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Make Your Portfolio Feel Better With Lithium

|Includes: Global X Lithium ETF (LIT), TLTHF

I've been thinking about ways our readers can benefit from the growth in lithium carbonate sales, which have been spurred by the booming success of iPad and the increasing traction car manufacturers are starting to get from their electric vehicle offerings.

Lithium is a strange commodity. It is the lightest known metal and has the lowest density of any solid element. It never occurs freely in nature but is found in crystalline minerals, clay, and ocean water. It is not traded on any exchange and, similar to the potash market, lithium production is dominated by four companies which together control about 95% of global lithium production. Those companies are Talison (TSX: TLH, OTC: TLTHF), Rockwood Holdings Inc. (NYSE: ROC), FMC Corp. (NYSE: FMC), and Sociedad Quimica Minera de Chile SA (NYSE: SQM).

Lithium's use in technology has been growing by about 20% a year for the past decade. That growth is likely to remain strong as battery manufacturers continue to turn to lithium in preference to the traditional nickel cadmium batteries that auto makers have been using for years because lithium batteries generate more electricity per cell than competing technologies.

Lithium is also used in cell phone batteries, particularly smart phones. Over 600 million units are expected to be shipped this year alone and that demand should steadily increase over the next several years. Demand for lithium batteries has growing at about 25% a year and has been outpacing the 4% to 5% overall gain in lithium supplies.

Increasing demand and limited supply usually leads to price increases and that's certainly the case here, with prices tripling since 2000. Pricing power should remain quite strong for the four major producers over the next few years since it should be some time before new supplies begin to meet a steady increase in demand. Chile has just announced that it will auction off exploration areas which will be suitable for lithium production and several companies are exploring new sources of supply in other regions but it will take some time before this new production comes online.

I should note that lithium has a number of other chemical applications, including pharmaceuticals where it is widely used as a treatment for bipolar disorder as well as other products. It's also used in lubricants as a thickener to reduce power consumption in aluminum smelting, and as an air treatment medium for industrial applications. Also, lithium can be used in glass and ceramic applications since it has durability and corrosion resistant properties. These are useful in high temperature applications like cook tops and cooking ware.

Now for a cautionary note. A couple of years ago, there was a similar speculation on rare earth suppliers, a commodity dominated by Chinese production. Speculation drove Molycorp (NYSE: MCP) to a huge spike in valuation, which IWB readers profited from after I recommended the stock at US$30.34 in November 2009 and then advised selling five months later at US$75.22. Since then the stock has dropped dramatically and is currently trading near its 52-week low at US$19.69. The message is that so-called "story stocks" can be propelled beyond their correct valuations with disastrous results for your portfolio if you don't get out in time.

With that said, aggressive investors could consider taking a speculative position in Talison, which is based in Perth, Australia even though it trades on the Toronto Stock Exchange. This company is the largest pure play lithium producer and the new CEO, Peter Oliver, was recently quoted as saying he expects at least a doubling of demand over the next two years. Should this in fact happen, Talison could benefit greatly.

The company just announced that it has completed an expansion of its main property in South West Australia, which doubles its production capacity. Talison also announced record sales results in the recent quarter, up 27% over last year, and a first half price increase of 15%. Results for the 2012 fiscal third quarter (to March 31) showed net profit of $8.2 million ($0.076 per share), more than double the results from the previous year.

Subsequently, on July 12, Talison announced it had reached agreement with its customers for a further 10% price increase in the second half of this year. That means the total price hike for 2012 is 25%, which bears out my point about the impact of the increased demand and tightening supply.

Talison is the smallest player of the four leading producers so its share price is the most vulnerable to market swings. The other three companies are larger and more diversified plays which should offer protection if this story turns upside down and for some reason lithium prices tank. However, you should not buy any of these stocks if you are a conservative investor as all have made big moves in the past couple of years. Talison is the best choice for aggressive investors as it appears to have the most upside potential. This appears to be a suitable entry point as the stock is down 21% from its 52-week high of $5.06. The shares closed on Friday at C$3.99. The last over-the-counter trade on the U.S. Grey Market was on July 12 at US$3.68.

There is another more diversified play in the form of an exchange traded fund. It is the Global X Lithium ETF (NYSE: LIT) and it includes the shares of all the above mentioned companies. It also provides some exposure to the battery producers like A123 Systems, which has been hammered this past year. Since A123 is 6.14% of the fund's holdings, it has negatively affected the overall performance of the ETF which is up 3.2% this year compared to 11.2% for Talison. To continue the comparison, FMC is up 17.1%, ROC has gained 14.5%, and SQM brings up the read with a loss of 0.7 %.

Action now: Buy Talison with a target of $5.

Disclosure: I am long OTC:TLTHF.