Nanotechnology investing: What about risk warning?

The other day, as I was looking through the web at trends at emerging technologies, I came across a research comment written by a Motley Fools contributor, Jack Uldrich. The comment dealt with the acquisition by Arrowhead Research, publicly listed company (NASDAQ: ARWR) specialised in nanotechnology, of another privately held firm, Carbon Nanotechnologies. The acquisition was presented as a “Carbon Coup for Arrowhead,” with the clear implication that Arrowhead was a good way to invest in nanotechnology. Of course, an usual disclaimer about risk was tucked at the bottom of the page, but the comment was included in the”High-growth investing” section of the site and its general tenor was upbeat. Furthermore, it was republished under company news at Yahoo Finance.

Yet, I, for one, would be very careful before investing in Arrowhead. The company had 2006 revenues of 595 000 dollars, which represented a 7% increase over 2005. A quarterly analysis confirms the sluggish growth. It looks like the booked revenues are not from commercial sales but from research projects. Losses on the other hand are growing nicely, from 2.1 million in 2004, to over 9.1 million in 2005 and some 21 million in 2006. The market capitalisation of Arrowhead is 157 million dollars (as of March 23, 2007) which represents a whopping price/sales multiple of 445.

All this suggests that Arrowhead is not ready for the prime time and is an extremely risky investment. And the risk is cumulative: emerging technology, which, for all its hype, is not yet deployed commercially, offered by a small and untested company. Anybody investing in Arrowhead should not only be patient but prepared for disappointment.

I have a relevant personal experience with a similar company, American Superconductor (NASDAQ: AMSC), which is worth recounting. Founded in 1987 by two MIT professors, AMSC has developed a revolutionary technology for a (relatively) high temperature superconductivity (HTS). This technology has a potential to solve a critical problem of inefficiencies in electrical power transmission and generation. The company went public in late 1991 and I bought a stock few months later. Until the late 1990s, the stock moved in a trading range, so I got impatient and sold it at slight loss. This was of course a wrong move. Pushed by the Internet boom, AMSC took off like a rocket in the mid-1999 and reached an all-time high in early 2000 (at 500% of its IPO price) before collapsing. Today (late March 2007), AMSC trades roughly at the level of its IPO price. The company is very active and has been acquiring smaller players. Its 2006 revenues are over 50 million dollars but there is no pattern of explosive growth. And AMSC continues to lose substantial amount of money, 30 million dollars in 2006. It looks like for all its promise and potential, the HTS technology is still not deployed on a large scale

It is possible that Arrowhead’s trajectory will resemble that of Internet start-up rather than that of companies seeking to deploy high-stakes industrial innovations such as AMSC. However, past evidence suggests that this is unlikely to be the case.

This brings to me to a final point about user-based rating systems such Motley Fool”s CAPS. Such systems do not pay sufficient attention to risk factors, thus overlooking a key aspect of financial investing: the tight coupling between risk and return. Such coupling is absolutely essential for emerging technologies but it also matters for mainstream stocks.