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Tech Stocks: Follow the Patents?

That's what one research boutique is doing--and its work suggests that investors should pay close attention to companies' patent activity.
Hungry for technology stocks? If that question leaves you feeling as if you just swallowed seafood of dubious vintage, I don't blame you. By any measure, the past two years have been enough to make even the stoutest investor shudder at tech. Yet abandoning technology companies, which account for one in five U.S. stocks, would be an obvious, if understandable, mistake.

That's why I was all ears when I heard recently about a novel approach to picking techs. It has nothing to do with counting eyeballs, checking book-to-bill ratios, or even estimating earnings per share. Instead, it's all about patents--first, trying to evaluate the potential of a company's patent portfolio, and then relating that measurement to the company's stock price. Early evidence of patents' role in picking winners is promising (chart).

Yes, many investors have long hazarded guesses about how key patents might pay off. But CHI Research, a consulting boutique in Haddon Heights, N.J., is pioneering a strictly quantitative method. CHI got started in 1968 reviewing patents for the National Science Foundation. It later nabbed corporate clients and, in 2000, branched out to Wall Street with a pricey stock-evaluation service it calls Investor Tech-Line. CHI each month examines nearly 400 companies with strong patent activity, ranking them on investment potential.

Far more important than just the number of patents a company holds, or even how many it is adding, are a battery of more subtle indicators. At the core of CHI's system is something it calls "citation impact." This is a measure of how often a patent is cited by later patent applications and, by extension, its importance. At the same time, CHI checks how many references a patent makes to scientific papers, as opposed to earlier patents. Its hunch is that patents flowing out of academic work are closer to basic science and likely more valuable. The firm also measures what it calls "technology cycle time," or the median age of patents cited in an application. Citing more recent patents can indicate a company is dealing in fresher technologies, with the possibility of greater future profit.

Tests of these theories, first reported in a 1999 paper published in the Financial Analysts Journal and later by CHI itself, are intriguing. CHI's back-test over the 1990-99 period found its picks outperformed the Nasdaq Composite Index in 7 of 10 years and the Standard & Poor's 500-stock index in 8 of 10.

Investor Tech-Line, for which CHI last year received its own patent (you can view it at www.chiresearch.com), is slowly drawing the attention of institutional investors. Christopher Rowane, manager of the $60 million Huntington Mid Corp America Fund, attributes much of the fund's outperformance since its start a year ago--a 4.5% gain, vs. a 2.6% loss for its average midcap rival--to relying on patent research for a first cut through the clutter of stocks.

So, which stocks does CHI like? Some surprises, notably Ciena (table). The maker of optical-network gear topped CHI's yearend rankings, when it was $14.31 a share, and again on Feb. 1, at $12.70. Ciena (CIEN ) has since announced a merger with ONI Systems (ONIS ) and revealed a bleak outlook for the current quarter, sending the shares below $8. Other CHI picks include well-known giants (AOL Time Warner) and tiny unknowns such as Isco (ISKO ), a maker of flow meters. CHI suggests Isco's miniature, $54 million market value belies the close link of its patents to the science of "supercritical fluids"--part-liquid, part-gas substances created under very high pressure--that are used increasingly in the chemical and food industries.

An annual subscription to CHI's monthly reports carries a $15,000 price tag. But its way of thinking about patents, future profits, and tech stocks is free--a new tool to add to your kit.