Profiting from a very good idea, patently

Knowledge is power. That makes it valuable. But a company’s intellectual property – unlike its factories or machinery – is scarcely visible in its accounts.

“US accounting, tax treatments and laws are all based on the success of the industrial economy,” says Keith Cardoza, managing director of Ocean Tomo, a finance firm that specialises in intellectual property.

Baruch Lev, professor of accounting and finance at New York University’s Stern business school, says a shift to a knowledge-based economy has left financial reporting “in the middle ages”. “It definitely doesn’t provide any meaningful information on intellectual capital and intangibles, which now are the only assets that create value,” Lev says.

Accounting rules and reporting practices, in other words, have failed to move with the times. Ocean Tomo says about 80 per cent of the market value of S&P 500 companies now resides in intangibles, or at least is not represented on balance sheets. Just 30 years ago, the figure was less than 20 per cent.

To help money managers and other investors redress the balance, Ocean Tomo has come up with a way to value patents and built the Ocean Tomo 300 patent index. The aim is to identify companies that have rights over ideas that will pay off in the future.

“Patents have been shown by a huge amount of research to be basically
forward-looking indicators of the success of companies,” Lev says.

Cardoza says his firm wanted the first index to be broad, so it is designed to accommodate a range of investing styles – from value to growth – and company sizes.

The first stage is to select the 1,000 most heavily traded companies listed on US exchanges. These are narrowed to those that own patents – about 700, according to Cardoza. The companies are then divided into five style and 10 size categories, making 50 groups in all.

Within each group, Ocean Tomo’s valuation system identifies the six companies (out of an average of 14 in a group) with the most valuable patents relative to their book value.

The resulting index of 300 companies is then market-capitalisation weighted, in line with traditional indices.

“We did not want this to be a technology index,” Cardoza says. “It’s an intellectual property index across the sectors.”

Ocean Tomo’s system for valuing patents is proprietary but he says it is objective and reproducible. It is based on analysing factual details of patents and their wording, from the US Patent and Trademark Office.

For example, most patents last 20 years from initial application. But they have to be maintained, by paying a fee every four years. “More valuable patents are maintained,” Cardoza says.

Others of the 53 factors in Ocean Tomo’s valuation system relate to the claims made for a patent. If more uses are claimed, a patent is probably more valuable. And the fewer words used for a specific claim, the more general it is likely to be, making its scope – and value – potentially greater. A patent’s business sector, specified by the USPTO, is another indicator of value.

The analytical task, especially constructing 10 years of historical data, has been “monumental”, according to Cardoza. It involved linking more than 4m patents to 4,000 companies. One challenge has been that patent owners may have names that bear no relation to their listed parents.

The sheer volume of patents is also daunting for anyone trying to keep up with developments. Millions exist in the US, and more than 3,000 new ones are added each week.

Ocean Tomo’s efforts to standardise the analysis appears to yield an index that, at least based on back-testing, outperforms traditional benchmarks.

In the 10 years to the end of October, the Ocean Tomo 300 returned just under 12 per cent annually, or more than 3 percentage points more than the S&P 500, with only marginally higher volatility.

Investors should soon be able to track the index with an exchange-traded fund. Claymore Securities has filed with the Securities and Exchange Commission to list a related ETF on the American Stock Exchange.

In the absence of accounting changes or other developments, investors have few other ways to evaluate a company’s intellectual capital, Lev says. “[Research and development spending] is a good measure but it’s an input measure. Some is successful, some is not,” he says. “Patents are not complete output measures but they are intermediate output measures – they are a measure of the success of R&D.”

Cardoza also sees Ocean Tomo’s index as a step towards a better representation of today’s knowledge economy. “It’s a meaningful step for investors to commit their capital to the intellectual property asset class and a powerful way to get better performance,” he says.

Eventually, Cardoza thinks intellectual property will become an asset class, with investors able to commit funds directly. Ocean Tomo’s plans for next year include the launch of a brand value index and another reflecting
copyright assets.

Putting all three indices together would produce some kind of “intellectuals composite”, Cardoza says.

For rivals who think the idea is a good one, be warned – Ocean Tomo has patented its system.