Absolute-Return Investing in Longer-Term Trends
James Fitzpatrick & Hugh Fitzpatrick
TWST: Please begin with a brief introduction to Princeton Capital Management, including some highlights from the firm's history, a bit about your role there and your total assets under management.
Mr. Hugh Fitzpatrick: Princeton Capital Management was founded in 1988 by Jim Fitzpatrick, who after a long career in New York City working at Moody's, Smith Barney, Citibank and lastly managing the YMCA Retirement Fund, retired - but not retired - in 1988 to found Princeton Capital Management. We've been in Princeton since 1988 managing assets for high net worth individuals. We are growing the firm to transition from working solely with individuals to managing assets for RIAs, family offices, consultants and smaller institutions as well.
We are currently in two wrap programs. We intend to build an institutional business, but I expect we will always relate to a blend of both individual and institutional clients. As a small firm, we all wear multiple hats. Jim and I relate to both clients and serve as a part of our investment team focused on finding appropriate investment opportunities for clients. We currently manage $200 million in assets.
TWST: Would you just provide a little bit more information about the three investment strategies that you have referred to on your Web site?
Mr. Hugh Fitzpatrick: Before I talk about our three strategies I would like to briefly talk about our investment philosophy and process, as they are integral to both who we are and what we do. We are strategic investors, and our objective is to make money for clients or to provide absolute performance instead of relative performance against a set benchmark or index.
Accordingly, we invest differently from many managers. We utilize focused portfolios of 25 to 35 companies incorporating what we believe to be outstanding companies, possessing sustainable competitive advantages, led by managements who truly understand their business and focus on building value. We select these companies from sectors and industries that are supported by strong long-term fundamental demand trends.
Risk appraisal suffuses all we do, hence, our primary consideration is what is the appropriate price paid for the investment against not only its own opportunities but all alternative opportunities. Succinctly put, it might be phrased as: We look to ride only in streams with strong currents and in boats able to maneuver safely in continually changing cross currents, that we can get in before others do so, and the price goes up accordingly.
Each of our offerings address differing investment objectives and risk profiles. Core Equity is designed as a wealth-preservation strategy. Its primary focus is to provide downside protection in times of market stress, yet participate fully in rising markets over a full market cycle. It blends both large-capitalization, growth-oriented and dividend-paying companies to generate yield and an income stream. The objective is to be defensive yet still have the capacity for capital appreciation. For these clients we own utilities and household names such as DuPont (DD) and General Electric (GE) amongst others.
At the opposite end of the investment spectrum, we offer an aggressive wealth-creation strategy we call Young Enterprise Shares. The strategy is uncommon in that it invests only in smaller, rapidly growing, human-creativity-driven companies focused on the life and physical sciences. There are no household names, but these companies are used in homes every day. The focus is only on companies that are significantly transforming society through innovation or creating what we refer to as "tomorrow." In many ways, it is akin to investing in a venture-capital-like manner, but only in public securities.
Our third offering is Growth Equity, which invests without market capitalization restrictions in companies that we believe have significant opportunities for growth. This strategy can incorporate both the growth-oriented companies from our Core strategy and the more mature, developed small companies from our YES strategy. With the three strategies we have what we feel to be product offerings that can address a diverse spectrum of investment objectives and risk profiles.
TWST: The YES strategy would be more early stage companies and when you say science, do you mean biotech, do you mean technology?
Mr. Hugh Fitzpatrick: In the physical sciences, in the broadest of terms, we invest at the forefront of the demand curve for faster, smaller, clearer and safer. So it would be semiconductors broadly defined, it would be communication chips, it would be cell phone components. We invest in display technology for cell phones and TVs and lighting, be it LEDs or OLEDS. It puts us in the cloud computing with disk drive data storage companies and Internet security. On the health care side, it would be medical devices and biotech companies ranging from stem cells, to vaccines to therapeutics.
Mr. James Fitzpatrick: These companies are small because they are young, their product lines are fresh, and every aspect of this offering is scientific involved. So the driving force comes from either the creativity of products or from creativity of applications and products plus solutions. This is our only offering where science is everything - science is essential for selection.
We've recently tried to minimize the enterprise risk by not investing in such early stages as we once did. In the health care area, sometimes if the product in gestation is a terrific product, we will be precommercial to introduction of the product. But product must have a highly probable, very significant commercial stage ahead of them. Normally, the companies we select are for the most part through the early adoptive stage into the rising adoptive stage, and the rates of growth are accelerating or expected to accelerate soon. In today's marketplace, most people give it a small-cap or micro-cap label. They are very small because they are young. We are not so size critical. This has to be constraining, and we prefer to invest with no constraints as we look for opportunities in any strategy. But some are quite small to say the least.
Mr. Hugh Fitzpatrick: Regrettably, we sometimes get pigeonholed as "technology investors" when we own many decidedly nontech holdings in client portfolios. YES is really a carve out of our generalized work for our Growth Equity strategy where clients use these as part of their holdings depending on their degree of risk tolerance
We invest utilizing both a top-down and bottom-up perspective. Earlier, we mentioned demand trends and business model. Accordingly, we see mankind's innate drive to enhance and extend our lives through scientific discovery as essentially part of our DNA and one of the most enduring demand trends we know.
A "better mousetrap" has always provided a competitive advantage and can be a key component to having a better business model. From both a sustainable demand trend and business model perspective, we believe scientific discovery drives value creation for both society and investors.
We utilize science across the board in client portfolios for this specific reason. However, it is not the only trend we look to, but one of several.
TWST: Would you walk our readers through your stock-selection process? You said you look at investments from both a bottom-up and top-down perspective while you evaluate each stock from three perspectives. Would you explain that?
Mr. James Fitzpatrick: In addition to finding enterprises that are growing at higher-than-normal rates of speed, we also try to invest in those parts of societies that are growing rapidly or consistently. So in research terms, if we categorize them for America, I rank them sort of this way for scale: communications broadly defined, health care broadly defined, agriculture, information technology and also out there ahead of us is a new huge market - lighting and displays. Of course, always there are few specialties that do not fit in nicely into any other themes but could be classified as enduring, such as utilities or providers of services - a UPS (UPS) or Amazon (AMZN). We do relatively little in energy, even though it benefits from a growing demand trend.
Mr. Hugh Fitzpatrick: From a top-down basis, we assess both an ever-changing world and a changing environment's impact on long-term demand trends, with the view that you want to invest with the wind at your back, not in your face. We're looking for trade winds, not puffs of winds, to support the companies we invest in. In terms of the industries Jim referenced, we look up and down the ecosystem to find companies with appropriate enterprise and valuation risk profiles to suit investor's objectives. We analyze a company's business model or what's special about the company, what's the proverbial moat around the castle, or what enables them to grow their business in an increasingly intertwined and competitive global world. That exceptional attribute could be anything from a product offering, size and scale in an industry, or intellectual property. Management is a key determinant in our business-model analysis. Do they really know the businesses they are in, and are they properly motivated to create value?
Mr. James Fitzpatrick: We do like to invest in companies when there is a fairly concentrated number of participants in an industry. Boeing (BA), which we own, is a good example in aerospace - there are really only two or three places to buy an airplane. Rails would be another good example. If you are going to transport raw materials, there are there are only four or five railroads. We own two rails. We own Union Pacific (UNP), and that's the best of the rails. It has the best interconnection with Mexico and the best interconnection with Asia. We also own Canadian Pacific (CP), which goes through the materials-providing part of Canada and terminates at salt water in Vancouver, another favorable gateway to access Asia. So that's a way of also investing in a more rapidly growing part of the world without taking the risk of foreign governments' decision regarding pricing of materials or goods. But Asia brings a long-term demand driver supportive of those two railways that no other rails have.
Mr. Hugh Fitzpatrick: And then lastly it's valuation. We focus on enterprise and risk valuation. What are the opportunities ahead of the enterprise? How will it fare in and respond to a rapidly changing world? What do we pay for the opportunity, and what do we pay for it against alternative opportunities? In looking at the larger companies, we spend most of our time focused on valuation risk, and in the smaller companies most of our time is focused on enterprise risk.
TWST: Would you give us few more examples of the firm's holdings that are representative of the selection process?
Mr. James Fitzpatrick: There are no boundaries on this, but let's start with communication. This is an always-growing industry. The number of messages sent has never gone down in your lifetime or in mine. Usage begets usage. This is driven by ongoing facilitations as provided by voice and data carriers and personal devices. So we have cell phones and tablets that are driving the industry at one end, and massive systems that are driving it at the other end, often through communication devices that weren't available until recently on something called an Internet that was in gestation 25 years ago. We invest in the biggest providers - the telecoms AT&T (T), Verizon (VZ) and Vodafone (VOD) - companies currently with yields of over 3% to greater than 5% and what we see as certain growth.
We invest in the critical components of the Internet and the components of mobile devices - JDS Uniphase (JDSU) and RF Micro Devices (RFMD) and TriQuint Semiconductor (TQNT). We don't generally invest in the end products, as the end products companies are too competitive. The expansion of the Internet leads us to something called cloud computing. It's open ended
it's storage of anything you wish at almost zero cost. We own the controllers and disk drives companies Fusion-io (FIO) and OCZ Technology (OCZ) that manage the massive systems required for data storage.
The other critical aspect of the Internet is security of the Internet itself, data transmission and the safeguarding of stored data. So we own CACI International (CACI) to invest in cybersecurity. That's of the highest importance and works with the most secretive of American agencies. We know them to be the best in the government's defense business, and their excellence doesn't exist anywhere else. Similarly, we own Computer Sciences (CSC). They do a lot of cloud work and cybersecurity
they do a lot of what they call in the industry bread-and-butter business, corporate and government systems integration and maintenance. In information technology, generally speaking, the massive companies are the ones that are changing life around the world. We own Google (GOOG) and Amazon. We don't own, but should have owned, Apple (AAPL). These are driving forces that are bigger and larger than life and are changing the world everywhere.
Mr. Hugh Fitzpatrick: Just to elaborate, along with Fusion-io and OCZ, we also own STEC (STEC) in the disk drive data storage area. When we find a trend in smaller emerging companies with greater degrees of enterprise risk, we hedge our bets to dampen our risk, so to speak, by riding more than one horse. So those three together give us terrific exposure to data storage, data manipulation and cloud computing.
TWST: On the flip side, what companies would you not be interested in right now? You said energy was one of them.
Mr. James Fitzpatrick: We do very little in energy. Buying Exxon (XOM) or Chevron (CVX) is riding the swings of oil prices. Demand is evident, but volatility is evident as well. The influence of geopolitics and governmental policies makes it difficult to value energy intrinsically. The influence of government has been pernicious in this area for decades.
Mr. Hugh Fitzpatrick: We are really on the sidelines in energy right now. We don't own financials nor expect to. We haven't owned financials since the early 2000s, because it was too difficult for us to fully evaluate balance sheet risk. Many say they are cheap now - and they may be - but we continue to think that the financials, certainly the large players in the banking system, are going to be under continued pressure from government and international regulatory authorities. Banks will have a difficult time making money in their traditional lines of business. We are also not in consumer stocks because they are driven by the rise and fall of consumer demand and too economically sensitive.
Mr. James Fitzpatrick: Investing is an additive process, and we have found that focusing on select industries serves to incrementally build our knowledge base. As a small firm, rather than being an inch deep and a mile wide, we prefer to be deeper than wider. We believe an investor can only have so many truly good ideas. We manage portfolios of 25 to 35 companies investing where we think the greatest opportunities lie. We have been, and continue to expect to be able, to find sufficient opportunities in the areas we focus on.
TWST: What strategies do you use to manage risk in the portfolios?
Mr. James Fitzpatrick: The risks are very different in each of those strategies. The risk appetite and tolerance of the client is different. So it's the client that determines how we select the strategy for them. But within these strategies, there is almost no enterprise risk in Core Equity. We try to manage risk by concentrating on enterprise and valuation risk. The risk is overpaying for the opportunity. Currently, the portfolio is focused on dividend-paying stocks. It is uncommon that investors now have the opportunity to obtain higher yields from dividends than from owning the underlying companies' bonds. Today, we are getting paid to wait until the issues before us and uncertainties dissipate.
In Growth Equity and YES, we incur degrees of enterprise risk for the sake of what we see as a multiple in the gain. But the enterprise risk even in YES is measurable and calculable. If that begins to run against us, we can cash out. We don't do any lock-ups. In marketable securities, the telephone is the cure - we can sell. We control risk by investing as much as possible in single-product companies or in industries with limited competition by calling on managements and knowing the companies we invest in.
Mr. Hugh Fitzpatrick: One more comment on risk. We do all that we can to try to mitigate risk. We believe that by investing in supportive demand trends, we have degrees of downside protection in times of uncertainty or when the economy turns down. We also try to invest in several entities within a space so that we are not riding one horse per se, as I mentioned before with the data disk drive companies, or UNP and CP in the rails. We try to invest away from the hypercompetitive big businesses where competition squeezes margins. We also believe that broad diversification guarantees exposure to risk. With a focused, narrower portfolio we can mitigate risk by reducing our degrees of exposure. This may engender "benchmark risk," but we do not manage against indexes nor seek to provide index-like returns. We have found this approach has been beneficial to clients over time.
Mr. James Fitzpatrick: The easiest risk to avoid is the most common of risk, and that's overvaluation. Valuation is critical to our entry and our departure from this type of shares. So that's the risk control, the most commonly used of all, the most effective use of all. We buy mispriced stocks - that is, stocks cheaper than we think they should be. If they capitalize the future fully, we let them go.
TWST: Would you give us an example of your sell discipline by naming a stock you recently sold?
Mr. James Fitzpatrick: We recently sold our position in Novozymes. It had a prestige value that we thought was excessive at that time. We might go back into it. We also sold Nuance (NUAN), which has gone from $10 since we first owned it, and we have traded around the name, to touching $30. Nuance has almost a $9 billion of market capital against almost a $1.5 billion revenue run rate. It is doing fine, but that's too rich a price even for a good growing company. We didn't sell it because anything's wrong with the company.
TWST: Would you like to add anything?
Mr. Hugh Fitzpatrick: Yes, to elaborate in terms of Novozymes, It's an European industrial enzyme manufacturer and in a space that we are very much wanted to be. But we felt that, as it had held its value relative to other holdings and DuPont's recent acquisition of a competitor Danisco, would increase competitive pressure. We swapped it for Crown Castle (CCI) to add another cell tower company to the portfolio. We already own American Tower (AMT). Cell tower companies are a nice conservative way to play the transformation from 3G to 4G and benefit the from increasing demand for data and voice communications. There is the expectation of a dividend coming from Crown Castle in the not-too-near future as well.
TWST: What is the most challenging aspect of your job at the moment, and how do you deal with that challenge?
Mr. James Fitzpatrick: I would say the greatest challenge we have is the same challenge that everyone else faces. Our market is structured ridiculously. People are buying and selling stocks based on computer driven algorithms and don't pay any attention to what they're buying and selling. It's risk-on-, risk-off-driven markets. The use of derivative securities is still a huge issue in spite of the difficulties they led us into in 2008. To the extent that leverage beyond anything that makes sense and the lack of visibility or transparency makes market calls very, very difficult. That's where the volatility has its greatest force. So the same crowd that gave you the collapse in 2007-2008 is still conducting itself with privileges that I had hoped would be addressed. So we haven't fixed that yet. That's everyone's challenge.
TWST: Would you like to add anything to that?
Mr. Hugh Fitzpatrick: To expand on that, the challenge that we face is that investment time horizons have shrunk. We are long-term investors, looking to find companies with something special about them, letting managements build and grow their business. With shorter-term investment horizons and the market structure we have in place today, it is an increasingly difficult to explain or justify what is going on to investors. This is driving people out of the market to what we fear might be their detriment or to index funds and ETFs. There is still a very positive case to be made for truly active management. Our philosophy and processes have stood the test of time, and we see no reason why thoughtful investors adaptive to a changing world cannot continue to do so.
TWST: Is there anything you would like to add?
Mr. James Fitzpatrick: Thank you for your questions and interest. We look to a more positive future. All the best in 2012.
TWST: Thank you. (JM)
Co-Chairman, Investment Committee
Princeton Capital Management, Inc.
47 Hulfish St.
Princeton, NJ 08542
(609) 921-9502 - FAX