What Bj?rn Paffrath Is Advising to Institutional and High Net-Worth Investors

The Gold Report: Please briefly provide us with a "State of the Metal" address for gold as summer approaches.

Björn Paffrath: We still could have difficult times over the next months before another bull market starts. The latest rally didn't really unfold the way we were hoping. We had a great January and everybody was optimistic again, but then a strong dollar and booming equity markets brought gold further down. We still are in a bear market, in our opinion, and if the market goes up we would see it as a bear market rally. We don't expect gold shooting through the roof at least until 2016, because there are things you can't just ignore.

The U.S. dollar remains strong because half of the world has debt in U.S. dollars. Then there is the obvious seasonality in gold demand, which tends to weaken the price. And based on U.S. economic data, (small) interest rate increases are still ahead. Then we could see Venezuela and Russia forced to sell their gold to halt runs on their respective currencies; that would briefly oversupply the gold market. Also, of course, as long as there is liquidity in the S&P 500, the Dow or Germany's DAX, that will keep investors in the broad market. The gold price is still shaking out and has more downside risk than upside potential over the summer months.

TGR: What role does China play in terms of gold demand?

BP: Chinas demand is one of the most important factors, but I would also include India. Together they are THE key players in the gold sector. Despite the overall negative sentiment, we see some positive signs, especially at the Shanghai Gold Exchange. Since 2009, gold deliveries from Shanghai are in an uptrend and are higher in 2015 than in 2014. Gold demand in India has increased significantly, too. In general, we want to see China and India buying gold and accumulating hard assets. That will drive the price. We all know that the actual paper market in gold does not really represent the underlying physical demand.

TGR: Are you seeing growing evidence of sector rotation through bought deals or mining equity trade volume?

BP: In January alone there were more than $1 billion in bought deals. And the bought deals took a lot of liquidity out of the market. On top we saw some takeovers (Rio Alto Mining Ltd. and Tahoe Resources Inc. [TAHO:NYSE; THO:TSX]) and mergers (Alamos Gold Inc. [AGI:TSX; AGI:NYSE] and AuRico Gold Inc. [AUQ:TSX; AUQ:NYSE]). In fact there is increasing volume in the Market Vectors Gold Miners ETF (GDX:NYSE.Arca) and the Market Vectors Junior Gold Miners ETF (GDXJ:NYSE.Arca) that doesn't reflect the downtrend in stocks. That's because more traders are entering the market, trying to catch a low. But they are in and out very fast and are not long-term investors. Despite a few smart generalists or industry experts, most people are still waiting on the sidelines in the mining sector.

TGR: When does that money move from the sidelines into the sector in a big way? What has to happen?

BP: It's difficult to say. I wonder why it is not happening now. We have crises. There is Russia and Ukraine; the Middle East just flared up again; and the whole world, especially Japan and the Eurozone, is adding debt that will never get repaid, yet we have a stock market rally based on liquidity. It doesn't sound like a stable situation for a single investor, but most of the people we talk to don't really care. They're all happy. Once they find out that the financial system is not as stable as they were made to believe, it's too late. No other sector is depressed like the mining sector. Without question the segment offers big opportunities, but nobody wants to catch a falling knife. Everyone is waiting for a lower entry point and then it gets even lower.

Right now the precious metals stocks look promising again. Since March they have trended upward and even broke the 50-day moving average, but still have a long way to even reach the actual year's high. All eyes are on gold. If the price moves toward $1,300/ounce ($1,300/oz) again and manages to be stable around that level, the mining sector will face a big run, especially in light of low energy prices and efficient cost reductions. Overall, I expect 2015 to be flat and I see the big recovery in 2016. Of course, I would be happy to see an earlier positive move.

TGR: You are also the chief-editor of Cashkurs Gold, a newsletter covering the precious metals sector and mining stocks. In it you provide advice to high net-worth investors. Tell us about some ideas you're giving them.

BP: You have to be careful in this market. If you tell people it's an undervalued sector but you don't really know where the bottom is, you lose credibility. In the end the investor really only cares if he or she makes money. Even the best companies do not guarantee a profit right now. We're still very careful. That means trading the trends. We've seen it this year again. You could have made great wins in January but lost almost everything if you didn't exit those positions in time. Since March the sector is up slightly again. Let's see how long it will last this time. There is still the risk of a final clean-out.

The market probably wants $1,050-1,000/oz gold and if the market wants it, we will see it. Maybe that will mean one final shakeout before things turn around. In general, you want quality, quality and quality. We look for companies that deliver on promises and are low-cost producers that can run for one or two more years at lower gold prices. Also, the sector is consolidating, which means we will see more mergers, joint ventures or takeovers. There are several companies out there that could be serious targets for other companies. The big players have to replace their reserves and grow. Right now, for most of them, it is cheaper to acquire than to drill.

TGR: Where should mining investors focus?

BP: In the end, you have to ask the usual questions. Does the company have a great asset in a safe jurisdiction? How do you rate management? Is the company able to finance on good terms? Is the company building or buying, or is it a target? We can't really recommend small caps at the moment because the market is just not right for explorers, with some exceptions, of course. There are certainly great exploration companies out there, like Falco Resources Ltd. (FPC:TSX.V), Integra Gold Corp. (ICG:TSX.V; ICGQF:OTCQX) or TerraX Minerals Inc. (TXR:TSX.V)—that's one of our favorites. Many juniors are keeping the lights on, but the final washout on the TSX Venture Exchange has yet to happen. That will come. Right now, investors should focus on great midcaps that are trading below cash or at significant discounts to net asset value.

TGR: What companies are you following with operations in North America?

BP: Nevada is still a great mining district, and elephant country with respect to gold production or potential discoveries. Even Barrick Gold Corp. (ABX:TSX; ABX:NYSE) recently announced that it would concentrate its exploration efforts there. Among the midtier producers in Nevada, Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB) has done a fantastic job. CEO Paul Huet has brought two mines—Fire Creek and Midas—into production, just as he promised. In 2014, the company delivered almost 25% more gold than guidance, over 100,000 ounces (100 Koz). The company has a good earnings before interest, taxes, depreciation and amortization (EBITDA) margin, and a nice free cash flow yield. That company makes money for the investor. Klondex, with a net income of about $18 million ($18M) last year, really made it happen. The first quarter was also impressive, so we expect another outstanding year from Klondex.

TGR: Klondex is a low-cost producer that has put together a few solid quarters. Is it now a takeover target?

BP: Absolutely. I am sure lots of companies looked at it already and probably have signed confidentiality agreements. The big producers need low-cost production, especially if they have problems with their own operations and fall short on numbers. I just hope a takeover doesn't happen too soon. I really want Paul and his team to show us the potential of these assets.

TGR: What else do you like in Nevada?

BP: Aside from Klondex, we have an eye on smaller companies because we think the district is ready for a consolidation play. Pershing Gold Corp. (PGLC:OTCBB) has a strong investor base. Two extremely wealthy American investors own almost half of the company and keep supporting it. Pershing CEO Stephen Alfers is well known and a former Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) executive. Money is not a problem and there is no debt on the balance sheet. So far the U.S.-listing on the OTC Bulletin Board locked out most of the European investors, but the company will be listed on NASDAQ shortly.

The recent drill results are extremely encouraging and the mill is ready to be turned on. But management decided not to go into production right now, which we think is a good decision, and instead use its cash for more exploration drilling. A recent drill result hit 123 grams per ton (123 g/t) gold over 1.4 feet at Relief Canyon in northwestern Nevada. And with those two big investors in the background, it's not unrealistic that Pershing itself would make a move on others. Time will tell.

TGR: Is that a one-time drill intercept or is the company on to something bigger?

BP: The management believes the property could host a multimillion-ounce resource. The company is at 500–600 Koz now. I think Stephen Alfers and his team can grow that substantially. The new preliminary economic assessment (PEA), which will come out shortly, should show a big increase. The full feasibility study is expected by the end of the year and will prove the project economics. It's the right strategy to drill further on. With its big backers, the company doesn't have financing problems. Pershing just raised more than $11M to keep the drills turning. Also, the liquidity in the company could increase substantially if it moves exchanges from OTC to NASDAQ.

TGR: Are you following other names in Nevada?

BP: We also like Bill Howald's Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) as a consolidation play. The PEA at Lincoln Hill reported a fantastic internal rate of return, but, of course, it's a bit small in size. It needs to grow. That's what the company is doing right now. One missing part is the results from the new metallurgy tests. The company intends to set up an extra crushing unit, similar to Coeur Mining Inc.'s (CDE:NYSE); that is expected to bring up the silver recoveries to 90% or more. With such numbers, it would be a great project to build for a relative small capital expenditure (capex) or even get bought out.

Rye Patch has about a $20M market cap and gets about $4M every year at the current silver price from a royalty on Coeur's Rochester mine in Nevada. With this royalty the management can do all the drilling on its other projects and advance Lincoln Hill without touching the cash in the bank. Furthermore, the funds are enough for a bankable feasibility study. If the silver price goes to $25/oz, that $4M becomes $8M. Rye Patch currently has $7M in the bank and is trading at $0.14/share. There's a real opportunity to grow Lincoln Hill into something significant and if it does, Rye Patch will likely get bought.

TGR: What are some equity picks with operating mines or projects in Africa?

BP: As European investors we like Africa. There we find impressive grades and low costs, but some unstable jurisdictions to deal with. Investors have to keep this "headline risk" always in mind. Burkina Faso recently has had a hard time, but we really like Roxgold Inc. (ROG:TSX.V). The Yaramoko project ranks among the highest-grade undeveloped gold deposits in the world, with a resource grading over 15 g/t gold in the Indicated category. The mine is fully permitted and already in the build stage. Once operating, it will be one of the lowest-cost mines worldwide (all-in sustaining costs below $600/oz for life of mine). At $1,300/oz gold the net present value is around $250M and the internal rate of return almost at 50%. Payback is only 1.6 years. The production is planned with 100,000 oz per year, but lots of exploration potential gives room for expansion.

TGR: With Yaramoko fully permitted, how much does Roxgold have to raise put it into production?

BP: The preproduction capex is about $110M. Roxgold has around $37M cash on hand and a $75M debt facility lined up with BNP Paribas and Societe Generale. If there are no major mistakes Roxgold should have enough funds to finish Yaramoko.

TGR: What are some other stories in Africa?

BP: Aside from Roxgold, we like SEMAFO Inc. (SMF:TSX; SMF:OMX) in Burkina Faso. The gold production at the Mana mine increased 48% to 234,300 oz in 2014, with all-in sustaining costs of $805/oz. Coming from a net loss in 2013, the company was able to deliver $17.7M net income over the last year.

We're also building a large position in Teranga Gold Corp. (TGZ:TSX; TGZ:ASX), which operates the low-cost Sabodala gold mine in Senegal. It is one of the most well-managed operations I have seen over the last few years. It produced about 71 Koz in Q4/14 at all-in costs below $900/oz. And it produced about 212 Koz last year, generating $39M in free cash flow, and that should reach 500 Koz once phase 2 development is complete. Franco-Nevada is paying Teranga $135M annually for 22.5 Koz gold from 2014 through 2019, plus a 6% stream on gold production from Sabodala beyond 2019. Teranga sits around $0.63/share and we keep adding to our position. I know there's a lot of interest from European investors for that stock.

I should also mention Caledonia Mining Corp. (CAL:TSX; CMCL:AIM; CALVF:OTCQX), which is in Zimbabwe. Everyone asks us, "Why are you in Zimbabwe?" In the first place, it is the 8–10% dividend rate, depending on the stock price, that attracted us. It certainly helps to warm up to the country, but the more you look into it, the more you see that management delivers. It's a smaller underground mine, 45–55 Koz/year, that Caledonia mines very efficiently. Once it restructures underground operations with a new shaft, I'm confident Caledonia can boost production. It was a dividend play in the beginning, but turned out to be a company in Zimbabwe where you can invest.

TGR: What are some companies you're following in Latin America?

BP: Things are getting more interesting in Latin America. Countries such as Colombia, which were more or less relying on oil and gas exports and didn't make it easy for the mining companies to get permitted, are finally issuing permits. Red Eagle Mining Corp. (RD:TSX.V) received its environmental license for its fully financed San Ramon gold mine in Colombia. In the next couple of months Continental Gold Ltd. (CNL:TSX; CGOOF:OTCQX) should get its permit for the Buriticá gold project. That is the next step and it is a much bigger project than San Ramon. This was once a $12 stock that is currently down to $1.88/share. Once permits are in place the company should get a rerating.

Elsewhere, certain areas of Mexico and Peru are totally hot for toll milling. When we first saw Dynacor Gold Mines Inc. (DNG:TSX) in Peru, it seemed to have a problem financing its exploration program, so it went into the toll milling business for cash flow. Essentially, a toll miner takes ore from small miners, processes it and takes a percentage of the processed metal. That worked out well for Dynacor, even if it took a couple of years to get it running. Now it has an $81M market cap.

Inca One Gold Corp. (IO:TSX.V) is following that model and the stock price almost tripled last year. With our ongoing financial backing, we were a key player in bringing Inca One to where it is now with a market cap of $16M. And that is just the beginning. It will soon reach 100 tons per day (100 tpd) capacity and generate more cash flow. From there the sky is the limit. But make no mistake, it is by far not as easy as it looks. We invested mostly in a great management team, which showed success in all the previous ventures they did together. And that was not mining! We especially liked that, as toll milling is not so much about mining as about building a company and operating a business. I cannot stress this enough, as we see many of other companies now trying to leverage Dynacor's and Inca's success and suddenly want to enter this sector.

I only can tell investors to be very careful which company they give their money to, as we watch our investments in Peru very closely and so far have been extremely impressed by management's progress. If people only run exploration companies so far, and fail even there to deliver, they might find it very difficult to survive in that environment. Personally we want to protect our capital and therefore work very close with the executives. That requires extensive due diligence and ends not with the investment. We expect Inca to go a lot higher from here based on results and not speculation!

We have been very pleased with that model and the returns it delivered on the equity and bonds that we structured. That's why we made another significant investment in Cyprium Mining Corp. (CUG:TSX.V), a base metals toll miner in Chihuahua, Mexico. A lot of people who invest with us do so because they've seen it work and know that we will stay on top of our investments. We found Cyprium, which has a good board, a good management team and a five-year lease on a 100 tpd flotation plant, Aldama. We think it can be upgraded to 200 tpd shortly and generate lots of cash. It will produce copper, silver and some zinc.

Cyprium CEO André St-Michel is very experienced and knows Mexico from his previous job at Diabras Exploration, where he built and ran a mine with 400 people. Cyprium also has the Las Cristinas project, a small copper-silver asset with high copper grades but without a resource yet. If Cyprium delivers on the toll milling goals we set out for it, we have more money available for building La Cristinas. For now the focus lies on the Aldama toll milling plant, which could, at 200 tpd, deliver as much as $6M to $6.5M in gross profits by next year. We expect the mill will be turned on very shortly and the sale of the first concentrate should take place next month. We hope Cyprium will follow Inca's success story.

In Mexico I also like Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE), which did well in 2014, but it is not cheap anymore compared to its peers.

I expect a strong rebound for Endeavour Silver Corp. (EDR:TSX; EXK:NYSE; EJD:FSE). CEO Bradford Cook had the company adjust to the lower silver price environment and initiated a major expansion of its El Cubo mine in Guanajuato. The main reason was to drive operating costs lower and generate free cash flow. As a result, El Cubo will become the company's largest producing mine. Also, the company has the highest beta in the silver sector. If you want leverage to the silver price, Endeavour is the pick. The latest quarter already has shown success.

In the gold space Timmins Gold Corp. (TMM:TSX; TGD:NYSE.MKT) is poised to bounce back big time, in my opinion. Once the Newstrike deal is finally approved, we will see the end of short selling. I think the two deals Timmins did will unfold its potential soon. If one believes in higher gold prices, it was absolutely the right thing to go out and acquire other projects, which can boost production significantly in the future.

TGR: Finally, what are some gold projects that are not yet likely on reader's radar screens?

BP: There are some outstanding projects. Falco is one. Osisko Gold Royalties Ltd. (OR:TSX) CEO Sean Roosen brought in Luc Lessard, who was key in building Canadian Malartic, as Falco's new CEO and he is advancing the company. Falco owns about 70% of Quebec's Rouyn Noranda mining camp, including the Horne mine complex. Falco's Horne project has a 2.8 million ounce (2.8 Moz) gold equivalent Inferred resource, but that should grow to over 5 Moz gold equivalent with more drilling. I see Falco as a project generator as well. It has many more properties to help grow the company. It's now sitting at about $0.48/share and has enough cash to survive a few more rough years. Stars are aligned for Falco to be either a producing company or get bought. Either way we will make money.

The other one we really like is TerraX Minerals, which owns the Yellowknife City gold project in the Northwest Territories. President and CEO Joe Campbell knows his business. TerraX doesn't grant big salaries or option packages; it just puts out one encouraging drill result after the other. The Yellowknife City project is not for people who want short-term gains. But over a 60-year span, the Giant and Con gold mines produced about 14 Moz at 16 g/t gold from the Yellowknife greenstone belt. Most industry insiders believe that TerraX has an outstanding project. Virginia Mines owned shares in TerraX before its takeover by Osisko Gold Royalties. So Sean Roosen has now some interest in this company too.

TGR: In North America we know it's spring because baseball season has started. How will investors know a bull market for gold is underway?

BP: It's difficult to determine. We are still deeply entrenched in a bear market. The headwinds are significant. Unless gold crosses the $1,240–1,300/oz line, we're not going anywhere. I am not certain how much worse shape the world has to be in before people think about different investments. The economy is weaker than anybody thinks. That's why we could still see $1,050/oz gold, but not for long. The time until the next bull market will be shorter and shorter. As stock market guru André Kostolany said: First the pain, then the money.

TGR: What's your one piece of advice for investors?

BP: Be prepared for the next big run in the sector and get well positioned over the next few months. You need a bear market to create a bull market.

TGR: Thank you for your time today, Björn.