Are lithium shares too good to be true?
The widely accepted narrative about lithium has captured the attention of investors but it may be too late to make outsized profits.
Today we appear to be on the precipice of the electric vehicle (EV) revolution.
Telsa and other pureplay EV producers are joined by traditional car companies in producing the vehicles which will lead to a lower carbon world. Everyone is onboard from governments to consumers. The possibilities again seem limitless.
And at the heart of this effort are batteries which require lithium to produce. Depending upon the model, a Tesla battery contains between 5 and 75 kilograms of lithium. The link between lithium and EV has not gone unnoticed by investors.
In 2015 lithium was priced at 5,125 USD per tonne. In mid-December 2022 lithium was priced at over 80,000 USD per tonne.
It makes logical sense that miners of lithium will do very well as EV demand continues to rise. In many corners of the investing world lithium mania is in full swing. Investing chat boards are filled with questions about the best lithium miners. I get questions in many of my webinars about lithium. Naysayers like Goldman Sachs get attacked for not following the standard narrative that prices can only go up.
The question for investors is can the widely accepted first order thinking about the linkage between lithium and EV demand lead to strong returns into the future.
Good prospects already baked in
To be an above average investor you need to depart from conventional wisdom. Doing the exact same thing as everyone else will make you an average investor. And average is pretty good. Average is the market return that passive investors achieve minus the fees they pay.
But if you are going to buy a lithium miner today it is important to ask yourself what you know that other investors don’t.
We must always remember that conventional wisdom is baked into share prices.
A share price reflects the consensus view of the future at a particular point in time. At the end of 2021 the consensus view was that inflation was transitory and interest rates would stay low for years. The changing of that consensus view had profound effects on share prices.
There are also additional considerations when investing in mining companies. Mining can be very cyclical. If expected demand is forecast to be high, mining companies invest in more capacity. Those investments may take years to come online but history suggests that we often see capacity gluts which drive down prices. This will have a profound effect on higher cost producers who can’t make money off lower prices.
We’ve seen something similar in the tech industry where forecasts that COVID growth would continue led to widespread hiring. These same workers are currently losing their jobs as reality has dampened these optimistic forecasts.
Does this mean investing in lithium is doomed? Of course not. But just be careful because there is a case to be made that the first order thinking from many investors will not work. Yes, more EV batteries increase the demand for lithium. The simplicity of that relationship doesn’t fully encapsulate all the forces that make something a great investment opportunity.
It may be too late to profit from this trend.
This often happens once an investing narrative becomes conventional wisdom. Remember that short-term high prices for a commodity can lead to long-term bad outcomes for commodity producers. Supply increases often follow and consumers of that commodity search for substitutes. Time will tell if there is a replacement for lithium in EV batteries.
Our equity research analyst Seth Goldstein believes Lithium prices will average 30,000 USD per tonne over this decade. A far cry from today’s highs.
Yet I’m willing to bet that many of the investors in small-cap speculative lithium miners are not anticipating the prices in Seth’s forecast. Goldman Sachs came out with a far more pessimistic outlook and suggested prices would fall to 11,000 USD per tonne in 2024.
What makes investing hard is that it isn’t how a company, or a commodity performs on an absolute basis. What matters is how that performance compares to expectations from investors.
It is hard to call investor expectations about lithium anything but sky high. As investors we tend to extrapolate the recent past into the future. We even have a term for it in the appropriately named recency bias. If you are one of those bullish lithium investors it might make sense to challenge some of your own assumptions rather than sticking to the echo chamber that all of us prefer to inhabit.
Yet I did none of that early on in my investment journey…
A lesson on expectations
In 1999 I started investing on my own. Investing seemed easy. And to be fair investing in 1999 was easy. One of the first shares I purchased was a company called WorldCom. It seemed like a can’t miss investment. The late ‘90s was a time where we seemed on the precipice of the golden age of the internet. The possibilities of the internet were endless. We would shop on the internet, consume all manner of content and communicate with people around the world. There was seemingly no limit to the uses of the burgeoning technology.
More internet use meant that we needed more capacity to support the limitless demand as dial-up connections over phone lines were replaced with fibre optic cables. And WorldCom was at the centre of it all. WorldCom built and owned the infrastructure to support the internet. Every company or person that wanted to use the internet would have to pay to use this infrastructure. And Worldcom was one of the largest providers along with Global Crossing.
I accepted the first order thinking that drove my investment decision. I did not challenge the assumptions of my fellow Worldcom cheerleaders. In some ways the narrative played out. The internet revolutionised the world and usage exploded in ways that couldn’t be imagined in 1999. The fibre optic networks built by Worldcom and their competitors was critical infrastructure to support this surge of internet use. The only problem was that the expectations of industry executives and investors for network capacity was grossly overestimated. Only 5 percent of the fibre-optic capacity was utilised by 2001. Worldcom filed for bankruptcy in 2002. Competitor Global Crossing’s bankruptcy proceeded Worldcom by six months. I joined my fellow investors in losing everything.
The true beneficiaries of this prolific fibre-optic network expansion were still to come. The glut of capacity lowered prices significantly, consumer adoption exploded and bandwidth was available for new companies like Amazon, Alphabet, Netflix and Meta.
Even the best sounding narratives warrant caution. If investing was as easy as replicating the recent returns from lithium miners there wouldn’t be enough space in the ocean for all our yachts. Unfortunately generating excessive returns is often a bit more challenging.