Mining The Vein Of Great Ideas

Patents can clue smart investors in to the Next Big Thing from innovative companies

In an intensely competitive global economy, the surest path to boosting a company's profit margin and stock price is a steady stream of novel products and inventive services. Think Apple Computer Inc.'s (AAPL ) iPod line and Google Inc.'s (GOOG ) lightning-fast search engine.

How can investors get in early on corporate innovation before a stock takes off? You could look for companies that spend heavily on research and development. But there is no simple correlation between increased research and development spending and higher stock prices. In fact, stepped-up R&D often depresses near-term earnings because those costs must be expensed now while the payoff of new innovative products could be years away. Besides, much R&D spending produces nothing that customers want.

MEASURING SUCCESS

That's why in recent years sophisticated investors such as hedge funds and mutual funds have been seeking an edge in the market by looking at R&D through the prism of patents. The U.S. Patent & Trademark Office (USPTO) awards patents to original ideas, granting the creator property rights for the innovation over a long time. In a sense, a patent is a gauge of R&D success. "Patents are an output measure rather than an input measure like R&D," says Patrick Thomas, principal at 1790 Analytics, a consulting firm that studies patents for hedge funds, institutional investors, and the like. (Why 1790? That's when George Washington signed the first U.S. patent, issued to Samuel Hopkins for a new method of manufacturing potash.)

The first trick is for investors to separate out the patent diamonds from the patent zircon. There is a lot of the latter, too, since the USPTO received a record 406,302 patent applications in fiscal 2005, up from 236,679 a decade earlier. Research shows that a key indicator of a genuinely innovative idea is how often a company's existing patents are cited in future patent applications. (To give just one historic example of durable ideas, 32% of Thomas Edison's patents granted between 1910 and 1930 were cited in patents awarded from 1976 to 2002, according to Tom Nicholas, an assistant professor at the Harvard Business School.) This is a key insight behind the patent Pipeline Quality index developed by 1790 Analytics. Other factors that affect the measure are a patent's originality, general applicability to different fields, and the growth trend in a company's patent activity.

In any list, it's hardly surprising that technology and biotech figure prominently in generating consequential patents. Yet every industry has its own idea factories. Take Weatherford International (WFT ). The oil patch company has a strong market position in improving the efficiency of marginal deposits in the U.S. and elsewhere, according to Morningstar (MORN ). Weatherford has tripled its R&D expenditures and more than doubled its patent activity over the past five years, mostly in advancing oil-field technology. Over the past 60 months, investors have rewarded Weatherford with a total return of 109%, vs. 3% for the Standard & Poor's 500-stock index (MHP ).

Companies that hit a rocky earnings patch are intriguing. International Game Technology (IGT ) is a formidable innovator in the gaming industry. Yes, its earnings were essentially flat in its fiscal 2005, and the maker of slot machines and other games is down 12% so far this year. But IGT spends more than twice its rivals on R&D, and it has increased by eightfold the number of patents it has issued annually since 2000, according to ipIQ, a New Jersey-based consulting firm that analyzes patents and intellectual property.

The list of innovative companies with high Pipeline Quality includes some old-line industrial companies, too. Deere & Co. (DE ), the world's premier agricultural equipment maker, got that way through its long R&D tradition. In fact, John Deere, the company's founder, filed his first patent application in 1864.

CLASSIC EXAMPLE

A good grasp of the quality of a company's patent portfolio is valuable information to investors. But that isn't enough. Companies need marketing, production, and other skills to capitalize on those ideas. A classic example is Sun Microsystems Inc. (SUNW ), a highly innovative company with a strong portfolio of intellectual-property rights. Still, because of erratic earnings and revenues, Sun's stock sells at a discount to its major rivals. Another example is Callaway Golf (ELY ), once in the model portfolio held by consulting firm ipIQ, which aims to identify undervalued companies with quality patent portfolios. "Fabulous technology," says Gerry Komlofske, chief executive officer of ipIQ. "But they didn't have Tiger Woods as a spokesman." The stock has been an underperformer for four years.

Another intriguing indicator of a company's innovative prowess is the money it earns from its patent portfolio through royalty and licensing fees. The practice is largely concentrated among R&D-intensive industries such as chemicals, technology, and pharmaceuticals. For instance, IBM (IBM ) has been awarded more U.S. patents than any other company for the past 12 years in a row (data ending in 2004). A little more than a dozen years ago, the computer giant earned some $300 million annually on its intellectual property. That sum has since swelled to nearly $1.2 billion. A problem for investors, though, is not all companies disclose their royalties as does IBM.

They should. A 2004 research paper by economists Feng Gu of Boston University and Baruch Lev of New York University found for one thing, that investors put a high value on royalty income as a source of persistent, high quality earnings. "What's more, royalties are like a good housekeeping seal of approval about a company's technological capability," says Lev.

Corporate accounting systems evolved during an era when a company's wealth was measured largely by its real assets, such as factories and machinery. Today, wealth is created by the impact of new ideas and other intangible assets, like patents. Find a way to assess the value of those patents, and you just might find some winning companies before they come out with a blockbuster product like the iPod.

By Christopher Farrell

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