Are patents a predictor of stock performance?

The Wall Street Journal has a recurring feature where they analyze a number of technology companies and list the number of patents they have been granted in a rolling 13-week period. The Journal further goes on to rank the companies by calculating several other measures such as "Science strength", "Innovation cycle time" and "Industry impact". They then list the companies with their associated stock performance.

I was curious about how this data might look on a graph. Being a believer in technology and creativity, my expectation was that companies with the most patents should show better than average stock performance. The chart below tells a different story (the magenta line is Number of Patents and the black line is Change in Stock Price).

[ Click chart to view larger image ]

IBM has the most patents but their stock price appreciation over the last 52 weeks, while quite solid, is not a standout among this selection of stocks. Apple (AAPL), with fewer patents, has seen their stock appreciate the most. EMC is an innovative company but the level of patents they have been awarded in comparison to the others is low. Still, EMC's stock has performed second best. The biggest surprise in the pack is Digimarc (DMRC). Few patents, relatively speaking, and third best stock appreciation, almost 80%. My reaction was: who are these guys?

Digimarc Corporation supplies secure identity solutions and technologies for use in media management. Its solutions enable governments and businesses worldwide to deter counterfeiting and piracy, develop traffic safety and national security, combat identity theft and fraud, facilitate voter identification programs, manage media content, and support digital media distribution models. These solutions include secure IDs such as drivers licenses and digital watermarks which can be embedded in various forms of electronic media content, including personal identification documents, financial instruments, photographs, movies, music and product packages.

With governments and financial institutions focusing on identity theft and content providers focusing on digital rights management, Digimarc is well positioned to benefit from these parallel trends in the security technology sector. Unfortunately, the company is not profitable, having made a large investment in plant and equipment recently, and sales seem to have stalled. The stock is off its high of about $12 but it looks like it's starting to rebound. It has a reasonable price/sales ratio for a young small-cap of about 2.

Another company in the sector is L-1 Identity Solutions (ID). They are twice the size of Digimarc, show much stronger revenue growth and have a chart displaying a nice up-trend. They are also more diversified with biometric solutions in their product portfolio and operations in security consulting and fingerprint services. However, L-1 has a higher price/sales ratio (about 7) and is losing twice as much money as Digimarc.

If you are looking to add a stock to your portfolio that is in the digital security sector, either one of these stocks might fit the bill, with Digimarc more of a pure play. It is clear that there will be increasing activity in this sector as more and more transactions world wide move to electronic formats and identity solutions become as critical in rapidly developing nations like China and India as they are in the US, Europe and other developed countries. These two companies may not be consistently profitable yet but they are mining a vein of great opportunity.

And to get back to the topic that started this post, the conclusion I would draw is that the number of patents awarded to a technology company is not a predictor of superior stock price performance. But you probably knew that already...