Rare earth stocks have been soaring higher in recent weeks. According to TickerSpy's Rare Earth Stocks (RAREE) index, the sector is trading up 18.4% over the past month, which is 15.1% better than the S&P 500 average. The move was driven by higher rare earth metal prices that rose last week for the first time in four months amid positive supply and demand trends.
But many of these companies have underperformed over a 52-week period, due to the past weakness in pricing. This means that the sector remains relatively cheap by historical standards at a time when rare earth metal prices may be poised for a lengthier recovery.
Stocks included in this index are:
- Avalon Rare Metals (AVL)
- Lynas Corp Ltd. (LYSCF.PK)
- Molycorp Inc. (MCP)
- Neo Material Techs Inc. (NEMFF.PK)
- Rare Element Resources Ltd. (REE)
- Market Vectors Rare Earth Strategic Metals ETF (REMX)
A Permanent Recovery this Time?
Rare earth metals investors have been on quite the roller coaster ride. Prices increased nearly 30-fold (in some cases) between 2009 and 2011, but have fallen sharply from their highs as supply caught up with demand in mid-2011. As demand fell, inventories were dumped and the downward plunge became very painful for many investors.
But rare earth metal prices have seen a strong recovery over the past month. Global demand has started to pickup outside of China, with strong U.S. consumer spending and employment figures, while the troubles in Europe appear to be moderating for the time being. These factors have led to greater demand for things like smart phones and wind turbines.
On the supply side, China has started to tighten its controls over the precious resources out of "environmental concerns". The country recently suspended the issuance of new licenses for prospecting and mining, imposed production caps, and export quotas. Combined, these factors have led to a very favorable environment for rare earth metal companies.
Sticking with the Industry Giant
Molycorp is the largest player in the group with a market capitalization of $2.94 billion, according to Yahoo! Finance. With a price-earnings ratio of 27.68x, the company trades at a slight premium to the S&P 500's 23.67x figure, but it trades at a discount to its peers. The firm has a cheaper EBITDA multiple than 9 out of 10 peers, according to Bloomberg's Real M&A blog.
Bloomberg suggests that Molycorp could become of the mining industry's most attractive takeover target, especially after diversifying its revenues into magnets. The company recently purchased Neo Materials Technologies that adds significantly to its rare earth metals portfolio, as well as expand its line of magnets used in the automotive industry.
After its acquisition of Neo Material Technologies for C$1.3 billion, which was a mix of 71.2% cash and 28.8% in Molycorp common stock, some analysts believe the discount may be due to concerns about dilution. But the combined company creates one of the most technologically advanced and vertically integrated rare earth metal companies in the world.
Investing in Molycorp with Minimal Risk
Molycorp may be more diversified and attractive, but investors may still want to exercise caution. The rare earth metals industry is extremely volatile and prone to sharp moves based on comments made by governments. As a result, a conservative investment strategy with room for upside may be the best way to profit.
Investors may want to consider purchasing long-term equity anticipation securities - or LEAPS - on Molycorp. For instance, at-the-money 35 Jan '14 call options trade with a premium of just $7.60 per contract at the time of writing. This means that investors can put less capital at risk ($760 vs. $3,503) and still benefit from long-term upside (although downside could result in a complete loss). The $760 could also be offset by writing shorter-term call options in a diagonal spread, but this carries a high opportunity cost if Molycorp is acquired.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.