Dynamite in Small Packages

Investors know to expect some market volatility, especially when firms promise the first commercial returns in a nascent science or technology. In the case of the nanotech sector, examples abound.

Stumbling stocks
Nanogen (Nasdaq: NGEN  ) , which is not yet a nanotech company, saw its share price jump nearly 300% in a matter of days in December 2003 on news that it secured a nano patent. In the last nine months, Nanogen's gain has eroded completely, and today, the shares are valued at less than what they were at the start of their meteoric rise. Now that's volatility. The stock fell after overeager and myopic investors clued in that a patent, although important in the long term, doesn't add a single cent to earnings in the short term.

In a similar story of unpredictability, Lumera (Nasdaq: LMRA  ) celebrated its IPO in July at an opening price of $6.95. But shares quickly fell to a low of $4.06, and then rose to $6.05 on Friday.

Clearly, individual nano stocks are not for the faint-hearted and only have a place in the high-risk portion of a portfolio. Still, is there some way investors can minimize the risk and avoid the roller-coaster rides? There are a few options, but we can only counsel patience for those looking for nanotech investment vehicles without choosing individual stocks from a limited number of companies.

Imploding indexes
For Merrill Lynch (NYSE: MER  ) , patience was in short supply when it made a hasty decision that at the very least embarrassed the company. On April 1, 2004, it launched its Nanotechnology Index (AMEX: NNZ  ) with fanfare.

The date couldn't have been more fitting, as the return has been something of an April fool's joke: The index is down 25% vs. the Nasdaq's loss of 5% over the same time frame.

Since then, Merrill Lynch has dropped and swapped several companies from the original 25. Just last week, it added Lumera, which produces proprietary polymer materials to optimize its electrical, optical, and surface properties. At least Lumera is a genuine nanomaterials company, which can't be said for four other firms Merrill removed from the list after discovering they weren't nano companies at all.

In March 2004, New York-based investment bank Punk Ziegel created its Nanotech Index, which is down 24% since its inception. Recently, the company added Lumera, along with Kopin (Nasdaq: KOPN  ) , Immunicon (Nasdaq: IMMC  ) , and Ultratech (Nasdaq: UTEK  ) , in its semiannual review of its Nanotechnology Index.

Neither of these products are investable. However, First Trust's Nanotechnology Portfolio does offer an alternative. We profiled the company's nano-inspired Unit Investment Trust (FUND: FTNATX  ) when it was launched in March. Since then, its returns are down only 15%, which is a little better than Merrill Lynch's or Punk Ziegel's indexes. This "better" performance is due to the index's several mega caps, which have far less volatility than the small- and micro-cap nano companies.

Fumbling funds
Outside the U.S., we know of three investable nano funds. All are from Germany and, in fact, were the first available worldwide. Activest created the Lux Nanotech Fund in September 2002, which is up 15% since its inception, but has fallen more than 18% so far this year, reflecting the sector's decline after the nano boom late last year.

In 2003, Hauck & Aufhauser created its fund, the Lux DAC Nanotech-Fonds, which is up 8% since its launch. However, its current star performer, Amcol International (NYSE: ACO  ) , states in its recent 10-K that sales are insignificant as they relate to its Nanocor subsidiary and provider of nanocomposite materials. Sales were so negligible, in fact, that Amcol stopped selling direct and offered the research to two new partners so they could develop commercial products from the materials. The nano sales still remain insignificant, yet Amcol's still included in the nanotechnology fund.

In May 2004, German bank group West LB launched a nano fund. Alas, it's also down since spring.

Punting to management
A final offering -- slightly different from funds or indexes -- gives an investor an immediate basket of public nano stocks and an entree into some private companies. Harris & Harris (Nasdaq: TINY  ) , a venture capital company, re-aligned its investment profile two years ago to focus exclusively on "tiny tech" investments.

In the new Rule Breakers newsletter, David Gardner teaches investors to "scout like a VC" and discover, in the early stages, future rule-breaking companies.

A stake in Harris & Harris might give you access to some rule breakers, but you still have to rely on management to pick the best developing nano companies to invest in. (Note that the majority of Harris & Harris' invested capital is still in non-nano companies -- a carryover from investments made prior to Harris & Harris' change of focus.)

Setting up a strategy
Of the few true nanotech companies, not a single one appears in all of the indexes and funds. To be fair, we're all in the discovery phase of the nanotech universe, and it's important to understand that each investing firm we've mentioned uses different criteria to try to establish a true nanotech index or investable fund.

The problem they've encountered, and the reason smart investors haven't rushed in, is that the nano companies are still at the stage of evolutionary nanotech vs. revolutionary nanotech. That is to say, although the products may work at levels smaller than 100 nanometers, they do not yet display unique properties that promise disruptive commercial applications. It is the potential of nano to provide the disruptive technologies that will bring forward the greatest investment returns.

So are there any promising nanotech investment vehicles? New market opportunities do exist for companies specializing in working at nano levels, and some of those names are included in the aforementioned indexes and funds. But those companies are not yet rule-breakers. That is why the companies in those indexes, with rare exceptions, collectively underperform the market.

If you're looking for the next growth company in ground-breaking industries like nanotech, then try our ultimate growth service, Motley Fool Rule Breakers.

Do you have high hopes for the nanotechnology sector? Share your views with Carl (TMFBreakerCarl) and John (TMFBreakerJohn) in the Nanotechnology discussion board.

Carl Wherrett owns shares of Ultratech and Harris & Harris. John Yelovich owns shares of Harris & Harris. You can reach them both by email.The Fool has a disclosure policy.


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