It seems so far away. In March, 2002, tech investors were deep in a second straight winter of distress. The Nasdaq had been cut by two-thirds in just two years. Tech was positively cryogenic -- and an irresistible draw for anyone hungry for companies with fresh technology. But which companies?
A consulting firm called CHI Research makes finding those companies its business. Two years back, when I asked CHI to share its top 10 tech-stock picks with BusinessWeek readers, half the names on the list were new to me. Yet CHI was on to something. Since then, its picks have returned an average of 59.2%, while the Nasdaq 100 and Standard & Poor's 500 indexes returned 4.2% and 6.1%, respectively. Each year since 2000, when CHI began issuing monthly buy recommendations to institutional investors (subscription price: $15,000 a year), it has killed the market averages. In 2003, as the average tech-stock mutual fund returned 55.9%, CHI's picks returned 162%.
HOW DO THEY DO IT? CHI uses a strictly quantitative method based on evaluating the strength of public companies' patent portfolios. Based in Haddon Heights, N.J., the firm got its start in 1968 reviewing patents for the National Science Foundation. It still consults for corporate clients, but its investment-research method, on which it has its own patent, is gaining renown. Here's how it works: Every month, CHI looks over the patents of 477 innovators, from mighty General Electric (GE ) to the likes of genomics outfit Lynx Therapeutics (LYNX ). It checks not just how many patents each company holds but what it refers to as "citation impact" -- how often they are cited in later patent applications. CHI also checks how many references a patent makes to academic papers, a way to see how closely to basic science the company is working. And it notes how quickly the companies exploit scientific advances by checking the median age of patents cited in their patent applications. Finally, CHI considers the companies' stock-price-to-book-value ratios.
Naturally, CHI's research isn't foolproof. Of the 10 picks listed in BusinessWeek in 2002, three had negative returns, including CHI's then-favorite, optical networker Ciena (CIEN ). Now, its favorites (table) include several biotech names, such as Maxygen (MAXY ), Transgenomic (TBIO ), and Caliper Life Sciences (CALP ), a repeat from 2002. Patrick Thomas, a CHI senior analyst, said basic materials companies lately are climbing the ranks. One is Arch Chemicals (ARJ ), which Olin (OLN ) spun off in 1999. CHI is keen on its patents for polishing copper-coated wafers and on the relatively low age of its patents -- indicating fast innovation.
Cabot, (CBT ) another name on the list that many investors may not associate with high tech, is a longtime producer of carbon black, a key material used by tiremakers. But Cabot also sells specialty powders for ink jets, fuel cells, and flat-panel displays. And it knows how to cash in on innovation. In 2000 it spun off Cabot Microelectronics (CCMP ), a supplier of polishing slurries and pads for microelectronics. Before the spin-off, Cabot had a market value of $2.2 billion. Within a year, the parent and offspring's total value topped $5 billion.
Expecting Cabot to hit another such lode is unreasonable, just as it's unlikely the NASDAQ will have another year like 2003 soon. Still, CHI's list strikes me as a good place for tech investors to keep prospecting.