Every few years, a hot new technology comes along that excites investors. Thinking that it could benefit from booming demand in years to come, they smell the prospect of profits. Over the past couple of years, alternative energy forms have been such an area. That helps explain why lithium shares have attracted growing amounts of attention. Lithium is used in batteries that power electric vehicles, for example.
So, if I want to focus on growth potential in my portfolio, ought I to buy some lithium shares for it now?
Pros and cons of early stage investment
First, I think it is worth considering whether a potentially promising technology makes for a profitable industry in future – and what that can mean for shares of early players.
If lithium does indeed turn out to be an important part of the alternative energy sector, then there is clearly potential for the industry to grow substantially. Already, lithium is a key component for many alternative energy applications, such as batteries for electric vehicles. Indeed, electric vehicle maker Tesla is so keen to secure new sources of lithium that in 2020 it expressed interest in mining the metal itself.
However, not all early stage technologies end up developing into large markets. Sometimes, anticipated demand can lead to a gold rush that makes the market unprofitable for everyone. That can damage enthusiasm even for a promising technology, hurting demand.
Another common challenge is alternative solutions emerging in response to a need. This could happen with lithium. As companies see how demand for lithium threatens to drive up prices, they may get more experimental in exploring possible alternatives. If any of them works and is cheaper, that could permanently threaten the appeal of lithium.
Both the potential rewards and risks can be reflected in the share prices of companies focussed on early stage technologies. The dotcom boom is a good example of this. Some shares that soared, such as Amazon, later went on to exploit the new business area successfully. Their shares ended up increasing in value even more despite their already high prices. But many other companies burned through their resources and went bankrupt, like Boo.com. Others, even with solid businesses, took years to see their share prices recover to the highs of the dotcom era. For example, UK IT services group Computacenter peaked in February 2000. It only reached the same highs again two decades later, in February 2020!
So, while investing in a technology in its early phases can be rewarding, it can also be very risky.
Lithium shares as a way for me to get exposure
There are different ways I could seek to get exposure to the long-term potential of lithium. For example, I could buy shares in a company that has plans to mine lithium, such as Zinnwald Lithium. I could invest in existing lithium miners, such as Tianqi Lithium. I could buy shares in diversified miners whose large portfolios include some lithium projects, such as Rio Tinto. Or I could invest in companies in a different part of the lithium supply chain, such as battery maker Contemporary Amperex Technology.
Immediately when considering these options, I already have some concerns about what they might mean for risk management in my portfolio. Some are listed on stock markets with very different standards of corporate governance to the UK. That could expose me to risks I am not used to when investing in UK shares, such as a different treatment of minority shareholders.
Another observation is that some lithium companies lack diversification. They may not have large or any interests outside lithium. Even within lithium, some of them are concentrated on just a single project. That could be good for me if the company does well. For example, if Zinnwald’s project turns out to be highly productive and lithium prices remain high, the return for its shareholders could be very big. But such a lack of diversification exposes me to more risk as an investor than I can accept. I prefer investing in companies that have some degree of diversification. Disappointments in mining projects are common, after all. Plots can contain less metal than hoped, extraction costs can be higher than expected, and successful projects sometimes find their profits hurt by new windfall taxes.
Lithium share valuation
On top of that, I have some concerns about valuation. Even a great company does not necessarily make for a good investment, depending upon the price I pay for it.
Given the excitement in recent years, many lithium shares have already seen their prices soar. Ganfeng Lithium, for example, may have lost 5% in the past year but it is still up 846% over the past five years. Tianqi Lithium is up 57% over the past 12 months and 246% over five years. Contemporary Amperex is up 55% in a year – and 1,018% in five years.
Does this mean that future prospects are already factored into the share prices of many lithium companies? Not necessarily. After all, it is still unclear what future demand and supply will be for lithium. That also means that future prices are hard to know, which will have a big impact on long-term profitability. If lithium remains in high demand, leading companies may increase their profits in years to come. That could drive their share prices up further.
Too much success, though, can also hurt the economics of a developing industry. It often leads to more competition, higher costs to secure exclusive rights, and possible downward pricing pressure. I think all of those risks could hurt lithium profitability in future.
So although I do think some lithium shares could help add growth to my portfolio, I will not be adding any at the moment. The risks are high and I am concerned about lack of diversification. I expect many lithium companies to end in failure. I would rather invest in shares where I can see that I have a strong chance of a good return than ones where I think I have a weak chance of a spectacular one.
Christopher Ruane has no position in any of the shares mentioned. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK has recommended Amazon and Tesla. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
