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Further reading: A patent return

A recent paper suggests data and research costs can help investors to identify cheap, high-innovation stocks
October 31, 2019

Against a fast-changing technological backdrop, big businesses today must innovate constantly to stay competitive. At the same time, they are increasingly safeguarding their intellectual property to maintain their dominant positions. The proof is in the numbers. In 1990, just over half a million patent applications were filed worldwide. In 2017, more than three million were filed.

In a nutshell, a patent is a legal right that allows inventors to stop others from making, using or selling their invention without permission, over a set period of time. Most individuals or companies applying for a patent will aim to make money from the idea that they’re trying to protect. It follows that “everything considered, patents provide a signal of future economic value through the creation of a competitive moat”. And while it can prove difficult to gauge the timing and significance of this economic value, such uncertainty creates market inefficiencies. And where there are inefficiencies, there are opportunities for savvy investors to capitalise.

That’s all according to Mispriced Innovation – Patents as a Leading Indicator for Earnings Growth; a July 2019 paper by Daniel Nitiutomo of O’Shaughnessy Asset Management (OSAM), and Philip Creutzmann and Lucas Von Reuss of Quant IP – a company that uses information from patent data to “help companies and investors identify trends and shifts in technology, find true innovation leaders and make better decisions”.

Through a step-by-step analysis, the paper shows how one can use quantitative measures to identify “innovation leaders” – stocks that are able to stay ahead in their respective sub-sectors or fields, and which should generate superior earnings and share price returns. The authors argue that applying "innovation factors" can provide investors with insight into companies’ potential growth prospects beyond those offered by conventional financial metrics.

 

Innovation universes

The report starts by taking all US public companies with a market capitalisation above $200m (£156m) – defined as the OSAM ‘US All Stocks Universe’. It then takes the companies (excluding the financial sector) that have had at least one patent granted in the last year, to create a "patent universe".

A comparison shows that patent activity is synonymous with excess returns. The patent universe outperformed the All Stocks by an annualised 2.2 per cent between 1990 and 2017, and the non-patent universe by 3.8 per cent. Looking at it another way, of every full one-year period from 1990-2017, the patent universe beat the All Stocks 72.5 per cent of the time.

The patent universe also saw higher average earnings per share than the All Stocks. This was true across all sectors, not just those more likely to have patents – such as technology, healthcare and industrials.

 

Higher number of grants, higher returns

The next stage reveals that there is a direct correlation between the number of patents granted, and positive future share price performance. The authors rank the patent universe by patent grants in the past year, and split it out into quintile portfolios, before back-testing each portfolio. The quintile with the highest grant count outperformed the All Stocks by 4.5 per cent – albeit the portfolio with the lowest grant count still outperformed. The return spread between the two quintiles was 4.1 per cent.

There’s also ostensibly a positive correlation between grant count and profit growth; the top quintile portfolio saw the highest uptick in earnings per share.

 

Bigger companies, more resources

The report acknowledges that companies with greater market values are likely to have greater resources at their disposal to apply for – and be granted – patents. So, they’ll feature more prevalently in the higher quintile portfolios, as they’ll have more grants. Still, testing the patent metric across market capitalisation ranges showed its effectiveness regardless of size.

 

Research and development  

Patents aside, the authors asked whether data on research and development (R&D) could be an equally strong measure of innovation in companies? Financial disclosures mean this information is more readily available than patent data. But on its own, “R&D capital is a less robust innovation metric than granted patents”, the paper concludes, noting that R&D feeds into the creation of the intellectual property that a patent protects. The way in which it’s accounted for can also vary.

Moreover, R&D doesn’t produce the same returns as patents. A specially created R&D universe only achieved an annualised excess return over the All Stocks of 1 per cent between 1990-2017 – and this outperformance stemmed predominantly from the last eight years of that period. Within this selection, greater volatility was observed than the patent universe.

 

Patents and R&D: good synergies

So, R&D does not produce stellar results when used alone as an innovation metric. However, it does work when amalgamated with patent data. Indeed, the report finds that a concentrated ‘innovation composite’ – including companies that are producing patents, and reporting R&D expenditure – shows considerable base-rate performance against the All Stocks, and good downside protection for the highest-ranked companies.

 

Bargain innovation

Finally – and perhaps unsurprisingly given the paper's previous findings – we learn that cheap, high-innovation stocks have beaten expensive, no-innovation stocks by a return spread of 12 per cent. Given its positive synergistic relationship with earnings growth, the innovation composite could help value-hunting investors to find inexpensive stocks with good prospects.