What do a Prius and an iPhone have in common? Both depend on the same rare-earth metal: neodymium. In the Prius, it stabilizes the magnets that make the electric engine go. In the iPhone, it makes the phone vibrate when there’s a new message.

Rare-earth metals have become a hot commodity. China consumes about 70% of world production; it also produces 97% of the world’s supply. It wants to keep them for its computer and auto factories, and recently imposed sharp export quotas. It also suspended exports to Japan over a territorial dispute. That saw the prices of some metals skyrocket. The U.S., Japan and the EU have complained to the WTO.

There are 17 rare-earth metals in the periodic table, ranging from scandium to lutetium. They occur together in the same mineral deposits. What makes them rare is the fact they rarely occur in sufficient concentration to make mining them economical.

Stock newsletters frequently tout rare earths as “metals more precious than gold” and cite Canada as a primary source outside China, along with the U.S. and Australia. Yet they have no intrinsic value. They are not potential currency substitutes or likely to be mounted in jewelry. And they aren’t used in the industrial processes on which life depends. Still, they can be valuable in lasers, X-ray tubes, industrial magnets, glass, microwaves and electronic components.

The Chinese crisis highlighted the value of rare earths for manufacturing. “[China] has been ratcheting down the quotas since 2004,” explains Jon Hykawy, head of Global Research Clean Technologies and materials analyst at Byron Capital Markets in Toronto. “It really only started to bite in the early part of 2010. That was when everyone got excited.”

Mathew Wilson, an analyst at Pinetree Capital in Toronto, agrees. “We saw how hot it was coming out of 2009 and then we’ve seen how quickly it cooled.” Rare earths are practical, but only if they stay inexpensive.And “you need a guaranteed supply,” says Hykawy. A car maker won’t design a vehicle that relies on rare-earth magnets unless it knows it can get that metal at the right price, at all times.

When China interrupted the supply to Japan, Toyota opted for a hybrid that doesn’t rely on rare earths. High prices, Hykawy notes, lead to demand destruction. Hence, while prices peaked in 2010, they’ve since fallen off. “People tolerate excessive prices, but will work toward substitution.”

He cites cerium, which is used to sequester the iron in glass that would otherwise leave it with an unattractive yellow colour. But it’s also a component in flatscreen and smartphone displays. Because of the way the Chinese quotas worked, exporters opted for higher-value rare earths. Cerium had been priced at $30 a kilo. It peaked at $150 a kilo as supply shortages bit, but it’s since resumed trading at about $30 a kilo.

Hykawy thinks there is a long term case for investing in rare earths. But it has less to do with scarcity and more with efficiency of mining and developments in their applications.

That leaves investors with four options. The first is physically owning the commodity. That’s difficult for individual investors. There aren’t funds like those for physical holdings of gold and silver. It’s also difficult to access non-Chinese sources of supply.

Still, a stock on the TSX Venture Exchange, Dacha Strategic Metals Inc., specializes in physical holdings, similar to publicly traded trusts that offer gold bullion or silver exposure. It claims to be the first to stockpile rare earths.

The second option is to invest in junior mining companies, mainly in Canada, the U.S. and Australia. In the U.S.,Molycorp has restarted the Mountain Pass rare-earths mine in California. It recently sought a friendly takeover of a prominent Canadian player, Neo Material Technologies. Another company, Lynas, seems to have a lock on mining in Western Australia.

The third way to invest, Hykawy says, “is to look at a basket of junior miners.” But they don’t have mines in production or they’re not producing large quantities. That said, “there’s probably room for four-to-six companies outside of China to be in substantial production.”

Adds Wilson: “If they’re looked at as mining projects rather than a momentum play, pick the one or two you really believe in.” For him, rare earths are a diversifier within a broader strategic-metals portfolio that includes lithium and potash.

Pinetree’s mining portfolio currently runs at 9%in strategicmaterials. Canadian markets are overweight in materials—they’re almost 17% of the S&P/TSX Composite. The global weight is only 8.4%.

Finally, there’s the ETF alternative, which has a broader focus than the 15 miners Byron tracks. The Market Vectors Rare Earth/Strategic Metals Index (REMX), sponsored by Van Eck Associate Corp. in the U.S., covers the 17 rare earths, plus another 26 strategic metals, including cobalt, manganese, strontium and tungsten.

Its holdings include miners, recyclers and refiners with a minimum market cap of $150 million. Small-caps constitute 51% of the index (there are no large-caps) and 60% of the market value belongs to companies listed in Australia, Canada and the U.S., each with roughly a 20% share. It includes some of the companies in the Byron index, such as Molycorp and Lynas.

Van Eck notes these companies are volatile, with a standard deviation of 62%, versus 19% for the S&P 500. And volatility can be dispiriting for all but the most seasoned junior-stock investors.

But there is another way to look at rare-earth metals, and that’s the value-chain approach. “You don’t just want someone who’s digging rare earths out of the ground,” says Hykawy. “Look at those who produce products people care about: a magnet alloy or the magnets themselves.” Indeed, Molycorp’s bid for Neo Materials was predicated on combining a miner and a processor.

Rare-earth investing isn’t about striking the mother lode; it’s about what you do with the ore. The advent of hybrid cars and smartphones means there’s plenty to do. Says Hykawy: “At the far end of the value chain, the only driver is intellectual property.”

Scot Blythe is a Toronto-based financial writer.

Originally published in Advisor's Edge Report