SAN FRANCISCO (MarketWatch) — Rare earths, as the name implies, make up a tiny market with huge growth potential. It’s also a market with little transparency, fraught with the kind of volatility that keeps investors wondering whether they can withstand the risks to reap the rewards.

Rare earths are minerals whose special properties make them ideal components in a wide variety of high-tech products, from hybrid cars to smartphones. They also have many key defense applications.

Prices of these metals began to soar last year when China, which controls 95% of the world’s rare-earth output, said it would cut its exports by 40% — prompting speculation that the restricted supply would drive prices up. The bubble burst a year later as strategic metals prices tumbled, hurt by fears of cooling global demand.

For instance, one of the most heavily produced rare earths, lanthanum oxide, sold in March for $93 a kilogram outside of China. The price peaked at $140 in July before diving 56% to $62 in November. Current lanthanum prices are still 12 times higher than in early 2010, when they hovered around $5, according to Jon Hykawy, materials analyst for Byron Capital Markets.

But despite the lower metal prices, rare-earth mining stocks have been edging up since early October. Last month, China’s largest rare-earth producer said it would restrict exports for one month, rekindling talk that long-term prices will rise on the lower supply.

“There will continue to be uncertainty around the amount of supply coming out of China,” said Jeff Wright, metals and mining analyst at Global Hunter Securities. “A number of rare-earth companies have come off their highs from the summer, and they’re looking at much more attractive valuations now than four to six months ago.”

It may take some digging to find pure-play, publicly traded rare-earth companies, yet there are a few. Among the biggest is Molycorp Inc. MCP, -1.25% the second largest producer of rare earths outside of China.

Molycorp began construction in January on a facility near its Mountain Pass mine, near the Nevada border in California’s Mojave desert. The company said it expects to produce 19,050 metric tons of rare earths by the end of September 2012, three months earlier than anticipated.

Despite the upbeat assessment of its mining operations, Molycorp shares are languishing around $33, down 58% from their $79.16 high for the year back in May.

Rare Element Resources Ltd. REE, +0.30%  (RES) is another, actively prospecting in Wyoming and reporting “encouraging” drilling results in a news release dated Oct. 27. The stock is currently trading around $6.29 a share, up 40% since bouncing off a 52-week low of $3.86 in early October.

Industry analysts say they also see potential profits from Avalon Rare Metals Inc. (AVL) and United States Antimony Corp. UAMY, +1.64%  Avalon is tapping one of the largest rare-earth element deposits outside of China in Canada’s Northwest Territories, while U.S. Antimony has mines in Montana and Mexico. Antimony is used in lead batteries in autos and flame retardants.

Like others in the group, their shares are all over the place. Avalon’s shares are down 46% so far this year while U.S. Antimony’s are up a staggering 322%.

Other companies in the sector include Australia’s Lynas Corp. (LYC) and Canada’s Tasman Metals Ltd. (TSM); Canada’s Dacha Strategic Metals Inc. (DSM) stockpiles and then sells strategic metals.

Misnomer

Strategic metals are defined as metals crucial for industry and national security. Of the estimated 43 dubbed strategic, 17 are rare-earth metals. But industry analysts say “rare earth” is a bit of a misnomer, because these elements are relatively common. What makes them rare is finding them in concentrations high enough to mine profitably.

Despite growing demand, betting on them carries big risks. Unlike such mainstream metals as gold, it’s hard to track rare-earth prices in the underlying commodities market. That means the only way to bet on the industry is through the mining companies themselves, along with a handful of specialized mutual funds and exchange-traded funds.

China’s near-monopoly also makes the rare-earth market less transparent, which can drive volatility as investors buy and sell on any rumor of China tightening its metals exports, analysts say.

China announced on Nov. 1 that it will likely implement a new state-run invoice system to crack down on illegal rare-earths miners in the country, which may be a source of future price fluctuations if Chinese exports shrink. Read more on the invoice system.

“This is a pretty volatile product,” said Ed Lopez, advertising director at Van Eck Global Fund, which launched its Market Vector Rare Earths/Strategic Metals ETFREMX, +0.07%  last year. “For somebody considering a long-term play, they need to consider what their time frame is and if they can tolerate the risk.”

That risk can be seen in Molycorp’s share price. The stock hit an intraday high of $79.16 in May; by October it had tumbled 63% at $29.19. Last Friday, Molycorp shares dropped 14% after the company reported record quarterly profits that nevertheless fell short of analysts’ estimates.

China’s chokehold on rare-earth output is due primarily to lax environmental and safety standards, lower labor costs and generous government subsidies. It also helps that the Middle Kingdom holds around 48% of the world’s proven rare-earth deposits, compared with just 13% for the second-place United States. China also possesses most of the expertise needed to process rare-earth ore, according to analysts.

Given the importance of these metals in national-defense systems, governments around the world have discussed stockpiling their own reserves. Earlier this month, the United States began probing the possibility of a strategic reserve of rare-earth metals after a Pentagon report showed the nation was “critically dependent” on China for them.

Prospecting for investors

Analysts estimate there are 250 to 360 public companies that claim to be exploring for or mining rare-earth metals. Of these, only about 25 have viable mining projects with “decent mineral-resource estimates,” said Gareth Hatch, co-founder of Technology Metals Research.

Putting money on rare-earth miners requires researching the underlying metals, because some are in higher demand than others. One factor to consider is “heavy” versus “light” rare earths, according to Malcolm Gissen, portfolio manager at the Encompass Fund, which holds strategic-metal miners.

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Such heavy metals as dysprosium, which is used in magnets inside hybrid cars, can fetch 20 times the price of lighter metals such as cerium, which is used to polish glass.

Because permitting, financing and building a mine can take up to 10 years, analysts advise looking for companies already producing these metals or those likely to start production within four years.

Gissen recommends asking companies which permits they still need, how much capital they’ve raised and what is their specific path to production. Investors should also ascertain whether companies are prepared for the time-consuming and costly chemical processing required in rare earths.

Mining for rare earths also sparks strong environmental opposition because of the radioactive waste it often leaves behind, said Van Eck Global’s Lopez. This can raise serious barriers for companies seeking mining permits.

Still, if investors do their research, they could reap significant long-term gains, Gissen said. “Because of technologies discovering more applications for rare earths, it’s very likely that demand will increase. At the same time, the challenges in finding the metals and getting them into production are so enormous that prices will remain high. This is a good place to be invested.”