Patent Alpha: Anecdote & Data

There’s a not very funny joke among statisticians that with enough anecdotes you can create a data set. Alternatively, if you’re a finance researcher you can take an anecdote, put together a data set, and see if the anecdote’s conclusion matches.

Dr. Herbert Wartheim

Earlier this year there was a profile piece in Forbes called The Greatest Investor You’ve Never Heard Of: An Optometrist Who Beat the Odds to Become a Billionaire. It was a thoroughly enjoyable article detailing the life and investing approach of Herbert Wertheim.

Go read it if you missed it.

While his life was fascinating, which makes the whole article worth reading, the two main takeaways for me as an investor were:

  1. It really helps to own a business with a net income of $10MM per year.
  2. Understanding a company’s patent portfolio is an overlooked source of alpha.

Dr. Wertheim’s investing success came down to buying companies with a deep patent portfolio that they were able to successfully monetize, and he pretty much never sold any of the shares he bought. The patent portfolio of the companies he invested in created a wide moat that allowed them to fend off competitors, maintain margins, and dominate their industry.

Sound familiar? They’re the types of companies that every investor dreams of owning.

But what if you don’t have the technical expertise of Dr. Wertheim and don’t have the ability to analyze the potential market value of a patent portfolio?

Mispriced Innovation

Remember how I said a finance researcher can take an anecdote and find a data set? I have a sneaking suspicion that Daniel Nitiutomo, Phlip Creutzmann, and Lucas von Reuss did just that. In their joint white paper with O’Shaughnessy Asset Management, Mispriced Innovation – Patents as  Leading Indicator for Earnings Growth, they divided publicly traded companies with a market cap of at least $200MM (excluding financials) into two categories: companies that were granted a patent within the past year and those that had not been granted a patent within the last year.

They found that the group that had patents issued within the past year outperformed the non-patent stocks on an annualized basis by 3.8 percent. Additionally, they found that the patent portfolio outperformed the non-patent portfolio 72.5 percent of the time (I.e., it’s not like the size and value factors that can go a decade with relative underperformance).

The results intuitively make sense and matches the anecdote, but it’s always neat to see it quantified.

Boeing: Deep Patent Portfolio, Questionable Management

Boeing of course has been in the news since the twin airplane disasters that befell them in October 2018 and March 2019. As more and more information came out it seems that management pushed the development of airplanes at the expense of safety and made the decision to charge extra for a safety feature. I understand wanting to be first to market, but when “safety” is one of the major selling points of your product I would think you’d want to make sure you got it right. I mean, selling an airplane’s safety record shouldn’t be the same as advertising the number of days a trailer park has gone without a tornado.

Before the twin disasters happened, Boeing was richly valued and understandably so. Air travel is projected to increase over the coming decades, Boeing is part of a duopoly, and roughly 21 percent of its operating earnings comes from service revenue that remains stable given the needs of Boeing’s worldwide fleet.

2019.08.07 BA

Investors largely shrugged off the first disaster as Boeing’s stock price dropped along with the rest of the market at the end of 2018 before rocketing to new highs by the end of February 2019. Investors (probably) rightly assumed that Boeing’s intellectual property, its existing fleet of aircraft, and the high barriers for new entrants would allow Boeing to continue printing money. It wasn’t until the second crash that investors started to get spooked. The second crash brought uncertainty for Boeing’s prospects, not only from a curtailment of future airplane orders, but also potential legal settlements from the two airplane crashes and whatever class action lawsuits are brought against them for negligence or misrepresentations.

It’s always hard to ascribe stock price movement to an underlying cause, although it doesn’t keep people from repeatedly doing it. It would be easy to point to the twin crashes and management’s response as the cause of the drop in Boeing’s stock price from $440 down to $330, but it might reflect an ongoing trade war that is likely to cause a global recession.

This isn’t an endorsement for investing in Boeing at the current price, even after its slide. There’s no indication that management learned their lesson, management certainly wasn’t replaced by the Board of Directors, they’re still richly priced relative to earnings, and there is not yet a resolution to the monetary damages that are likely in their future.

But it’s a good example of how companies with a whole lot of valuable intellectual property can survive events that would be disastrous for most anyone else.

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