Stop Gambling On Patent Lawsuits

Includes: ACTG, FH, MARA, MGT, VHC
by: Greg Miller

I have no idea how to predict the outcome of a patent lawsuit. We need to stop pretending that we are lawyers on Seeking Alpha. It takes thousands of hours to research a patent's validity. None of us are committing this time to any of our IP investments.

Maybe you won some money in VirnetX (NYSEMKT:VHC) or Vringo (VRNG). Many people correctly predicted (guessed) the outcome of these companies' lawsuits. Winners have tended to be loud. Losers left quietly. This phenomenon goes by many names: Texas Sharpshooter Fallacy, Observational Selection, Proof by Selected Instances, Enumeration of Favorable Circumstances.

Counting the hits and ignoring the misses.

We love to brag about winning ridiculous games. Boisterous casinos teach us that even if odds are far worse than 50/50, gambling is just irresistible. Humans spend billions on games they know they will collectively lose - everyone hoping to be the minority.

How does this relate to patent lawsuits and intellectual property (IP) stocks? Well, over the past few months while realizing that IP is Wall Street's hottest sector, I have spoken with as many lawyers as possible. All of them have told me the same thing.

No One Knows How the Jury Will Vote

To phrase this another way, "Even if you are lead counsel, you have no idea." If that is what every lawyer is telling me, just imagine how much of an idea we have as blog readers and stock traders.

Bear in mind, this is coming consistently from dozens of lawyers. All of them laughed when I mentioned that it has become popular to blog about public companies' chances of winning lawsuits. When I showed one of them an example on Seeking Alpha, his face responded as though I had presented an elementary coloring assignment.

"Do you know how much I get paid to perform one patent invalidity study?" I had no idea. "$50,000," he said. "$50,000 to work for a defendant on a patent's prior art and a freedom-to-operate study, minimum."

Bloggers do not understand this. They also do not understand that even after spending this much money on analysis, most lawyers walk into most courtrooms at the mercy of chance. They do as much as they can to explain the concept to the jury, but in the end, it is up to the jury. Maybe the jury is sexist, racist, or just fills out a form incorrectly. Also, juries vote wrong all the time.

Assuming, of course, that the lawsuit even gets to trial. Most of the time, small plaintiffs are strong-armed long before trial.

I Am Sick of Gambling

Buying a stock because you think you know the outcome of its patent lawsuit is delusional. Admittedly, I am guilty of this myself. I used to believe that I could understand a lawsuit, at least enough to estimate a company's likelihood of winning within a ballpark range. No more. When a company like MGT Capital Investments (NYSEMKT:MGT) sues casino companies like Caesars Entertainment (NASDAQ:CZR) and MGM Resorts (NYSE:MGM), defendants do not mess around. Casinos are rich and will do everything within their power to frustrate the lawsuit.

  • Non-responsiveness
  • Enjoinment objections
  • Jurisdiction transfer
  • USPTO re-exam submission
  • Invalidity and freedom-to-operate exams
  • ...and on and on

I have no understanding of these processes. Even worse, there is a hefty cover charge to invest stocks with lots of easy-to-read explanations. It is incredible to me how much people risk when betting on popular lawsuits. I have already explained the delirium of Vringo investors risking over $200 million in market capitalization for $2 billion in maximum gains when an identical bet was available next door for $10 million.

Alpha For Sale

All of this means that the IP sector remains one of the most irrational niches on Wall Street, with ample opportunities for alpha seekers like me. People gamble on the outcome of lawsuits, paying excessive popularity premiums to be involved in trendy stocks. They forget about other stocks and let them drift to apocalyptic prices.

Right now, there are some very cheap IP stocks. Acacia Research (NASDAQ:ACTG) lost $1 billion in market capitalization before it started buying back its own stock. On April 30, I wrote about Marathon Patent Group (NASDAQ:MARA) before it cleverly disclosed that it would generate annual revenue worth twice its market capitalization. ("Wait, $39 million from 97 and 64 outstanding, so, what is that, hold on, did they just say $25 million?") That stock rallied 30% while people slowly pecked at their calculators. There are many other cheap companies.

More importantly, the IP space is recognizing that the sales pitch, "We have a great patent! Invest in us!" no longer works. As I explained in a series of articles, no one cares if a company has a great patent lawsuit and trades for almost the cash it has in the bank. I wrote about MGT Capital Investments as it languished near $3 per share for weeks - just pennies above its debt-free cash balance. Marathon Patent Group also languished for weeks on almost no trading volume. Both companies had great patents, huge lawsuits and cash-rich defendants.

No one cared. It was not until these companies announced a low-risk business model that their share price started to move. MGT Capital Investments announced that it had entered the daily fantasy sports industry. Marathon Patent Group announced that it was entering the consulting industry. Suddenly, both companies had current customers and revenue.

Real Business, Not Just Blue Sky

As the title of this essay suggests, investors want real business operations, not lottery tickets. I liken this trend to the carnage in the junior mining sector over the last decade. No one cares if your mine will produce a million ounces of gold in 10 years. What low-risk business do you operate right now?

The sentiment is exactly the same in the IP sector. No one cares if your patent could earn $1 billion. What low-risk business do you operate right now? Sure, we like blue sky potential, but meals consist of meat and potatoes, not a dessert buffet sometime this decade.

How far we have come. At first, every intellectual property company wanted to be a one-hit wonder like Vringo. We were bombarded with companies claiming to have equally lucrative lawsuits in every conceivable field. They would lie to us: "We have a better patent than Vringo!" We believed them.

Now, finally, we are questioning the hype. Yes, we like IP and we want to invest in something with blue sky potential, but we also want an operating business and diversified revenue streams. We want built-in risk management. We want executives with a Big Audacious Goal who are executing on their mission now.

Casinos are fun for a while, but eventually, we all want to get back to real life.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.