Investing in growth is a fascinating business, especially when focused on the realm of business innovation – new trail-blazing products, new redefining industry services, new next-generation business models, new democratizing platforms. It can be likened to a multi-dimensional chess game with an eye towards the future that cannot solely rely on current mainstream investment metrics or analysis frameworks.
Innovation investing requires specialized knowledge on the innovation creation and delivery process - which is a very unique business dynamic - and persistent attention to uncovering meaningful nuggets of ongoing insights buried in overwhelming amounts of data and noise. It also relies on finding the forward-looking talents of company managements that can create new demand and provide supply profitably in extremely competitive markets that are now driven by accelerating rates of change.
To learn more about innovation investing and the unique investment mindset and approach it entails, we reached out to Institute member Alfred R. Berkeley III, Chairman of the Investment Committee of Princeton Capital Management – a registered investment adviser and separate accounts manager for financial intermediaries, family offices, institutions, corporations, and endowments. Al and his firm focus on looking for companies that can discover and take advantage of major shifts in their markets and present key investment opportunities for growth investors. In our discussion, we explore their thoughts and perspectives on what indicators and frameworks they use to make better informed decisions that lowers risk and increases probabilities of innovation and investment success.
Hortz: From your perspective as investment managers, how do you characterize innovation? What do you look for?
Berkeley: First of all, it is important to note that innovation can occur in a product or service, in distribution, in marketing, in payment mechanisms, in client experience design, and in financing. When being successfully applied, innovation typically creates a new price-performance curve, often reducing costs while improving performance.
In our company research, we seek to understand whether a potential investment is “iterating” (doing more of the same); “innovating” (doing something new for existing customers); or “disrupting” (doing something new for previously unserved or underserved customers) thereby enlarging the market.
In general, we look for investments that fill important human needs, incorporate scientific and technological advances, and create compelling price-to-value combinations.
Hortz: Are there any sources of research that have informed your views on innovation and your investment process?
Berkeley: We are big believers in learning from the excellent academic analysis that has centered on business strategy with different academics focusing on various areas of business and innovation strategies. The academic community’s gift to the investment community has been the development of insights into the cause-and-effect relationships (theory) that lead to business success. These insightful theories or “signals” at times have emerged from what otherwise seems to be random “noise.”
We start with more questions than answers. For example, how should an investor think about market share? Emory Business School’s Professor Jagdeth Sheth’s work on the evolution of markets observed that markets move from local to regional to national to global with an observable characteristic: at each stage, just before the market moves to a larger arena, the dominant vendor has about twice the market share of the next largest competitor, which, in turn, has about twice the market share as the third largest, with all other competitors sharing the remaining scraps. When automobile markets in the United States were national, General Motors, Ford and Chrysler fit this pattern. Now the automobile market is consolidating on a global basis, with Toyota dominant, even in the US market. Frederick William Lanchester and Shinichi Yano’s work looked at market share from another perspective - that of “commercial combat” - and came to insights similar to Sheth’s.
Clay Christensen’s focus on disruptive technologies created theories about the value to be created by bringing unserved and underserved customers into the served market. Clay articulated theories about the basis of competition (capabilities, reliability, convenience, and cost) that are extremely useful in investing in evolving products, like batteries for electric vehicles. The theory of “jobs to be done” is another area in which Clay clarified ways for investors to understand the nature of demand for new products.
Mike Porter’s FIve Forces is a good way to assess the relative strength of an enterprise and look at which market participants garner the lion’s share of an industry’s profits. For example, many people observe that of the various participants in healthcare, it is the insurance companies that harvest the most profits even though we think that the doctors provide the most value added. Others might argue that drug discovery provides the most value added.
This academic work helps inform our thinking and helps us as investment managers to focus on probabilities (investing) vs. possibilities (speculation) through applying a proper mindset based on the actual, real-world business dynamic of innovation creation and delivery.
Hortz: Are there common characteristics for innovative companies?
Berkeley: Typically, we look for investments in which the vendor is offering so much capability, reliability, convenience, and value-for-money that it can command high economic rents over many years. For example, we have had good success with software companies that are keeping the required books and records for a class of customers, say hospitals or apartment buildings. If the innovative vendor is delivering good value, the customer is unlikely to switch vendors. High switching costs make revenues more predictable.
If these vendors are continually re-investing to stay current, they can have decades long associations with their customers. Said another way, we particularly like recurring revenues, perhaps subscription revenues that free vendors from starting from scratch each year. We like companies that are solving so many and such complex problems for their customers that the vendor can earn high rents for decades.
These companies tend to have a strong commitment to research and development and also a strong ability to buy into adjacent markets. Cisco is a good example of a company that both invests in development and buys emerging research. We also like to see a well understood “catalyst” or “growth driver” creating demand for the product or service.
Hortz: Does your research tend to lead you to particular areas of concentration or types of companies that cluster in specific areas or themes?
Berkeley: A portion of the portfolios we design use both information and communications services and health and life sciences companies to harness growth. These are major segments of the U.S. and world economies with significant unfilled demand and both are driven by dramatic improvements in the capability of evolving technologies.
Looking at healthcare there are many different approaches to take but we tend to look for companies bringing scientific breakthroughs to the market. Particularly promising ones are in the areas of diagnostics and therapeutics. For example, there is a tectonic shift in diagnostics from radiography to liquid biopsies where cancer cells can be detected much earlier in a cancer’s progression in a much less costly and more accurate fashion.
On the computing and communications front, our insatiable demand as humans to communicate and the thousands of our activities still open to computing automation, demand looks solid and durable. We have many choices here as we can look at the “bill of materials” that goes into a product or service. For example, we can invest in rare earths through AXT which are essential to high performance communications, or components like color touch screens made by Universal Display, or telecommunications carriers, or cell tower companies. The point being that our research takes us into the various segments and suppliers of the industries we invest in.
Because the way we invest in equities is so very knowledge intensive, we tend to find new opportunities when we are maintaining our knowledge on existing investments. We also hold interests in many other industries, often more mature, more generally understood companies, that we buy for diversification of innovation opportunities.
Hortz: Can you share some more examples of the types of companies in your portfolios?
Berkeley: The compounding power of microprocessors applied to both computing and communications reaches much farther than the market share giants of Google, Facebook, or Amazon. The cellular radio telephone tower companies are a good example. They are a specialized real estate business or, essentially, digital railroads carrying data rather than freight. They typically see their revenues grow as telephone and data traffic grow. They offer investors less volatility in their share prices than do technology companies selling products.
In our healthcare holdings, we invest in both diagnostics and therapeutics. Big gains come from drug or vaccine discoveries that work, that cure or prevent disease. Large, solid businesses can be built on diagnostics as well.
We like investments in oligopolistic industries, where the concentration that almost always occurs has run its course and are beneficiaries of product pricing freedom. The leading companies in these industries often produce reliable income for years. High market share holders typically capture disproportional shares of earnings and cash flow. In a sense, it is about the reliability of growth in free cash flow.
Hortz: What are your views on portfolio construction and risk management?
Berkeley: We think a lot about portfolio construction. We have clients that come to us for wealth preservation; others have come for growth, and some want a very aggressive, very focused innovation portfolio. We try hard to understand the client’s risk tolerance. We tend to be long term investors, and we add to existing holdings when we believe fundamentals are intact and the general market is speculating on bearish sentiment. We tend to trim existing holdings when we believe fundamentals have changed and the general market is speculating unreasonably.
What we do not do is to time the market by moving in and out of cash wholesale. As I like to say, I was a lot smarter when I was a lot younger. I am too stupid to time the market speculatively. We are fundamentalists: We look to the management teams in which we invest to create demand and fill it profitably. We are investors looking at the supply of goods and services in the markets for goods and services. We are not speculators looking at the supply of bids and asks in the financial markets.
Hortz: Can you offer any recommendations to advisors on how to communicate innovation investing and integrate this approach and mindset into clients’ portfolios?
Berkeley: Innovation-based investing requires an active investment approach driven by specialized innovation knowledge. It also requires persistent attention to company managements that are anticipating the future and can create and deliver new solutions and revenue streams into their marketplace. As we discussed before, it is an investment approach with a practical focus on probabilities (investing) versus possibilities (speculation) through a singular mindset trained on the nature and mechanics of business innovation.
We offer advisors and their client the benefits of investing strategically utilizing in-depth innovation research and well thought out portfolios geared towards important innovations and the management teams that can seize investment value from innovation creation and delivery. These innovations can be seen as major drivers towards long-term growth trends for the U.S. and world economy and can position investors to capture some of that growth for their investment portfolios.