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Rare Earths Investment Strategy 101: Identifying Patterns

|Includes: ARAFF, GWMGF, NEMFF, REE, UURAF
In my last post, I directed readers to an article in the December 2010 issue of the Harvard Business Review titled "China vs. the World: Whose Technology Is It?" which describes Chinese government policies that seek to appropriate technology from foreign multinational companies.  I also promised to discuss how investors can use research to identify attractive rare earth mining stocks for investment, and to allocate their capital as effectively as China toward long-term, strategic investment opportunities in other areas as well.

However, I also cautioned that research is a two edged sword, with opportunity on one edge, and risk on the other. As such, I believe that the alpha seeking capital allocation process that I am about to describe must take place within the risk-first approach advocated by The MDE Group. At the same time, it is important to note that the views expressed about rare earth investing do not necessarily reflect those of MDE.  With that in mind, I will do my best to capture what I believe to be the most important factors to consider when allocating capital to companies in the rare earth mining industry.

An Important Lesson from the Greeks: “Know Thyself”
The first step is to identify your own priorities. Given your circumstances and objectives, are you more concerned with wealth accumulation or with wealth preservation? Investing in junior mining stocks with small market capitalizations, and typically no current earnings – or even revenues, for that matter – entails risks that investors more concerned about ways to preserve their existing wealth may prefer to avoid. However, investors in this category may also be better able to sustain such risks if it represents only a small portion of their portfolio, and a relatively small percentage allocation within their large portfolios could be more impactful than a relatively large percentage allocation within smaller portfolios. So, I would urge all investors to consider whether these types of investments should play a role in their portfolio.

An Important Lesson from my Mother: “Look both ways before crossing”
If an allocation to rare earth mining stocks is desired, some of the best ways to address the risk of doing so are research, diversification, and hedging techniques. Because knowing what you are doing is often the best way to avoid risks associated with any endeavor, I intend to emphasize the role of research both for the purpose of addressing risk and identifying opportunities.

But, investors should not rely upon research alone to address risk. There are many risks that can’t be addressed solely through research, primarily because future outcomes often can’t be predicted with a high level of certainty. As Yogi Berra once said, “It’s hard to make predictions – especially about the future.”   Even if a high probability is assigned to a particular outcome, when and where that outcome might manifest itself may not be known, and this additional uncertainty could be just as important as the risk that the underlying event will manifest itself at all.

Furthermore, other unanticipated events, whose timing and location may not have been anticipated, can overshadow the importance of those risks that we believed to be of primary concern. For example, the Japanese earthquake and tsunami seems to have very little to do with rare earth mining stocks, but its impact on the economy and markets could have a meaningful impact on investors in rare earth mining stocks, just the same. So, no matter how confident we are in the quality of our research, we should still avoid putting all of our eggs in one basket.

Important patterns to recognize with respect to Rare Earth Mining stocks
Having come this far, we are now ready to consider one of the most fundamental characteristics of junior mining stocks in general, and rare earth mining stocks in particular – recurring patterns. Historically, the stock price pattern for this niche industry progresses as follows:

1. The stock price spikes upon an announcement that a deposit has been discovered.   Typically, the junior mining company does not have sufficient capital to develop this resource itself, so the stock price increase usually evidences an expectation that the junior mining company will be acquired, or it will profit from a sale of the resource to a larger company with sufficient capital to develop the resource.

2. If no acquisition is forthcoming, the junior mining company may then choose to develop the resource on its own into a profitable, revenue-generating enterprise.   However, this process can take years to complete, and may require additional capital to be raised which could dilute the ownership interests of existing shareholders. As such, not long after such a price spike, stock prices tend to drop, and often languish at their new low levels for a protracted period.

3. If management of the company can successfully develop the resource to a level that better evidences the attractiveness of its investment potential, and can attract enough capital to make completion of the project more likely, their stock price may then begin to rise, making it more attractive for the company to issue new shares in order to raise the remaining capital needed to launch the operations that may fund further development of the company’s business plan.

Further development efforts might include the acquisition of additional deposits which would enable the company to achieve greater economies of scale, or to utilize its existing infrastructure to process different types of rare earth elements.   Expanding the composition of rare earth elements comprising a company’s raw materials inventory to include the full range of rare earth elements – from more abundant light REEs to relatively scarce heavy REEs – offers an opportunity to achieve improved economics of production, relative to the economics of processing either type of REE on a standalone basis. Such acquisitions may also help a rare earth mining company achieve a more complete portfolio of separated rare earth oxides.

The latter objective could be especially important to companies pursuing a vertical integration strategy, whereby the separated rare earth oxides would then be combined and further processed so that they may be converted into the various downstream products that eventually find themselves in a vast array of high-tech products. I mentioned many of these applications in my previous post, titled Rare Earth Elements – The Missing Ingredient in a Powerful Concoction.  There are, of course, many variations on this theme, but at a minimum, potential investors in this space must understand these basic characteristics of rare earth mining companies, and of rare earth mining stocks.

Why can’t we just let someone else worry about this?
One of the main problems plaguing the rare earth mining industry historically has been the fact that global revenues from sales of rare earth elements amounted to only a few billion dollars, if that, which can make it difficult to attract the attention of financial institutions that may be willing to underwrite the capital needs of the relatively small companies trying to establish themselves within this industry. Furthermore, larger mining companies have likewise found it difficult to justify the effort required to monitor such a small allocation of their capital. In addition, China’s growing share of global production drove prices for REEs below levels that would permit competition from profit-seeking companies subject to the discipline imposed both by free market economies and by those opposed to environmental degradation and violations of human rights.

Does this mean I won’t be able to get the new iPad?
China’s growing market share and the corresponding decline in REE prices was evidenced most dramatically beginning in the early 1990’s.  This illustration featured on the Lynas Corporation website should put this into better perspective.   However, prices for REEs have recently begun to soar, due to a combination of increased demand, and decreased supply as China continues to reduce its export quotas, and to increase its tariffs on the constricted levels of REEs that remain available to buyers who have not established manufacturing operations within China in order to secure more ready, reliable access to these vital materials. These higher prices, as well as a recognition of the commercial and military risks associated with China’s control over the supply of REEs, has set off a wave of investor interest in rare earth mining stocks.

Great, so someone else is going to take care of this, right?
This is a positive development, but the question that remains on the minds of investors is whether the current price levels for REEs are sustainable.   The answer to this pricing question would typically be established by the market forces of supply, demand, and open market competition.

On the supply side, it can be noted that there are currently only a few rare earth mining companies outside China close to starting production. These include
Lynas Corporation (LYC:AX), Molycorp (MCP), and Great Western Minerals Group (GWG:TSX).   Furthermore, the bulk of their combined production is expected to be comprised of lighter REEs, rather than the less abundant, and more expensive, heavy REEs. Nonetheless, their eventual production could result in an increase in the available supply of REEs outside China.

However, demand for REEs is also expected to grow, and this demand is relatively inelastic, since the cost of REEs is usually insignificant when expressed as a percentage of the cost of the products in which they are used. Moreover, there are often no substitutes for REEs in many important technological applications.

Even if adequate substitutes could be identified, the development of such substitutes may not seem urgent to many midstream users of REEs since the demand for REEs is relatively inelastic. In light of the above, current price levels would seem to be sustainable, at least for the next few to several years.

Before you pay the price, ask yourself what is “the China price”?
However, traditional investment analysis based upon the assumption of free market forces may not be sufficiently relevant in this case. Consistent with so many other trends described in my previous posts, control over the rare earths industry has been consolidated. Consequently, the dominant position that China has been able to accumulate in this overlooked industry provides it with monopolistic power over the prices at which rare earths may be sold by its aspiring competitors.   It is important not to overlook this, since stock price valuations of these competitors, some of which you may be considering as an investment, are heavily influenced by the expected prices of the products that they intend to sell.

For example, based upon a discount rate of 15% (higher than the historical rate of returns for equity investments in general, but one I will assume in order to account for added risks), the discounted PV of #22,000,000 kilograms of rare earth oxides with an average price of $80/kg – reduced by anticipated expenses of $10/kg – might suggest a $10.236 billion market cap for a rare earth mining company with this level of capacity for production and sales. Dividing that market cap by a hypothetical number of #1,655,500,000 shares outstanding, therefore, would translate into an expected share price of about $5.95 per share. Furthermore, if tariffs and/or further restrictions in the availability of REEs to companies with manufacturing operations outside China were to cause the market price of the same basket of rare earths to jump to $115/kg, all else being equal this would imply a 50% increase in the price of the shares to $8.92 per share. If the current share price was $2.00, this might appear to be what many would describe as a “no-brainer” investment.

However, what’s wrong with this picture is that that the current REE price may not be sustainable, in part because it depends upon the level of access that China allows for its leading-market share of REE supplies. Investors should, therefore, be conservative with their price estimates when establishing target prices for their investments in REE mining companies. They should also ponder what actions by competitors might be penalized or encouraged by China.

I suspect that China would be pleased if a mining company with no downstream operations was to emerge on the scene, since that might even serve as a potential source of product to China. The lone presence of such a competitor might also validate that the current high prices influenced by China’s controversial policies and actions were fair prices because they are consistent with the prices being charged by one of its competitors. However, if the competitor was to evidence an intent to reinvest some of its profits into the manufacture of downstream products, China might take retaliatory actions to drive down the price in order to prevent such a potential competitor from capturing its coveted market share in the higher margin, downstream businesses.

Armed with this knowledge, we are now ready to consider a framework that should enable investors to more effectively choose the rare earth mining stocks to which they may wish to allocate their capital. Due to space constraints, the remaining discussion of this topic will be featured in my next post, but that post will follow this one very soon. A small hint in the meantime: “It’s all about the people.”

End Note: These insights have been culled from many sources, and there are many individuals with much greater expertise in this area than my own who are just as anxious to share their knowledge. Rather than relying upon me to attempt to repeat all of their insights, here are a few suggestions for further reading:

Submitting a search for “rare earth elements” in your internet search browser will obviously provide you with many sources of information. I encourage you to explore these. You should also visit the websites of the various rare earth mining companies. I have found the following to be particularly helpful:
http://lynascorp.com/                                   http://www.molycorp.com/                      
http://avalonraremetals.com/                   http://ucore.com/
               
Jack Lifton is one of the most respected experts in the field of technical metals in general, and rare earths in particular. Periodic commentary reflecting his keen insights, as well as those of the very talented Gareth Hatch, is available through the following website: http://www.techmetalsresearch.com/ Don’t forget to download Jack Lifton’s Free Report titled “Rare Earths in the Age of Technology.”

Clint Cox, also provides valuable research and insights through his website, The Anchor House, Inc. (http://www.theanchorsite.com/). Included are field trips to many of the deposits being developed by the rare earth mining companies, as well as summaries of the presentations made at the various conferences attended by the leaders involved in this industry.

One can only communicate so much in an article, or even a Special Report. To put this information into better perspective, readers should develop a better understanding of the broader context in which developments within the rare earths industry are unfolding. A recent book that should help to provide this perspective is “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks” by Adrian Day.
But, the big picture may seem like abstract art if investors don’t also understand important details. To fill this knowledge gap, I would suggest the book, “Junior Mining Investor” by Kevin Corcoran.
For information regarding policies intended to ensure secure and diverse supply chains for technology metals, including rare earth elements, the IAGS TREM Center website can also be useful ( http://www.tremcenter.org/). The Institute for the Analysis of Global Security (IAGS) is a non-profit organization which directs attention to the strong link between energy and security and provides a stage for public debate on the various avenues to strengthening the world's energy security.   Their March 2010 Report titled “China’s Rare Earth Elements Industry: What Can the West Learn” authored by Cindy Hurst is a real eye opener. Cindy Hurst is an analyst for the U.S. Army’s Foreign Military Studies Office. The concerns raised in this Report are echoed in an April 1, 2010 GAO  Briefing for Congressional Committees titled, “Rare Earth Materials in the Defense Supply Chain.”

Also, Stratfor has been following developments in this space very closely, and often provides up to the minute accounts of important developments as they unfold. (http://www.stratfor.com/)

Seeking Alpha (www.seekingalpha.com) has also fielded a number of articles related to rare earth elements and rare earth mining companies.  Those posted in 2008/2009 were my original favorites.  They may still be useful as primers to others since they served to introduce investors to rare earth elements at a time when such introductions were generally more necessary.  With the passage of time, subsequent articles tend to focus on new developments and unique new insights which I now find to be more valuable.

Finally, very little that affects this industry escapes the attention of the many individual investors who share their thoughts regarding rare earth mining stocks on the Yahoo! Stock message boards. I prefer the message board for Lynas Corporation (OTCPK:LYSCF), since it invariably includes links to the latest articles and reports from a variety of sources around the world. 


Disclosure: I am long OTCPK:LYSCF, MCP, OTCQX:UURAF, OTCPK:ARAFF, OTCPK:GWMGF, OTC:NEMFF.

Additional disclosure: I am also long Alkane Resources Ltd, whose symbol is ALKEF.PK.