AOL and the Case Against Efficient Market Theory

Photograph by Scott Eells/Bloomberg

This time last week, I, like nine out of every 10 investors, believed AOL was a dead-end investment. How could it not be? This is no longer a 56k, dial-up world, when those ubiquitous AOL disks inundated mailboxes. AOL botched the chance to morph into a broadband player with its spectacularly bad marriage to Time Warner. AOL is behind on social media, and is struggling to compete for ad dollars with Google and Facebook. Its sales declined in each quarter last year.

How many chances does a legacy company get? (Remember this reinvention?)

Then, on April 9, as if out of nowhere, Microsoft dropped in to buy $1 billion of AOL’s patents, sending the latter’s shares up 43 percent in a single day. In the two years leading up to the deal, the stock was down 37 percent.

How could a supposedly omniscient market get this story so wrong? One explanation was offered by MDB, an intellectual property-focused investment bank. MDB says the AOL patents had more relevance to Microsoft and that company was uniquely well-studied on them, especially in light of AOL’s ancient acquisition of Netscape, that Microsoft nemesis in the age of Windows 95. MDB found that Microsoft cited AOL patents as related intellectual property 1,331 times in its own patent filings, vs. AOL citing its own patents 1,267 times.

Even so, it’s surprising that this play remained largely the province of tech-geek attorneys. After all, about 15 Wall Street analysts cover AOL—nine of them rating it either a hold or sell. Hedge funds and bloggers are constantly on it. The Microsoft deal shot AOL shares up two and a half times where they traded in August, when the company owned the same patents.

I was similarly puzzled last summer when Google paid big (63 percent-premium-to-close big) for remnants of Motorola—placing major emphasis on the legacy tech company’s patents. Motorola Mobility shares popped 57 percent in a matter of hours. I also scratched my head in September 2010, when Hewlett-Packard emerged victorious from a bidding war for a tiny data storage company called 3Par—by paying $33 a share for a stock that traded below $10 just three weeks earlier. How did everyone completely whiff on 3Par’s desirability and valuation?

These disconnects have me thinking back to the words of my friend, Justin Fox of the Harvard Business Review Group, whose book The Myth of the Rational Market excoriated the idea that “the decisions of millions of investors, all digging for information and striving for an edge, inevitably add up to rational, perfect markets.”

I, for one, am that passive, index fund-appreciating investor who doesn’t believe he can time the market or play easy arbitrages. That everything is already baked into closing prices. That all we are is dust in the wind.

Perhaps I’m giving the market too much credit.

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