Follow the Patents; Looking for hot stocks? Go for companies whose ideas are often cited in other innovations

BYLINE: Staff

There's almost always a big payday for shareholders of truly innovative companies. Since the introduction of the iPod in 2001, for instance, Apple Computer stock is up ninefold. For investors, the big challenge is putting a number on a company's creative and intellectual prowess. Corporate accounting is fine for keeping track of inventories but not for valuing ideas. Reports on research and development spending are spotty and make no qualitative judgments.

That's why hedge fund gunslingers, private equity mavens, and other professional money managers are turning to patents for insight. "You want to own a company for the innovation embedded in its patents," says Keith Cardoza, managing director at Ocean Tomo, a Chicago merchant bank specializing in intellectual property.

The U.S. Patent & Trademark Office awards patents on original ideas. Each patent application contains lots of information. Problem is, more than 4 million patents have been issued since 1983, according to Ocean Tomo, and some 4,000 new ones are accepted every week. Obviously, most patents won't pay off. So which ones will?

Scholars have learned that a powerful proxy for innovative expertise is how frequently a company's existing patents are cited in patent applications. Indeed, one-quarter of all patents receive no citations, and a mere 0.01% earn more than 100 citations, according to Bronwyn Hall, an economist at the University of California at Berkeley. In a study by four economists covering seven industries that generate a large number of patents, researchers found that a patent mentioned 14 times by other patents is worth, on average, 100 times as much as a patent cited only 8 times. Another estimated that companies with widely cited patents and a track record of turning them into products outperformed the market by 1,000% over a 10-year period.

This insight is behind the Pipeline Quality measure created by 1790 Analytics, a consulting firm in Mt. Laurel, N.J. (The name comes from the date the first patent was issued in the U.S.) The other critical factors that feed into the measure are a patent's originality, its applicability to different fields, and the growth trend in a company's patent activity.

MIXED BATCH

The firm generated a list of interesting prospects for BusinessWeek in December, 2005, and the subsequent results have been terrific (table)--11 winners, 4 losers, and an average return that was more than twice that of the Standard & Poor's 500-stock index and more than three times that of the NASDAQ Composite. Now it has 15 picks for the new year.

1790 Analytics uses several factors to come up with its choices. Among them are companies with a high Pipeline Quality number and a low price-earnings ratio relative to their industries. Some of the names aren't surprising, such as 3M, Palm, Zygo, and Wyeth. High-tech and pharmaceutical companies are traditionally R&D- and patent-intensive.

But Grant Prideco? Grant is an oil and gas equipment services company with a worldwide market share of some 50% in drill pipes. It's the world's third-largest manufacturer of drill bits. The energy business is inherently cyclical, but the global economy's thirst for energy appears unquenchable. The company has several patents for drill pipes that go very deep. They are also resistant to metal fatigue. "These are the kind of technologies you need as oil and gas reserves become harder to get," says Patrick Thomas, a principal at 1790.

Pactiv is a leader in waste bags and food storage products that is best known for its Hefty line. Although earnings have been depressed until recently, largely because of higher costs for plastic resin, the company has been able to raise prices, and it's known as an innovator in plastic products.

Or take a look at Magna International, an auto parts company that is doing relatively well in a seriously troubled industry. The company devotes a sizable portion of its profits to R&D. Also on the list is Polaris Industries, the Minnesota maker of snowmobiles, all-terrain vehicles, and Victory motorcycles. Polaris engineers are among the most admired in the business, according to researchers at Morningstar. "When people think of patents, they often think it will be all pharmaceuticals and high tech," says Thomas. "It isn't."

Not interested in picking stocks? With the growing focus on patents, Claymore Securities launched a patent index exchange-traded fund on Dec. 15. The ETF is based on the Ocean Tomo 300 Patent Index (winnowed from an initial list of 1,000) created by the merchant bank. It's a market-weighted index that covers a broad spectrum of industries. Among its more important valuation metrics is the observation that while a patent lasts for 20 years, a fee has to be paid every four years to maintain it. That the company continues paying the fee is a clue the patent is valuable.

The investment returns on innovative activities are inherently uncertain--it's the nature of the beast. Evaluating patents may not be a surefire way to stock market profits, but it is an intriguing way to gain an edge.

Patent Picks of 2006