By David Sterman
An ideal portfolio contains a nice blend of mature, established companies and younger, fast-growing businesses. To round out your exposure, why not also load up on young upstart companies that are still not ready to go public? When they do, the initial public offering (IPO) can often deliver an embarrassment of riches to investors.
But how can individual investors own shares of companies that aren't yet publicly traded? Well, quite easily -- simply by owning shares of publicly-traded firms that act as Venture Capitalists (VCs). A pair of VC-like firms has established impressive track records, and their current roster of private investments could possess major upside when the economy turns up and the IPO market is flourishing.
A focus on tiny technology is why New York-based Harris & Harris (Nasdaq: TINY) chose its ticker symbol: it focuses investments on companies working with advanced miniaturization technologies, such as nanotechnology. The premise behind nanotech was simple. Scientists had found ways to develop ultra-tiny particles that could be used in a range of biotech, industrial and cosmetic applications. We're talking smaller than "micro." Smaller than "milli." You have to go down below the width of a human hair, or one millionth of a meter to get a sense of just how tiny nano-particles are.
A decade ago, this investment firm generated ample buzz, and its shares soared past $25. These days, the stock trades for around $5. As it turns out, few companies have succeeded in commercializing the technology. It didn't help that the investment firm kept finding new opportunities throughout the last decade, but saw only one holding go public.
But the timing may finally be good. Harris & Harris currently owns stakes in 33 businesses (half of which currently generate revenue), and the process of bringing them public or selling them finally appears underway. A pair of holdings, Neophotonics (Nasdaq: NPTN) and Solazyme (Nasdaq: SZYM) recently completed IPOs. Another holding, Biovex, was recently acquired by Amgen (Nasdaq: AMGN), while Innovalight was bought by DuPont (NYSE: DD). [My colleague Ryan Fuhrmann recently wrote an excellent bullish piece for DuPont. Go here to see what he had to say...]
In recent quarters, a number of Harris & Harris' still-private holdings have made considerable progress. (Visit the home pages of companies such as Nanosys, Bridgelux, Ensemble, Cambrios Technology and Laser Light Engines for company-specific progress reports.) As a sign of that overall progress, Net Asset Value ((NAV)) has been steadily rising recently as its holdings get upward valuation revisions. (Look for an update when quarterly results are released on Aug. 12.)
Valuing the company's holdings is more art than science. All assets must be valued at "fair value" as determined by the Board of Directors' Valuation Committee, which is comprised of independent directors. Every quarter, the committee issues an updated NAV for the whole firm. In the past 10 years, Harris & Harris has traded for an average of twice its NAV (with a move up to five times NAV at the height of the nanotech bubble). Nowadays, shares can be had for just 1.1 times NAV of $4.73. Analysts at Needham figure shares deserve to trade at 1.7 times NAV, or $8 a share, more than 50% above current levels.
Safeguard Scientific (NYSE: SFE)
This Pennsylvania-based investment firm was a highflyer during the dot-com boom, with shares briefly surpassing $400, thanks to stakes in some companies that pulled off richly-valued IPOs. Many of the dot-com holdings eventually flamed out, and shares skidded to around $2 at the bottom of the 2008/2009 economic crisis.
These days, Safeguard is looking a lot healthier as its portfolio of companies start to make real progress. Unlike Harris & Harris, Safeguard Scientific has now chosen to cast a wider net, seeking investments in a range of technology and biotech niches. The firm seeks business models that are on the cusp -- or already experiencing -- rapid sales growth. On an aggregate basis, the collection of privately-held firms boosted sales 30% in the second quarter from year-ago levels.
The track record is enviable. In the past five years, management has invested roughly $270 million in its portfolio of investments, while also harvesting $600 million in profits. Asset sales have pumped Safeguard's balance sheet (which now sports $263 million in unrestricted cash), enabling the company to keep investing in the next wave of young start-ups. (Management looks at more than 1,000 potential deals every year.)
A recent flurry of asset sales allowed Safeguard Scientific to book nearly $6 a share in profits in the second quarter. This may be it for a while, as few late-stage holdings remain to make imminent exits, but much of the portfolio looks set to ripen in 2012 and 2013.
Unlike Harris & Harris, Safeguard Scientific doesn't apply a rigorous updated assessment of the value of its holdings. An investment in the stock is largely predicated on trust that management can continue to secure strong returns on its investments. If recent history is any guide, that's a good bet to make.
As is the case with traditional venture capitalists, these business models are most effective when the IPO market is strong, or large established companies look to acquire younger upstarts. Without that backdrop, shares of these firms could languish for a stretch, as has been the case in the past. So these are best viewed as long-term holdings and not short-term trades.