5 Rare Earth Stocks Due for a Fall

Rare earths are like Justin Bieber. Few people had heard of either of them until fairly recently, it's unclear precisely what they do, and each is suddenly at the center of a creepy, manufactured public display of ecstasy. In the case of rare earths, the euphoria is manifested in rallies that have carried the stocks of some mining companies from pennies a share into the high teens (dollars, not cents).

Here are some details: Avalon Rare Metals (AVL) went from about 40 cents a share early in 2009 to about $8 as 2011 began; Molycorp (MCP) more than quadrupled after it began trading in late July; China GengSheng Minerals (CHGS) rose tenfold in less than two years; China Shen Zhou Mining & Resources (SHZ) soared from about 25 cents to more than $10 in the same time, and the granddaddy of them all, Rare Element Resources (REE), has made the trip from about 20 cents in late 2008 to the high-rent district above $17.

The stocks have been sold aggressively in the last few weeks, however, and that could mark the start of a long, uncomfortable trend for shareholders.

In case you're wondering, rare earths are elements in the bottom-middle of the Periodic Table, far from old favorites like Hydrogen, Oxygen, Chlorine and Calcium. They are used to make cool scientific things like superconductors, luminescent materials, lasers, night vision goggles and radar equipment. Some examples of rare earths are Lanthanum, Praseodymium, Dysprosium and Ytterbium. (Upsidasium from the old Rocky and Bullwinkle cartoons apparently is not a rare earth.)

The story behind the spectacular move in the stocks is that the supply of rare earths has been drastically curtailed, first by environmental regulations that resulted in an overwhelming proportion of the world's production migrating to China and then, recently, a decision by China to limit exports to ensure that it keeps enough to meet the needs of its own industries.

So are you ready to cash in on the craze? Good luck. While the story sounds compelling, it may not generate the windfall you're hoping for. Buying the stocks two years ago would have been a fabulous idea, obviously, but the colossal leaps seem to have been driven by little more than hope and expectation that the supply/demand backdrop would translate into spectacular profits. That has not occurred yet, and there is good reason to believe that it never will, at least not to the extent necessary to justify current share prices.

It turns out that the name "rare earth" is a bit deceptive. Some rare earth elements are quite abundant. There is about as much cerium in the Earth's crust as copper, for instance. What makes the elements rare is that miners have a devil of a time extracting them from wherever they are ensconced. Rare earths command high prices, but that is because it costs a lot to accumulate them.

The result is products with high prices but also high costs and limited supply. It doesn't sound like the ingredients for great financial success that advocates of the stocks think it is, and indeed there is little evidence of financial success at all among rare earth miners. Few of them are profitable, even after rare earth prices soared by several hundred percent in 2010, and the companies that do make money make so little of it that their price-earnings multiples are extremely high.

When companies outside China ramp up production to meet global demand, moreover, prices of the commodities themselves will have much less support, making the backdrop for the stocks more challenging. And if the global economic recovery proves to be less robust than economists hope, there will be even less underpinning prices. Put it all together and there is very little to recommend rare earth stocks at these levels.

So, who's Justin Bieber?