Patent

A patent is a form of intellectual property that grants an inventor exclusive rights to their invention. Think of it as the government giving an innovator a temporary monopoly on their creation as a reward for their hard work and for sharing the details of the invention with the public. For a limited period, typically 20 years from the filing date, the patent holder is the only one who can legally make, use, or sell the patented item or process. For a value investor, a patent isn't just a legal document; it's a potential fortress. It can be the source of a powerful and durable competitive advantage that protects a company's profits from would-be copycats. However, not all patents are created equal, and understanding their true strength and limitations is a critical skill for any investor analyzing a business.

From an investment perspective, patents are all about one thing: protection. They can be a key ingredient in creating a formidable economic moat, the term popularized by Warren Buffett to describe a company's ability to maintain its competitive advantages and defend its long-term profits.

A strong, defensible patent on a core product or technology is like having a deep, alligator-filled moat around a company’s castle. It legally prevents competitors from launching a similar product and stealing market share. This exclusivity allows the patent-holding company to command higher prices and earn superior profit margins than it otherwise could. The most classic examples come from the pharmaceutical and technology sectors.

• Pharmaceuticals: A patent on a blockbuster drug can generate billions in high-margin revenue for years, as no other company can sell a generic drug equivalent until the patent expires.
• Technology: A company like Qualcomm holds essential patents on mobile communication technology, allowing it to collect royalty payments from nearly every smartphone sold.

This protection gives a business a long runway of predictable, high-profit earnings, a quality highly prized by value investors.

While powerful, a patent is not a golden ticket to guaranteed riches. Wise investors know to look at them with a healthy dose of skepticism, as they come with significant risks and costs.

Getting a patent is a long and expensive legal process. Defending it is even more so. Patent litigation can cost millions of dollars and drag on for years, draining a company's cash and management's focus. A smaller company with a brilliant, patented invention might even find itself bullied by a larger rival willing to spend it into submission in court.

Patents expire. This unavoidable fact creates what is known as the patent cliff. This is the terrifying drop in revenue a company faces when its key patent expires, and the floodgates open for competitors. The pharmaceutical industry is the poster child for this phenomenon. When a major drug goes “off-patent,” its sales can plummet by over 80% within a year as cheap generic versions hit the shelves. An investor must always be aware of when a company's most important patents are set to expire.

A company bragging about holding 10,000 patents might sound impressive, but it can be a meaningless vanity metric. Many of these patents could be for trivial improvements or be so narrowly defined that competitors can easily design around them. The quality, breadth, and importance of a patent are far more critical than the sheer number. A single, foundational patent on a core technology is worth infinitely more than thousands of patents on minor features.

You don't need to be a patent lawyer to assess the strength of a company's patent portfolio. You just need to know what to look for and which questions to ask.

A great place to start is the company's annual report (Form 10-K in the U.S.). The “Business” and “Risk Factors” sections often contain a wealth of information. Companies are required to disclose their reliance on intellectual property and the risks associated with its potential loss. They will often discuss the general status of their patent portfolio and any significant ongoing litigation.

When evaluating a company's patents, consider the following:

• How essential is it? Is the patent for the company's main cash-cow product, or is it for a minor, non-essential feature? The more central the patent, the bigger the moat.
• When does it expire? Check the expiration dates of the most important patents. Is a patent cliff on the horizon? Does the company have a pipeline of new, innovative products ready to replace the lost revenue?
• How strong is the defense? Does the company have a track record of successfully defending its patents in court? Or does it frequently lose legal battles or settle for unfavorable terms?
• Innovator or Litigator? Is the company a true innovator that uses patents to protect its groundbreaking R&D? Or does it behave more like a patent troll—a company whose primary business model is not to create products but to acquire patents for the sole purpose of suing other companies for infringement? A true innovator creates value; a patent troll primarily seeks to extract it.