Compliments to the promoters but the recent run in graphite smells too much like lithium

Stockhouse Ticker Trax is equity specific research (Canadian listed and market cap < $300 million) published every Monday to paid subscribers. Our free Friday column may feature companies previously featured to paid subscribers (with a minimum one month delay) or discuss topics of interest to the general investment community and relevant to overall portfolio management.

Market observation:

It is very possible we tested a bottom on many of the small stocks May 9th. Selling was very aggressive on Tuesday but Wednesday morning I witnessed what appeared to be outright panic selling. It subsided across the board by afternoon and Thursday the buy orders were still thin but selling had slowed dramatically.

This doesn't mean we are going to bounce back rapidly anytime soon but it sure improves our odds of a summer rally because many shareholders are refusing to sell much lower and the first significant turn in momentum may attract a lot of buying.

I have mentioned in the past that I use Pinetree Capital (TSX: T.PNP, Stock Forum; $1.12) for an indicator of the overall health of the junior resource sector because they control approx. $300 million worth of micro and small-cap resource stocks.

If you look at their three-year chart you will see where everything hit bottom the summer of 2010 and did very well into February 2011 (PNP gained almost 300%).

By March 2011, junior exploration stocks started coming off the rails and PNP started a downward slide from that $4.20 high in February. Now PNP is back to the 2010 low again. Many investors do not have the money to buy back in and take advantage of these lows but as I watched in late summer 2010 with Pinetree, it didn't take much to turn stocks around once the momentum shifted.

Graphite sector running on unstable fuel cells

Since January there has been a lot of (we will have to call it hype) surrounding graphite and graphite stocks. Only a year ago you couldn’t give away a graphite stock. Now many mining promoters would have you believe it is worth it’s weight in gold.

http://en.wikipedia.org/wiki/Graphite

What we have seen so far in graphite exploration stocks pales in comparison to what we saw with lithium stocks in 2009. However, the comparisons being made to the growth potential of graphite are almost identical to what we saw with lithium. For those who don’t remember the lithium run, it went something like this.

The lithium sector in 2009 generated junior exploration gains of several hundred percent to almost 1000% within the year. A few have held a good percentage of those “initial” gains but anyone late to the party is sitting on dead money after three years. For some (like WLC) the gains have evaporated entirely. It is great to be on the early bus, but typically the large majority play out the same way.

It was Northern Graphite (TSX: V.NGC, Stock Forum) that started the frenzy in January and several others followed suit.

The graphite company valuations are being driven off very well orchestrated promotion - and kudos to the promoters and financiers. Building momentum is no easy feat in this market. The old saying of selling ice to an eskimo really applies here. If you can move a junior exploration stock in this market, you are very good at what you do.

The money may be moving but fundamentally the play is flawed. When you have the darlings of the junior exploration stocks (gold) hitting such dramatic lows, it is extremely difficult to justify the economics of building a new graphite mine. Gold is comfortable above $1500 per ounce and most juniors are struggling to get a valuation equal to $20 per ounce. Years ago we would see gold at half this price and yet the junior exploration stocks would be comfortably valued at $50 to $200 per ounce.

Lithium remains in the dog house

Graphite is being heavily promoted as an integral part of the explosive growth for electric cars we are still waiting to see – yet have heard about for years. Equally so, the growing demand for lithium batteries.

The problem is, had we seen a large uptake in lithium demand (and stock prices) it would make sense to see graphite riding along with it. Lithium stocks have done nothing since 2009 and globally there is no shortage of graphite.

In fact, China who are the largest graphite producer by far, are struggling to improve the economics of the industry. Raw material producers are very fragmented and have been losing money for years. Unlike the rare earth (REE) industry, which came under the control of the Chinese government without issue, the graphite industry is proving difficult to manage and control. It is not because the supply is not there, it is because of the fragemented (and often small scale) nature of the miners and processors.

It is well known that within China the money is not made in the mining of graphite, but in the processing. In fact, Chinese producers had been exporting graphite at low prices before they realized that Japanese made graphite processed products could be imported and sold for 20 to 30 times the price.

In the past year graphite has seen some supply/demand imbalances – primarily because the supply in China was very mismanaged by farmers and factories. Now the government is demanding that large graphite processors and factories setup bases around the multiple large graphite deposits in the Provinces of Heilongjiang, Hubei, Hunan, and Shangdong.

In doing so, China will improve productivity and competitiveness considerably. Unfortunately this is something that the new entrants to the junior graphite exploration world may not be aware of, or may not be discussing with investors. In the world map shown above you can see where China produces a massive amount of graphite in relation to everyone else. The next big players are India, Brazil, and North Korea.

It is not a case of the world running out of graphite, it is a scenario where the world’s largest producer was very fragmented and mismanaged. That could change dramatically over the next year or two and it could make it extremely difficult to finance new projects outside China – or compete with China on price.

Conclusion

Lithium had a short day in the sun years ago and has failed to recover. Graphite after REE’s died off appears to be the next attempt at a junior resource push by (very skilled) promoters and financiers. Economically it is an industry that faces some serious challenges.

I know these comments will not be well received by investors in graphite companies. In fact, I am expecting the “flaming” on this one. However, it is important that investors and speculators be made aware of the current risks. Lord knows enough money has been lost on everything else that is resource related this past year so we don’t need another lithium sector in the making – although I realize this report is likely several weeks “too late” for many investors.

This is a very unforgiving market environment and marginal is not good enough. Investors are not mindless monkeys and the bar has been raised very high for all companies no matter what mineral or metal they are looking for or producing

As lithium investors found out, you treat these stocks as your “girlfriend” and not your “soulmate.” The graphite stocks may still power higher this year and I really hope they defy the odds. We need more success stories on the TSX and the Venture - I am just not convinced those will come from graphite.

If you remain a fan of graphite then maybe companies like Focus Metals (TSX: V.FMS, Stock Forum; 88 cents) make sense. Its stock has not behaved irrationally and this past week they announced an important partnership with a division of Hydro Quebec. The importance they are placing on the “processing” side is critical to long term success (as the Chinese are now learning).

Share structure is also critically important. Companies like Standard Graphite (TSX: V.SGH, Stock Forum; 37 cents) are very grass roots but have done an excellent job avoiding excess dilution – this is critical to survival and protecting shareholder value.

For those interested in the sector, this website has listed all the players: http://www.graphitestocks.com/

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Disclosure: Danny Deadlock does not own shares in any companies discussed above.