In December 2013 I contributed to a thoughtful paper authored by Pierre Ferragu, Bernstein Research, entitled "Deep dive into the licensing potential of Nokia’s IP portfolio: forecasting the unforecastable?” This exercise followed similar project work on Alacatel Lucent and preceeded the current Wall Street guessing game regarding BlackBerry. The experience of working with top-quality Wall Street analysts gave me pause to consider whether any metrics of IP health are meaningful for the mainstream investment community.
To answer this question, you have to get under the hood of what drives share prices – beyond the apocryphal 'fear and greed' thesis. In essence, aside from momentum (what Warren Buffet calls 'exuberance'), stock market valuations are driven by growth rate, cash-flow generation and credit quality. In other words, how fast is my investment growing, what is my dividend likely to be and how likely is the company to be around tomorrow?
While each of these metrics is affected by intellectual property in some way, the meaning of the relevant IP data to senior management can be as vague as an oracular prediction to the ancient Greeks.
Consider growth rates. Rapidly growing companies often lack formal intellectual property. The practice of 'backfilling' patent holdings as companies become successful has consequently emerged as a pragmatic strategy to deter litigation, particularly in communications technologies. In these situations, intellectual property behaves like insurance and is not a primary driver of market valuation. The exemplar of this strategy is Google, whose 2012 Motorola Mobility purchase provided valuable patents for defensive purposes.
This is not to say that growth is unrelated to intellectual property. Growth companies often derive their unique selling proposition from some form of unique intellectual property (where would Rovio be without Angry Birds?), but frequently competitive advantage derives from more subtle sources: an innovative business model, trade secret or even a patent filing strategy. This can be critical in category-defining first movers such as eBay and GroupOn, but much harder to quantify as industries mature – which is why 'disruptive' companies often take the market by surprise.
Cash-flow generation from intellectual property is a primary driver of stock price in many industries. Pharmaceutical companies trade on multiples of cash flow from current drugs with minimal value attribution to pipeline assets until the patent cliff approaches. Content providers such as Disney or ICONIX (or even Microsoft) are essentially royalty aggregators. Where cash-flow valuations are less relevant is where rates of growth are so fast that current cash flow is minuscule compared to the expected earnings of future innovations. Witness the valuations of Facebook or Twitter and their volatility as sentiment moves from bull to bear.
The idea that strong intellectual property leads to enhanced financial performance seems intuitively sensible, and this is the basis for emerging investment strategies (eg, the Ocean Tomo Index of IP-rich companies). However, many studies reveal no significant correlation between intellectual property and stock price performance. Moreover, commonly used IP metrics such as the number of patents filed or forward citations are shown to be unreliable indicators of performance at best.
One area where intellectual property does seem to have a demonstrable financial impact is on corporate longevity and survival.
The life expectancy of an S&P 500 company has fallen from 61 years in 1958 to 18 years today. Corporate longevity is threatened as product lifecycles shorten, accelerated by innovations in IP-protected technology. The skew given to survival data by IP-sensitive tech companies (including Compaq, Dell and Kodak) is significant, and it seems certain that intellectual property and the systematic exploitation of intellectual property have played a fundamental part in birthing new entrants and killing off others.
Underpinning corporate survival in this environment is a culture of innovation that welcomes change and innovates in anticipation of it. In Japan, such companies are known as shinise. Ironically, the poster child for shinise is a US company, Du Pont – where 30% of all revenues each year must be generated from intellectual property that is less than four years old.
Other companies have recognised the value of intellectual property as a driver of financial success, but adopted a strategy of acquisition rather than invention. The stock-price relevant intellectual property in these companies relates to a core competence of integration. Disney’s acquisition of Marvel, Pixar and Lucas Films is a case study in this strategy.
Away from the limelight of the S&P 500, many smaller, often family-owned firms have understood and mastered the art of capturing value through strategic management of intellectual property. This community includes some of the world's oldest firms, found in Japan and Europe. For example, the UK Tercenternarians Club includes nine firms more than 300 years old. Many of these companies are rich in trade secrets and have fostered ecosystems wherein unique skillsets reside, almost impossible to replicate elsewhere. The recent death of Loro Piana highlights a topical example of a family-owned business that nurtured and protected a monopoly of skills along the value chain from llama-rearing to cloth manufacture to build a dominant industry champion.
So does intellectual property confer value that can be translated into investor sentiment? My own view is that when studied carefully, the IP strategy of a company is the canary in the coalmine of success in R&D-intensive companies. Put another way, intellectual property matters as a lead indicator of the appetites, vision and talent of a company to exploit its R&D. Such companies are stronger and will last longer – but will they outperform? That question is not yet answerable.
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