Nov

17

A new patent index was recently launched by Ocean Tomo:

The Ocean Tomo 300(TM) Patent Index, which is priced and published by the American Stock Exchange(R) (Amex(R)), is a diversified market-weighted index of 300 companies that own the most valuable patents relative to their book value. The 300 member companies have an average market capitalization of $21 billion and a median market capitalization of $7 billion. The Index is split equally between small cap, mid cap, and large cap stocks. The smallest member company has a market capitalization of $400 million.

According to the site, over the last 10 years it outperformed the S&P by 3.10% annually.

However, I have the following observations of this:

  1. Though this is one “value” index, a growth guy may embrace it as a measure of “growth” potential. I wonder if it suffers from the common value survivorship bias problem — especially when one considers that 2000 seems to account for its outperformance.
  2. Though it attempts to “measure” patents, I am not sure I endorse their measurement method. It would prove much more useful if it was somehow weighted by this measure, instead of simply market weight.
  3. Eyeing the comparison chart to S&P over last 10 years, it appears that it tracked closely until 2000 when it outperformed before underperforming through the 9/11 drop and then it outperformed again since late 2002. But this is hard to say without numbers.
  4. Considering the notion that stopping to tie your shoelaces hurts you only if you are going intellectually fast, (i.e. laying off people) I wonder if the outperformance in 2000 is due to employee job security in these companies and how the individual components are ranked on this basis. Though I suspect the stock and the index lead the lay-offs.
  5. It seems to be best of both worlds — it tracks the S&P when it dominated with growth stocks, and it outperforms the index when it dominated by “value”.

It seems a good idea, but hard to perfect, to try to measure a patents worth.

Allen Gillespie replies:

This is something we have been trying to understand for awhile, because I once read an article about the development of the steam engine. The idea was developed and patented in 1818 but not commercialized until 1831. There is a difference between having a patent and successfully monetizing a patent.

In short, I believe there are lags in the value of patents. Some patents turn out to be valuable, some do not. Sometimes managements reward shareholders, sometimes they do not. During the internet bubble (’99) we conducted a study of biotech stocks from the early 1990s. In our study we found purchasing a basket at the top eventually yielded a return over 7 years roughly equal to the risk free rate and closer to the market rate over 10 years, however, your results were completely driven by the success of a few ideas like Amgen and Biogen which developed multi-billion dollar products. Buying the same basket at the lows, when the market had sorted out what was valuable and what was not, produced returns in excess of 40%/year. Even the successful stocks like Amgen experienced 70+% drops.

Our study of Biotech and subsequently Internet stocks shows a similar pattern. An initial flurry in the stocks based on concept, followed by capital raises by investment bankers, a fall due to lack of profits, taming of euphoria by the increased supply of stocks, and finally recovery as the ideas begin to bear profits and managements are forced to show profits as opposed to developments.

One of the things we have noticed in our momentum studies is the tendency for certain stocks to reappear after a number of years on a much sounder financial basis (though it frequently doesn’t look like it at the time). For example, energy trading companies were high momentum stocks during the bubble period, collapsed, but then reappeared in 2003 as high momentum stocks as distressed recovery names.

Another company which illustrates the concept is SEPR. The company for years as been run more like a research company than a business, as they have maintained a very high plowback ratio into new ideas, now however management is beginning to run it like a business for the shareholders rather than the lab. Here are the earnings and stock price:

Year EPS High Low

1999 -2.77 70 29

2000 -2.80 140 45

2001 -3.19 81 23

2002 -3.11 59 3

2003 -1.33 32 9

2004 -2.05 59 23

2005 -0.11 66 48

2006 1.31 2007 2.18

Important times in the life of a stock are inflection points like when earnings can be anticipated to begin recovery or decline (because this creates an earnings slope) - at year end 2002 you had inflection from 2001, crossovers into profitability, and eventually new highs in profitability matter because the valuations get more compressed if the stocks do nothing or go down. Companies with new highs in earnings power can recover quickly from some fantastic declines.

Steve Ellison adds:

Patents are a one-dimensional view of intellectual property. Intellectual property also includes trade secrets, processes, and expertise. Pepsi has enormous intellectual property, none of it patented. Dell and Southwest Airlines became successful by perfecting processes that their competitors could not imitate because of constraints imposed by the ways of doing business that had made the competitors successful.

A patent measure can be gamed.

An ex-CEO trumpeted increased patents while cutting research.


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