths. It’s worth $2 billion in the ground. It’s the former mine that made up 80% of Russia’s rare earth production. It’s been shut down and under care and maintenance for many years. They’ve acquired it very cheaply and they’re going to do some confirmatory work on the resource. They’ve also got an option to buy the old processing facility. So not only do they have a resource, they could have a processing facility and known metallurgy.

One of the biggest challenges in mining rare earths is separating all the various elements out or the metallurgy. This operation has proven metallurgy, which is a huge step. Most of the other juniors will have to figure this out and it’s quite tricky.

It’s quite often very different for each deposit. Each deposit has different mixes of these metals and it’s quite a challenge to effectively separate them all.

TGR: Is Stans in production?

SP: No, they’re not in production yet. They just acquired the asset in December, so not many people even know about it. They’re just starting to do some IR now and get the story more widely known.

TGR: Do you have other rare earth companies that you’re looking at?

SP: There’s another very early-stage company that has a rare earth interest as well as interests in some other assets like molybdenum and a gold-copper exploration property. It’s Bolero Resources Corp. (TSX.V:BRU).

There is also a private company called Spectrum Mining with a property in British Columbia. They had some very good drill results for rare earths. Bolero was quick to stake some ground around that property. In the next couple of weeks, they’re going to be sending a team of geologists up there to do some initial work. Hopefully they’ll be in a position to drill it later in the year.

I like that company because it’s got a very low market cap of about $7 million. They have a very prospective rare earth play. They’ve got a very prospective copper-gold play that is also in B.C. alongside Imperial Metals Corp. (TSX:III), which has had very good results on their property. They have this molybdenum asset in Montana. It’s 360 million pounds of moly. So it’s got multiple chances of success, each of which could be a company maker.

TGR: Are you looking at primarily exploration companies or producers or a combination of both?

SP: I prefer the exploration companies. With producers you don’t generally get as high a return potential and the commodity price becomes more of a significant factor. When you start introducing the macro factors, it makes it harder to predict. It’s harder to predict where the commodity price is going to go month to month.

TGR: Is there anybody in the energy sector that you’re watching at this point?

SP: There hasn’t been a big focus on the energy sector. It’s been more on the metals side. Although we do have a few investments in the energy sector. Quetzal Energy Ltd. (TSX.V:QEI) is one that I like. They’re drilling a property in Colombia. They also have very small production in Guatemala. One of the properties in Colombia is surrounded by producing oil properties. It’s very prospective ground.

Colombia has been a very hot area to invest in recently. There have been many big wins over the last year with companies with gold properties and oil properties in Colombia. So it’s a very hot area. A lot of investors are looking for the next big winner in Colombia. I think this could be one of them.

TGR: You mentioned earlier buying warrants. Is purchasing warrants a big part of how you look at these companies?

SP: With the private placements, they are usually structured as a unit that you buy. It’s a share and half-warrant or sometimes a full warrant. So I like to buy those because if it works, you have additional leverage to the upside. If it is a full warrant, it effectively doubles your leverage and thus your return if it works out.

TGR: In your November fund review you stated, “It remains unclear how much further the gold bubble will inflate before the gold bugs are silenced yet again.” What’s your feeling about gold and the precious metals in general at this time?

SP: I’m not as negative now on gold as I was when it made that parabolic move up to $1,200. I’m somewhat indifferent at this point. It’ll have a hard time getting past $1,200 again in 2010. I don’t necessarily think it’s going to decline that much either from current levels. My previous comment was a result of the euphoric sentiment by almost everybody that gold was going materially higher. Anytime you get a situation where everyone is just in total agreement on something, it’s usually time to go the other way. My technical indicators also pointed to a short-term top which proved correct, and we executed a very timely trade shorting gold. We have since covered with a nice profit.

TGR: We talked to somebody recently who was saying because of inflationary pressures and additional demand worldwide for gold that he could see scenarios where gold would approach possibly $1,375. Are you thinking that’s beyond where gold might head this year?

SP: I don’t see much in the way of inflationary pressures. The U.S. CPI was up 0.2% in both December and January. Core prices fell by 0.1% in January. The last time core prices fell was in 1982. I don’t know where the inflation is. I’ve heard that argument for the last 10 years about inflation around the corner. That argument has been wrong for 10 years. At some point it will be right, but I don’t see it being right in the near term.

TGR: Isn’t the big hubbub around it now the fact that the U.S. specifically has done all the big bailouts and is trying to re-inflate the economy to an extent it has not done before? Do you see that causing the inflationary pressures?

SP: The bottom line is I don’t see how you can have inflation if you have excess capacity everywhere, and you have people that have no capacity to spend. Inflation results when everybody tries to buy stuff and you can’t make enough of it, so the prices are going up. That’s not at all the situation right now in the U.S. The primary driver of gold prices is the correlation with the U.S. dollar.

TGR: Do you expect the dollar to decrease because of the fact that the U.S. is increasing their money supply?

SP: Yes. Over the long term, I expect the U.S. dollar to trend lower. However, a lot of countries are increasing their money supply also so the U.S. will have many periods of strength.

TGR: Steve, your approach to making money is looking at the small caps. These are the companies that have opportunities to increase in size. Can you give our readers your viewpoints on what you’re looking for in a small cap? Is it specific properties? Is it management? Previous successes?

SP: Management is important. I’m looking for opportunities where I can invest where the downside is fairly limited and the upside is significant. I’m always trying to optimize the risk versus reward.

TGR: How do you limit that downside? Is it price per stock that limits the downside or something else?

SP: A couple of things. One of the biggest risks of investing in small cap companies is having the company run out of cash. That’s a particular risk in the junior resources because they have to spend a lot of money on exploration, etc. Then they have to get back to the market for the next round of drilling or whatever. If it’s a time when it’s very difficult to raise money, it could be a lot of dilution that occurs for the company to move forward or they may not be able to raise money at all. That’s why I buy a lot of private placements, because not only do I get the leverage of a warrant with the deal, but I’m also purchasing at a time when the company is raising money. This eliminates the risk in the short term of the company running out of money. Quite often, private placements are done at a discount to market price, which is another benefit. Another factor I use is technical analysis. This helps time my entry and exit points.

TGR: Thank you for your time.

Steve Palmer and Joey Javier, an investment team since 1998, took three key assets—their excellent track record, their experience and their belief that exploiting inefficiencies in the Canadian small-cap universe would produce superior long-term equity returns—to AlphaNorth Asset Management, launching the Toronto-based investment management firm in August 2007. AlphaNorth currently manages the AlphaNorth Partners Fund, a long biased small cap focused hedge fund and the AlphaNorth 2010 Flow-Through LP.

Steve, who is a Chartered Financial Analyst, earned his BA in Economics at the University of Western Ontario. After starting in the investment community as a research associate, he moved to a major financial institution in mid-1998, where he met Joey and built his career. As Vice President of Canadian Equities, he managed assets of approximately $350 million, including a pooled fund that focused on small-cap companies.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.

1) Tim McLaughlin of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None
2) The following company mentioned in the interview is a sponsor of The Energy Report or The Gold Report: Colossus Minerals.
3) Steve Palmer: I personally and/or my family own shares of the following companies mentioned in this interview: None. Funds managed by Steve Palmer at AlphaNorth Asset Management own shares of all of the companies mentioned in this interview. I personally and/or my family are paid by the following companies: None.

Junior Mining Stocks: Canada’s Subprime

Junior Mining Stocks: Canada’s Subprime
Source: Trey Wasser, Pilot Point Partners LLC 12/12/2008

Prior to the recent market meltdown, the market for junior mining companies had already been experiencing a severe correction since its peak in early 2007. Despite rising and historically high metal prices, money began leaving the market, in earnest, in the summer of 2007. By late last year, the correction had become a full-fledged bear market. Then the credit markets collapsed in September 2008. This caused another leg down which also included the major mining companies and the underlying commodities. Many junior mining stocks are now trading at a market capitalization that is less than their cash holdings. Most are down over 80% from their 2007 highs. What went wrong in a market that held so much promise just 18 months ago? How can the market undervalue precious metal properties at $800 gold and $10 silver? Will the markets for junior mining stocks ever recover?

To answer these questions, we must look very closely at the cause of the demise. Unlike in the late 1990’s, there is no Bre-Ex to take the blame. There is not one major speculative company, with salted samples and geologists jumping from helicopters, for the market to point to and say “they ruined it for all of us.” The fact is that in an environment of easy credit, wild speculation and an “it’s different this time” attitude, many investors have been caught shamelessly doubling and tripling down in junior mining stocks that are now simply doomed to fail.

The parallels between the mortgage market in the United States and the junior mining market in Canada are striking because they are a product of the same loose credit policies. Based on the false premise that everyone should own a home, American bankers and brokers were allowed to leverage the housing market with a seemingly endless supply of mortgage-backed securities. They then leveraged these securities many times creating today’s still incalculable risk in derivative products. Today, shareholders are losing all their equity. Bankers and management have already made millions in fees, salaries and bonuses that were based on the “paper profits” from all these leveraged securitized transactions.

While we won’t (but probably could) make the case that Canadian investment banks operated on the like premise that everyone should run a mining company, the process is very similar. As money from yen carry trades and other loose credit sources poured into the Canadian Venture Exchange, PPOs, RTOs and IPOs flourished in the mining sector. A retired geologist and a financier could joint venture a property in an obscure part of some third world country and become a mining company. The bankers would gladly raise them $5 million, then $5 million more for fees that often approached 10% and also included a piece of the pie. The process was fueled by greed as “blue sky” was promoted as an “asset”, as defined by a 43-101 report. Insiders made millions on their private placement shares as the process was repeated over and over. No one really cared if there was a truly developable project in many of the “shells.” Drill rigs began turning, with geologists in charge, and a belief that the equity window would never close. Investment bankers were highly compensated, but few of the companies ever even received (or warranted) research coverage.
Leverage was added as companies morphed themselves into separate entities, one for gold, one for silver and one for base metal. Senior executives were often found starting a new company while still holding management positions at several others. The bigger the “blue sky” the more money a company could raise. In many cases, less than fifty cents of every dollar actually went into the ground as promotion budgets swelled. Many of the majors were even caught in the folly and invested into some overpriced or questionable projects. This added to the speculation as the ‘buyout” business model replaced the concept of building a legitimate mining company. However, when buyout offers did appear they were often rejected. Management proved unwilling to part with their ticket to the equity window and their place at the feed trough.

Barrick Gold’s (NYSE:ABX) 2006 buyout offer for NovaGold (TSX:NG) (AMEX:NG) was deemed inadequate by management and rejected. When the dust had cleared in April 2007, it marked the exact top of the market for the Venture Exchange. Barrick explained that their “fair and final offer of $16” was based on “deteriorating economics at Galore Creek and the newly filed litigation at Rock Creek.” At the time, these appeared to be face-saving excuses for a failed tender offer. Today, they seem more prophetic, as NovaGold struggles to survive.

Interestingly, many of the pundits and gold bugs who have been warning of the leverage and speculation in the U.S. mortgage/derivatives markets failed to recognize the same risk in the junior mining stocks. Most also failed to predict the deluge for mining stocks as those loose credit policies were arrested and unwound. Many actually participated in the leverage at the private placement level. Today, they continue to bash the U.S. Dollar although it stubbornly remains the safe haven currency in a financially troubled world.

Where do we go from here and when does the market for junior mining stocks recover? Unfortunately for shareholders, a majority of the companies will never recover. Many are out of cash and have no prospects for additional equity. These will slowly fold and their only legacy will be as historic drill results. Some companies have developed bankable assets and might secure some type of debt financing. The process will be slow and painful, much like mortgage foreclosures. Many cash strapped companies are now in “hunker down” mode. It appears that “hunker down” is mining terminology for “stop all operations and cover G&A as long as possible.” When their cash is depleted, many of them will also fold.

Unfortunately, even some of the best juniors failed to focus their resources on a flagship property and advance it into an actual development project. Easy capital enticed them to build a “pipeline” of properties more appropriate for larger companies. Investors were easily swayed with this “irons in the fire” business model. Today the market is seeing these undeveloped properties for what they are, liabilities not assets. There are a few that were smart (and lucky) enough to advance a project that is truly developable. These will receive additional equity, albeit at substantial dilution to existing shareholders. Others will proceed, without shareholders, as debt holders take over the projects. Some will merge. But, mergers won’t bail out existing shareholders as few premiums will be paid in the consolidations. Even the companies with projects nearing production are finding it difficult to finance construction in the current market. Companies with once profitable poly-metallic mines are being forced into “care and maintenance” at current base metal prices.

Easy capital is mostly inefficient capital. Looking at mining projects today, it is amazing to see just how little was actually created with the billions invested into the junior sector over the past several years. The capital was simply spread too thin. Way too many companies were created. But, like the mortgage market, it was mostly the securitization process that created profits for insiders, bankers and management.

With mortgage backed securities, somewhere underneath all that paper, is a house. The sub-prime analogy stops here. Obviously there will be no bailout for junior mining companies, but there will be survivors. There are some real developable mining assets, under all that paper, that are currently being severely undervalued. Unlike most other assets, gold continues to hold on to the bulk of its gains of the past five years. Base metals appear to be forming a bottom and their current underperformance relative to gold cannot be sustained. President-elect Obama has stated that he will develop a series of infrastructure-based jobs programs in the U.S. This build-out will compete for metals with China, India and other emerging countries as their growth accelerates in a worldwide economic recovery. Money will begin to flow back into commodities and other hard assets as credit market free up, early next year.

In this financially challenged market it is still difficult to differentiate the “baby from the bathwater.” Our North American Gold & Silver Explorers Model is currently following 24 companies we believe will survive to drill another day. Companies with cash flow or high cash balances will not only survive, but will be positioned to acquire new assets as other companies fail or drop properties. We are currently positioning our clients for a strong rally beginning in Q1, 2009.

A few of our favorites:

We recently visited Capital Gold’s (CGLD) (CGC.TO) El Chanate mine in Sonora. This is truly a first class operation. They are now producing close to 5000 ounces of gold per month at a cash cost of about $270. We believe that they will continue to increase production and achieve a 70,000-ounce profile in 2009. Capital has $11MM in cash, solid cash-flow and open credit lines. Being a U.S. company, their mining costs are currently benefitting from a stronger dollar versus the Peso. They are well positioned to pick up additional assets in Mexico.

Fortuna Silver (TSX.V:FVI) (NYSE:FVI) has over $40MM in cash and is operating their Cuylloma Mine in Peru at a small profit. They were smart enough to hedge the lead and zinc production, although most of the hedge will roll off in Q4. Next year they intend to shift production to the bonanza silver veins they have recently discovered on the property to keep the mine cash-flow positive. Fortuna has consolidated their San Jose property in Oaxaca, Mexico and should have an updated resource out early next year. They have completed construction on the first phase of the ramp and infill drilling continues to produce excellent results. We believe that the San Jose resource could grow to over 100MM silver equivalent ounces.

Eastmain Resources (TSX:ER) (ER.TO) has well over $20MM in cash from their recent offering and warrant exercises. Their corporate burn rate is very low and drilling costs in Quebec are partially offset with tax credits. The cash will support their current ($4MM) exploration budget for the next 5 years. Eastmain’s flagship asset is their Eau Claire deposit in James Bay, Quebec. They already have about 1MM ounces (indicated /inferred) and drill results continue to indicate a much larger resource. They will benefit from the infrastructure build-out at Goldcorp’s (TSX:G) (NYSE:GG) Eleonore mining camp. They have joint ventured their Eleonore South property with Goldcorp who is funding the current drill program. They also have several other properties surrounding the new camp.

C. F. Wasser III (Trey), President & Director of Research, Pilot Point Partners, has been in the brokerage and venture capital business for over 23 years. Trey spent 20 years as a bond salesman and trader with Merrill Lynch, Kidder Peabody and Paine Webber. He specialized in corporate cash management and his clientele included many Fortune 100 companies and institutional money managers. In 1993, he formed III-D Capital LLC to assist early staged technology companies developing business plans and securing venture capital financing. Today, III-D Capital is involved in various consulting and finance activities for mining companies Trey organizes site visits for analysts and fund managers through DD Tours LLC where he is President. He consults with FINRA and other regulatory agencies on a pro-bono basis.

1. This report has been written for informational purposes only and strictly reflects the opinion of the analyst on the date of publication. Opinions may change at any time without notice. No earnings projections or target prices are intended or implied. All conclusions are drawn from information provided by the company which the analyst has made a “best efforts” attempt to verify and confirm, but its accuracy and completeness is not guaranteed. While this report has not necessarily been written in accordance with current SEC regulations and the Standards of Practice developed by the Chartered Financial Analyst Institute (CFAI), the opinions herein are believed to be consistent, reasonable and supportable.
2. The research analyst principally responsible for preparing this report was Trey Wasser, President of Pilot Point Partners, LLC.
3. Pilot Point Partners LLC, its affiliates and family may have positions and effect transactions in the securities or options of the issuers reported herein.
4. Pilot Point Partners LLC, its affiliates and family have received no direct compensation for this research report.
5. Mr. Wasser is a Principal of DD Tours LLC and may be involved in arranging site tours of a company’s properties and may receive compensation based upon various factors involved with these tours.
6. Mr. Wasser is a Principal of III-D Capital and may have other agreements, including finders fee agreements with companies, mentioned in this report, regarding potential joint ventures and/or property sales and may receive compensation based upon various factors involved with these agreements.
7. The research provided herein should not be considered a complete analysis of every material fact regarding the companies, industries or securities named above.
8. This report was prepared exclusively for the benefit of institutional investors and Pilot Point Partners may receive compensation directly or in soft dollar arrangements.
9.Additional information and disclosures on the subject companies is available upon request.
10. As of the date of this report, Pilot Point Partners LLC, its affiliates or family hold positions in CGLD, FVI and ER. They do not hold any positions in the common stock of any other companies mentioned in this report.
11. As of the date of this report, DD Tours has been compensated by CGLD for analyst tours within the past 12 months.
12. As of the date of this report, III-D Capital has no finders fee agreements with any companies mentioned in this report.