An investment strategy based on IP value beats the market

BVWireIssue #96-3
September 22, 2010

Ocean Tomo tracks, at a macro level, the components of the S&P 500 market value.   It’s a familiar graphic for those who do a lot of IP valuation, but it’s still a shock to realize that 79% of corporate balance sheets are made up of intangibles.  “There’s a lot wrong with this number,” admits Michael Freedman (Ocean Tomo) last week during his session “IP Valuation and Management and Their Impact on Shareholder Value” at the BVR/Morningstar Summit on Best Practices in Intellectual Property Valuation.

“It’s not all copyrights and patents and trademarks—there’s goodwill and other intangibles included.  But there’s still no better way to make the point that IP plays a dominant role in many valuations.”

Freedman concludes that investor value is going to be created by analysts who can correctly value IP.  “There’s a caveat; there is more correlation in the market now than at any time since the ’87 crash.” So, at this particular moment in time, finding transparent value anywhere in this market is near impossible.  Eventually, Freedman hopes that we’ll return to “a market of stocks rather than a stock market” and that IP value will be identifiable based on three criteria:

  • The value of the technology
  • The ability of the group to bring the technology to market, and
  • The quality of the legal work that protects the IP

One way Ocean Tomo monitors potential IP value is to measure maintenance rates.  Via regression analysis, they found 53 factors that gave them predictability. They create an “IPQ” grade and they can predict how likely it is that the patents will be maintained.  “Our assumption is that IP owners wouldn’t pay to maintain their patents if they didn’t think they were worth more than the maintenance costs,” explained Freedman.

By combining this proprietary research with sector and other market trends (betas), OT has been able to create enhanced investment vehicles based on intellectual property value.  For example, they have an enhanced NASDAQ fund, an enhanced S&P 500 Index fund, and others.  “In all these cases we outperform their specific benchmarks with lower risk,” he claims.  Evidence of this:  OT’s 300 patent index (NYSE Euronext: OTPAT), the first IP indexed fund, invests in a diversified portfolio of 300 companies with the highest “innovation index.”  Morningstar rates this fund 5-stars—and as the fund with the highest return over the last 3 ½ years.

Mike Pellegrino (Pellegrino and Associates), conference chair, asked Freedman about whether current financial accounting standards limit the success of their method.   As Mike points out “Word is not on Microsoft’s balance sheet, but they bought Visio, so that is—typical of the misstatements in corporate balance sheets everywhere under FASB.”  Freedman’s response:  Ocean Tomo’s patented IP rating system relies on maintenance rates of patents—it’s not influenced by the financial data most other analysts live and die by.

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