Beyond patents: a value investor's view
It has bemused me for some time why there is little to no correlation between patents and stock price performance. It would seem obvious that patent-protected products and services generate premium pricing, suffer less margin erosion and fulfil a clear unmet need (since, by definition, patents protect novel products). Accordingly, companies with many patents should perform better in the equity markets – but they do not. Just look at IBM.
Some of the surprising lack of correlation between patent quality, quantity and performance I ascribe to 'signal to noise' ratio. This is the amount of systemic beta in the equity markets that is driven by interest rates, liquidity, programme trading, external shocks (eg, oil prices) and human herd-like behaviour. But there is also another reason for the lack of expected correlation. Simply put, patents, while often portrayed as strategic assets that support innovation and growth, are in fact mostly tactical assets around older technologies that are used defensively to protect market share. This means that companies with many patents may live longer, but they are unlikely to exhibit the growth prospects typically associated with innovation. To put it another way, innovation, stock price and patents are not at all correlated.
That is not to say that patents are not valuable. On the contrary, the defensive attributes of patents can be important since if an investment horizon is long (eg, 25 years), it is the companies with the smallest drawdowns that perform better, as recovery from troughs takes a long time. If you can protect or cushion downside price movements with patents, you can survive and ride the market up when it gathers momentum. Thus, defensive patenting supports what can be best described as a 'beta-plus strategy'. In ruthlessly competitive markets, anything that blocks the other guy or allows you to toll new entrants is a plus. It is a zero-sum game where you protect your share, try to eat theirs, fall slower and then recover quicker on the bounce. But patenting is a double-edged sword in that it influences (or perhaps reflects and reinforces) a certain type of corporate culture.
I am all for invention disclosure and even paying inventors for patenting, but the ease with which a party can reach for a patent attorney is a bad thing. When filing patents is rewarded as a virtue in its own right, you quickly lose track of business outcomes. For many companies, filing is a lazy and inadequate solution to competitive pressure and as much about covering personal risk as it is about corporate value generation. To paraphrase, "no one ever got fired for filing a patent". For many companies, patent filing has become a universal backstop that masquerades for innovation management and takes the pressure off really managing the inventive process and linking it to the products and process that have tangible business impact.
Outside the Dow, in the growth-company world, zero-patent companies (ZPCs) often outperform both the index and their patent-protected competitors. This is precisely because they have no patent shield and, as a result, they must work harder and think more creatively. Interestingly these companies often acquire or backfill their patent arsenals when they become established in order to protect their position and extend their hegemony.
For ZPCs in the growth phase, however, patents are the enemy because they allow the better-resourced legal departments of multinational companies to toll more economically productive companies like them, and cement the incumbency of the old guard by virtue of superior balance sheets. This type of economic behaviour is a form of market and industrial colonialism.
Multinationals typically defend their enforcement actions by claiming that they should be paid for innovation and that their patent troves reflect a huge R&D investment. In some cases that is certainly true. But for many, it is not. I would challenge readers to identify the last true innovation from a major multinational (excluding Apple) that was worthy (in a disruptive sense) of patent protection.
These features of the colonial patent system are not all bad for investors. They help yield hungry investors and bond holders by supporting cashflow. Against a backdrop of shortening corporate longevity, it also seems that patent-rich companies survive longer then others. Of course there are exceptions such as Kodak or Nortel, but generally patents help competent management to eke out longer lives by continually re-protecting their franchise with more patents and by using the cash to buy smaller companies, execute stock buybacks or pay dividends. Their vampire-like immortality is a gift from the monopoly power granted to them by the courts. But such vampires do not outperform the stock market.
However, a cadre of IP-rich companies appear to buck the rule: Johnson & Johnson, L'Oréal, Reckitt & Coleman, Bank of America, Nestlé... what I would call 'soft IP companies' (SIPs). SIPs are primarily brand, trademark and trade secret-rich enterprises. While they certainly have some patents, they do not compare with the titans of patenting such as IBM, Siemens and Philips. What these companies all have in common is an integrated and long-lived culture of IP strategy that permeates the boards with such ubiquity that no one talks about intellectual property. No chief IP officer is required at board level because intellectual property is not relegated to the IP department – it is a business function commonly devolved across the organisation.
As UK fund manager FundSmith has shown, a portfolio comprising this cadre of companies can significantly outperform the benchmark. For SIPs there is a relationship between intellectual property and superior stock market performance; it is not just patent driven. SIPs' secret is found in brand management, trademark strategy, corporate culture, trade secrets and a management style that integrates these elements of IP value into normal business activity.
For those growth companies on the road from zero to one, the observations about ZPCs and SIPs are important. Do not get bamboozled into filing dozens of patents (unless your exit strategy is simply to sell your patent bundle to a better operator). Such activity is generally a distraction from the business of thinking hard about your business and managing it right. Intellectual property is important and will add significant value across the lifecycle, but your competitive problems will not be solved by the US Patent and Trademark Office. Embrace the challenge of creating an IP culture and building your organisation strategically around it, and the benefits will accrue.
For investors, the takehome message is to look beyond patents and use business sense. Well-managed businesses do better. These will be the winners. And no business can be well managed without an integrated and well-articulated IP strategy, so drop everyone who fails that hurdle. It really is that simple.
This is an Insight article, written by a selected partner as part of IAM's co-published content. Read more on Insight
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