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December 20, 2006

With Liquidity The Overriding Story Thematic Mariners Beware
by Brady Willett

The contradictions running wild today have rarely been more acute. To be sure, and depending on the source, the U.S. economy is supposedly already in recession, stocks are in a great new bull market, China is about to dump greenbacks for gold, and the commodities bull is dead but will last another 30-years. For yet another example of just how far the confusion stretches consider that Merrill's chief investment strategist, Richard Bernstein, recently co-authored a report covering ten "growth themes" with an "unrecognized twist", and that his first platform was to 'Buy large-cap stocks in developed markets'. That Mr. Bernstein has resorted to suggesting that large cap stocks have an 'unrecognized' safe haven appeal is, to say the least, surprising. After all, before the most recent rally large caps had underperformed for 6-years and everyone on Wall Street had already beaten this contrarian theme to death.

Suffice to say, as potentially dangerous amounts of liquidity in the marketplace congeal with a profound air of contradiction, attempting to smell out big theme opportunities is akin to trolling an overfished river at high noon: both the timing and location are unlikely to yield a catch. Mr. Bernstein - who has been more bearish than most since taking the helm at Merrill in 2001 - is hardly oblivious to today's unique challenges:

"...it is getting harder to find growth themes that have not already been exploited because of the continued abundance of liquidity and leverage".

But in the face of uncertain waters many on Wall Street are compelled to float investment idea that may - hopefully - benefit from the next major liquidity shift in the marketplace. Moreover, in many cases people like Mr. Bernstein concoct these themes regardless of whether they run contrary to their macro beliefs.

As the example below will show, finding an attractive and potentially under-covered investment idea can in fact be done. However, taking the plunge and actually investing is a different story altogether. The lesson is that many investment themes have become slaves to the overriding theme of liquidity, and in order to pursue many ideas you must believe that the good times are here to stay. For his part Mr. Bernstein has started to believe*, which in and of itself may be a sign that the good times are about to end.

Discovering Trees within the Forest

An alternative method of thematic extraction is to find themes within themes. As a quick example, consider the LCD industry, which is breaking out in America and is expected to grow strongly for the foreseeable future. Given that investors are already pricing growth into the major players, an alternative approach is to look at a key material used to produce LCD products: namely indium.

Then there is the solar panel boom, which - receiving more attention because of 'peak oil' - should continue to be an excellent growth story over the long-term. But again, investors may already be pricing in the boom into the obvious solar panel investments (for that matter, there is the risk that as rising raw material costs/shortages ebb and more capacity comes online that margins will quickly be eroded). As an alternative consider polycrystalline silicon (polysilicon), which is the key material used to manufacture most solar panels today.

From this general overview two less covered investment platforms are concocted: go long polysilicon and indium as they will continue to be in high demand because of growing solar panel and LCD consumption.

Getting More Specific

The next goal in theme research is to unearth fundamentals that may not otherwise be largely recognized by market participants. Admittedly this is not always easy to do, but here goes:

Deeper analysis suggests that next generation solar panels, thin-film CIGS panels, could soon be a serious challenge to polysilicon based solar panels. In response to current supply-chain restrains, these new panels will no longer require polysilicon, but will require a significant amount of - you guessed it - indium.

With the above knowledge/speculation the original investment theme evolves into the following: be extra bullish on indium. Or, to play on some of the analysis making the rounds today, aggressively buy Teck Cominco Limited and the profitless Avalon Ventures and sleep safe in the knowledge that today's liquidity driven mania will soon demand an indium ETF!!!

But Is Indium Really An Unsung Hero?

While indium could continue to paint an attractive supply/demand portrait in the years ahead, uncovering this bullish supply/demand story does not guarantee investment success. Quite frankly, and before you start loading your garage up with indium, it may be worth noting that the price of indium is already up by more than 1100+% since 2002. With the indium theme crafted, the investor needs to conclude whether or not it has already been exploited. This is a difficult conclusion to make not only with indium, but with many of today's hot themes (Excel).

Limitations to Theme Analysis in an L&L Driven World

As Coleridge said in 'Rhyme of the Ancient Mariner, "Water Water everywhere but not a drop to drink". In other words, just because there is plenty of liquidity in the markets doesn't necessarily mean that there are many attractive value investments to be found. Many theme profiteers will question this conclusion and argue that with the world changing new and exciting investment alternatives/themes are cropping up all the time. I concur. However, the world was also changing back in 2000/01, and investing most of the popular themes back then would have proven lethal.

Which brings us back to the battle between fundamentals and liquidity: as theme enthusiasts multiply and/or start believing that no price it too high, capital flows themselves (liquidity) can quickly become the only, and often times unpredictable, variable. For example, copper had supposedly become a hedge against a falling USD earlier this year and hydrogen was supposedly the only answer to peak oil a few years ago. In both instances many latecomers purchased the fundamentally attractive story while ignoring the fact that prices were being influenced by unsustainable liquidity flows, and in both instances many investors got hurt. Needless to say, copper bulls still have plenty to be excited about even though the price of copper has fallen and may never see $4/pound again, and hydrogen enthusiasts still have reason to be enthusiastic even though ringleaders like Ballard are more the 95% off their 2000 highs.

* Although he recently warned of an ominous peak in corporate earnings growth and fretted over the dangers of a liquidity and leverage driven marketplace, Mr. Bernstein tossed his apprehensions overboard last week (Reuters):

"This is the first time in several years that the target analysis has not pointed to a single-digit return".

After watching the liquidity auditorium take 4-years to fill, that Mr. Bernstein is no longer worried that a rush to the exits can, and likely will, happen quickly is remarkable. Fortunately the individual investor is not duty-bound to risk being harpooned by wadding into potentially treacherous waters. Instead they can watch $800 per kilogram indium sail by, and wait to land the rare glimpses of undervaluation when they appear. Some of these glimpses will be covered next week...

"I call investing the greatest business in the world, because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it." Warren Buffett.

Brady Willett
FallStreet.com

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