The Patent Bubble Is Getting Ready To Pop
Irrational Exuberance and Patents?
I'm certainly not going to win any popularity contests for writing this article. The last thing anybody wants to talk about after a presidential election is a patent bubble. After all, most of us took a nice stock market beat down during the recent housing bubble and mortgage crisis.
For the past 40 years, intellectual property, technology development, and invention ideas have been the driving force behind the United States and much of the world's developed economy. Companies like Apple, Amazon and Amgen have been the leaders in wealth creation. Biotech, software, and communications systems have made fortunes for many and changed the world we live in.
It has resulted in a mad rush to capitalize on the “next big thing.” And that is creating a global patent bubble. The chase of Intellectual Property (IP) has created the next "irrational exuberance." If the term rings a bell, it's because it was the phrase that Federal Reserve Chairman Alan Greenspan used when warning about stocks being overvalued during the DotCom Bubble of the 1990s.
Since Microsoft burst onto the scene, IP has been seen as the next gold rush. Companies, venture capitalists, private equity shops, and universities worldwide are searching for new patents and copyrights that will create killer returns.
Patent Bubble Numbers Don’t Lie
The prices being paid for patents are all over the place. In 1975, more than 80% of an S&P 500 company's net worth was based on tangible assets (real estate, machinery, receivables, etc.). By 2010, that number has completely flipped to 80% of the net worth being based on intangible assets (patents, goodwill ,etc.).
The numbers are clear. Intellectual property now accounts for over 38% of the U.S. economy, but interestingly only 12% of exports. If that’s not the start of a patent bubble forming, I don’t know what is.
It seems that the race to patent a product has overshadowed the product itself. I am not discounting the importance of patents, however, when almost 40% of the economy is about protecting the right to make a product (rather than the product itself), there is something wrong.
95% of Patents Don’t Make a Dime
The common perception is that patents are a path to riches. If an inventor or entrepreneur files a patent, he can then build a successful technology company under the protection of that patent and eventually sell out to companies like Apple and Facebook.
Nothing can be further from the truth. A patent does not create a shield or grant you freedom to operate without competition. It gives you a tool to attack a competitor that you believe is infringing on your patent. Enforcing your patent is typically a nightmare, even for well funded corporations. It can take up to 5 years and cost up to $5 million to actually win a patent litigation. And that's if there isn't an appeal. And you better pray that the company infringing on your patent isn't too comfortable in a courtroom. They can make your life a living hell and make you wish you never filed for a patent in the first place.
Ever Heard Of The Tulip Bubble?
The Tulip Bubble is regarded as the first record of a widespread financial bubble in history. In the early 1600s, Tulips were newly introduced in the Dutch Republic and investors scrambled to get on board. At the peak of the bubble a single tulip bulb could sell for ten times the annual income of a skilled craftsman. Tulips were the fourth largest Dutch export! This was at a time when food and clothing absorbed almost the entire bulk of national income. In this environment where most people had barely enough to eat, it was simply bizarre that a useless luxury item absorbed such a huge chunk of Dutch wealth. Then in 1637 the bubble burst and the price of tulips fell to 1% of their former value. The Dutch economy crashed and the consequences were felt throughout Europe.
The bursting of the Tulip Bubble didn’t just affect those who owned and traded tulips. It caused a deep recession and a liquidity crisis in the Dutch Republics. The tulip bulbs were leveraged by finance, just as we leverage homes and commodities in the United States today. When a widespread bubble bursts, it up-ends the balance sheets of the entire nation.
The price of tulips never recovered, as you can see for yourself at any WalMart in Spring. You can buy them by the dozen for under five bucks.
The Crash of 1929 and the Mortgage Crisis Were Bubbles
The great Stock Market Crash of 1929 was brought on by similar forces. Investors were making huge returns all through the 1920s. The stock market was the place to be if you wanted to get rich quick. People borrowed heavily to purchase shares. And then it all came crashing down.
The Mortgage Bubble, which burst in 2008 showed us the same pattern again. Following 1999, when the Tech Bubble burst, the safe place to put your money was into homes. Prices were bid to unsustainable levels. All of it was commodified for investment purposes. When it crashed, almost every major bank in the U.S. and Europe found themselves in negative territory. On paper they were bankrupt. They owned a bunch of mortgages tied to homes with inflated values. The government had to step in with cash to keep the banks afloat.
The bursting of the Mortgage Bubble led to the deepest economic downturn since 1929 and its aftermath is still felt throughout the U.S. economy.
The Patent Bubble Will Hurt the Entire Economy
It is my opinion that when the Patent Bubble bursts, it could be far worse than the housing bubble.
Today, a company's most valuable asset is its intellectual property. Their wealth is in their patents. These patents are held on their balance sheets as intangible and undisclosed assets. They attract investment, issue bonds, and obtain credit based upon those numbers.
These patent bubble assets are not liquid and they do not trade easily. It isn't like selling a publicly traded security. Patent assets do not trade frequently and don't have any valuation consistency. If a company fails, it is forced to liquidate these patent assets at fractions of their assumed value. When Kodak filed for bankruptcy, experts were predicting patent portfolio sales of $1.8 billion to $4.5 billion. They sold between $94 million to $525 million. Quite a difference. There was nothing unique about the way Kodak was valuing its patents. They were just following accepted accounting principles. Imagine Kodak happening over and over again. It would create an international liquidity and balance sheet crisis.
Don’t Confuse Inflated Prices with Economic Growth
Too much money chasing the same sector results in price inflation. Those inflated prices are always unsustainable. When this patent bubble bursts, it will hurt the entire economy.
This is the opposite of productive investment, which has given us tremendous growth and a high standard of living. Investment in goods and services for reasonable returns is vital to economic growth. Investment in paper monopolies, patents and copyright, can be good for the economy. But when it gets out of balance, as it is now, it can lead to very bad economic outcomes for the global economy.
Why isn't anybody sounding the patent bubble alarm?
When bubbles are on the rise, a tremendous amount of wealth is created. Even a pure Ponzi scheme created plenty of profit for the early investors. During the Housing Bubble, many on Wall Street and in government knew that housing prices were unsustainable. Even Federal Reserve made comments suggesting that the economy was now “different” and there would be a soft landing.
Well the economy wasn’t different. Ponzi Schemes and bubbles always end the same way. Traders like Nassim Taleb, who wrote the influential book “The Black Swan”, and made a killing by investing against the home mortgage industry, were laughed out of the room. They were called alarmists or even branded as negative and destructive. But of course, Ponzi Schemes always fail. Everybody wants to believe it is different this time. But, it never is.
There is one thing for sure. We are in a Patent Bubble right now and history always repeats itself.
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