The returns you can generate from investing in the right ASX penny stock can be huge. However, the trade-off is that these types of investments can be very risky.
One penny stock that I believe offers a compelling risk/reward for investors over the long term is Arafura Rare Earths Ltd (ASX: ARU).
It is the rare earths developer behind the Nolans Project in the Northern Territory.
The company notes that this globally significant and strategic project is underpinned by low-risk mineral resources that have the potential to supply a significant proportion of the world's neodymium and praseodymium (NdPr) demand. Once developed, Nolans will become a major supplier of these critical minerals to the high-performance neodymium magnet (NdFeB) permanent magnet market.
The NdFeB permanent magnet market is the largest market for NdPr oxide, and Arafura's product mix is ideally suited to meet demand from leading magnet producers in Japan and China, as well as automotive and wind turbine end users in Europe, Japan, Korea and the USA.
Why could this be a penny stock to buy?
I think Arafura Rare Earths could be a great long-term option due to the growing demand for NdPr and the lack of supply. In 2020, the total global supply of NdPr oxide was 46,000 tonnes. To meet projected demand in 2030, global supply for NdPr oxide needs to expand by a further 52,000 tonnes.
The company notes that this increasing demand is being driven by the permanent NdFeB magnets market. These magnets typically contain up to 30% NdPr metal and are shaping the future of the automotive and wind power energy generation industries.
In respect to the automotive industry, maturing powertrain technologies in the sector are driving growth for permanent magnet electric motors used in hybrid EVs (HEV) and battery EVs (BEV). This is being supported by leading automotive manufacturers across the world increasingly avoiding traditional petrol and diesel combustion engines for more efficient and cleaner HEV and BEV alternatives.
A testament to this is that Arafura has already signed agreements with Hyundai and Kia for almost half of its planned annual production that will be made available on long-term sale arrangements.
Recent capital raising
One of the reasons why I think now is a good time to buy Arafura shares for the long term is the company's strong balance sheet following its recent capital raising.
Earlier this week, Arafura received firm commitments for a $121 million placement to accelerate the Nolans Project development schedule. This will see the company's construction program kick off in 2023, which means production isn't too far off.
It is also worth noting that mining magnate Gina Rinehart took part in this capital raising. Her Hancock Prospecting business put $60 million into the placement, which leaves it with a 10% shareholding.
Given Rinehart's track record, I wouldn't bet against her on this penny stock.
