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Rare Earth Investing Considerations

|Includes: DCHAF, Great Western Minerals Group Ltd. (GWMGF), NEMFF, UURAF
Rare Earths may well be one of the best small cap trades of 2011. But understanding the story and landscape of the trade is key. Right now almost every one of the stocks has had a great run (and took a breather today). I think much of the run is a stock squeeze followed by profit taking off extended future valuations. That is to be expected with a bunch of pink sheet stocks getting a daily shout on Bloomberg or CNBC. But the key here is to understand the facts and have a set of metrics that will alert you if the trade is going sour. To this end I have a few suggestions:
1) Rare Earths are not traded on any exchange and no one of any size (no offense to Dacha or the like) is speculating directly on the metals themselves. This means the price of the metals do not bounce all over the place. They should follow more steady trends based mainly on supply and demand. This point is illustrated on the Asian Metal Pages (which can be peeked at through the Pele Mountain link on their website). If the prices drop this would support a bear case. If they rise unabated then demand is overwhelming the supply restricted by China's quota and the bull case is supported. Right now every one of these metal's charts is a climbing staircase for the last several months. No matter how many bubble heads "say rare earths are not rare" (which is true and irrelevant) I think price support of the metals is what matters.
2) These stocks will remain VERY volatile. Bubble or "The Next Big Thing" there will be big volatility. I think the best way to handle this is to take some off when the valuation is way too high (Ex: Moly without operations @ 12 times book). And stocks can be added to when the value of the mine and certainty of the project seem undervalued. This can be a judgment call as an investor. But I would suggest if you use book values, metal prices, and mine sizes compositions and capital required for development you can develop a fairly simple discipline in this area.
The other choice is to invest smaller amounts to a level where you can handle the ups and downs that go with this volatility. This takes a different sort of discipline. But good money managers can take this more passive approach.

Further considerations especially when investing in Juniors:

3) Very few junior miners ever get anywhere. These stocks have always been better widow makers than money makers since the earth's crust was formed. The funniest thing I read about rare earths is that everyone will produce LREE in their efforts to get HREE. I agree that HREEs are more valuable because they are harder to mine economically. But the truth is much more likely that almost no one will reach production. The few that do reach production might buy a few of the other projects. But the rest will disappear with investor money. That's junior miners. Ask your favorite Bloke or Cannuck if you don't believe me.
4) The stage of development of a mine should never be ignored. REE prices appear to be in more of a bottleneck than a permanent up trend IMO. The rise of green technology demand and government support for green technology combined with China quotas has caused this investment story. If those elements change before a working business model and producing mine is created the junior miner gets wiped out. So if you think the window is small go with Lynas or Molycorp. If you like Great Western, Rare Earth Elements or Avalon you must think the window is larger. And if you like every miner that finds 1.5% TREO with a 1% cutoff then you must not believe there is a window and you may be worshiping a sacred cow made from Dysprosium.
5) Size of mine is important. Smaller mines will not succeed due to poor return on equity. It does not matter if a mine produces if it isn't profitable with enough mine life to justify the necessary capital expenditures.
6) TREO is very important to marketability. It is no coincidence that the mines closest to production have the highest TREO numbers. Perhaps lower TREO's can be tolerated where the project is larger with higher HREE ratios. But lower TREO's require more effort to mine and concentrate before the metallurgy can be performed.
7) Rare Earths require a lot of chemistry. Market prices list at 90-99% pure oxides and metals. Lynas says two-thirds of their cost is the activities at their Advanced Materials Plant. That means after concentrating the 8+% TREO at Mount Weld and shipping the concentrate to Malaysia they still have two- thirds of their costs at their LAMP in order to produce market quality product. Compare this to projects needing a billion dollars to extract the HREE ores at the mine site, and you can see the challenges out there. This also means ore concentrated at a mine will not earn many dollars and non-integrated projects will miss out on a large part of the rare earth value chain.
8) Lastly, one must consider metallurgy in evaluating a project. Radioactivity or a mine with a mix of ores and metals that can't be separated in a cost effective way will not produce. So even if everything looks great at the mine site a project could still die in the laboratory.
These issues are just a few things for investors to consider. And admittedly I have only scratched the surface of each of these general issues. But I tired to write this information to provide some perspective to these stock stories. Personally I hate reading the bubble heads that dismiss the rare earth story because REE aren't rare or the stocks have run, ect.. I also laugh when a stock doubles because a junior drilled a hole in the north pole and found 1% TREO. I enjoy speculating in this area and I believe due diligence is everything. These thoughts are some of the things I think matter. You are welcome to disagree. That's what makes a market. All comments welcome.
Disclosure: I am long Lynas, Moly, Great Western, Northern Uranium, Ucore and Neo Materials.