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The Building of a Market

We believe the science of nanotechnology will transform many industries, disrupt others, and create an industry of its own in time. For us, it is very exciting to watch those scientific developments hit the commercial highway.

The faster it does that, the better it is for us as investors because it means products get made, profits get earned and share prices rise. Not only is it the American Way, but it's also the Rule Breakers way.

Therefore, we were disturbed by a recent report that fully 30% of nanomaterials (items such as carbon nanotubes and quantum dots) supplied to buyers were of inferior quality or, in some cases, were totally useless for the buyer's needs.

Not only does this delay commercial development, but it also creates doubt about the viability of scientists' claims. Telling the R&D departments of blue-chip companies that they need to start working carbon nanotubes into their product development only to deliver inferior samples is not good. It's how projects get left on the back burner.

However, it's also a truck-size opportunity for better suppliers with good products. They have a chance to "widen the moat," as legendary investor Warren Buffett said, meaning to increase one's competitive advantage.

From an investment perspective, the report of shoddy deliveries reminds us that nanofakers are still out there, making promises (e.g., a way to take advantage of the nanotech investing buzz). Yet they are unable to provide a product to their intended customers. That will eventually show itself in your investment if you make the wrong choice.

How to spot a dog
The key to distinguishing between a nanofaker and a nanomaker lies in two areas: intellectual property (IP) and partnerships. Companies with a strong IP portfolio are developing a commercial base and demonstrating that their products are built on sound science. But even rabid pack dogs will exude a veneer of top pedigree. In other words, they, too, will have some intellectual property.

So, do you have to become a patent lawyer in addition to a physicist, a chemist, an engineer and a biologist to find the right nano investments? It would help, but there are easier ways to uncover a dog's pedigree.

We can examine their mating histories (commercial partners) and how many litters they have produced (actual sales). Dogs with a bogus IP portfolio will fall short in those respects.

A few good ones
That's why we have high hopes for established nanomaterial suppliers, such as Nanophase Technologies (Nasdaq: NANX  ) , and for some private companies such as Carbon Nanotechnologies and Quantum Dot.

Nanophase has an established customer base, including BASF (NYSE: BF  ) , which has signed a contract to get 75% of its nano-oxide requirements for sunscreen products from Nanophase. We can and do argue that Nanophase's customer base is too small, and that it must reduce its reliance on BASF for real growth and development.

But at least we know Nanophase is not the one supplying inferior products. The same applies to Carbon Nanotechnologies and Quantum Dot. Despite being private, they, too, have an impressive list of clients to take advantage of their patented products and processes.

Weird science
If we contrast that with some other nano wannabes that issue news releases announcing this patent and that grant -- yet fail to attract meaningful commercial partnerships and pull in less than $100,000 a year in revenue -- we begin to see where the useless products come from.

Spare a thought, too, for the scientists working in some of these blue-chip companies who might be desperate to include nanotubes in their product mix to see the potential for themselves. They are stuck buying nanomaterials from another company. Their knowledge is so limited, they end up buying from companies that can't even make the product.

If the scientists don't know what they are buying or where, then what chance do we have to find meaningful investments from this nano thing?

Caveat emptor
When you read of a company doing great, new things with nano -- it is going to solve the homeland security issue, win the war on terrorism, and find the cure for cancer -- check out its IP portfolio and commercial partners and customers. Discount the companies that accidentally discovered they were a "nano" company after years as unsuccessful mining companies. Be wary of companies that suddenly added "nano" to their names, products, news releases, and annual reports.

Patents lead to products. Products lead to partners and revenue. If any of these is absent for a nano company you are watching, wait awhile for it to put all the colors in the picture before you invest in something that is likely to put the red in your returns.

About 11 months ago, our Foolish colleague Seth Jayson said "nano" was Greek for "100% increase in market cap." Nano is Greek, but it means dwarf. Seth, of course, was referring to nanofakers.

As exciting as it is to watch all this unfold, it is still undeniably frustrating. It will have to evolve as all other markets do -- by driving out the pretenders and leaving the best standing. That's when we invest in them.

Greater investment minds than ours preach the virtue of patience. In the meantime, caveat emptor, whether you are buying tiny materials or shares in tiny companies.

For other nano-market articles, see:

Carl Wherrett owns shares of Nanophase. John Yelovich doesn't own shares of any company mentioned. You can reach them both by email.The Fool has a disclosure policy.

If you're looking for the next growth company in groundbreaking fields such as nanotechnology, try our ultimate growth service, Motley Fool Rule Breakers.

Share your views with Carl (TMFBreakerCarl) and John (TMFBreakerJohn) on the Nanotechnology discussion board.

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