As many investors are no doubt aware, events surrounding patent litigation often move stocks materially. For companies involved in patent cases, milestone events in the course of litigation can also lead to significantly elevated volatility. Despite this, patent-litigation plays aren’t well understood by the broader investment community. In order to shed some light on how investors should position around patent cases, Seeking Alpha’s Colin Lokey recently spoke with Markman Advisors.
SA Editors (SA): For those who aren’t familiar, tell us a little about what Markman Advisors does.
Markman Advisors (MA): We are a consultancy run by three practicing patent attorneys that specialize in analyzing patent investment situations, based on our extensive knowledge of patent law and patent litigation. We advise companies, investors and traders active within the space of investments driven by patent-litigation events. There are a number of micro-cap and large-cap companies that are suing or being sued for patent infringement, and the anticipated outcome of such cases often creates volatility with respect to the company’s share price. That volatility is typically driven, in part, by a gap in the market’s understanding about the patent-litigation process. We fill that gap. The members of Markman Advisors are all USPTO-registered patent attorneys.
SA: Can you talk a bit about “Markman hearings,” so readers can understand where the name comes from?
MA: Nearly all patent cases will have what is called a “Markman” hearing. The name derives from a 1996 case before the United States Supreme Court (Markman v. Westview Instruments, Inc., 517 U.S. 370 (1996)), where the court decided that construction of a patent’s claim terms are an issue of law to be decided by the Judge, rather than an issue of fact for the jury. That is a rather technical, legal distinction, but for investors, the important takeaway is that “Markman” hearings can often make or break a case, and for that reason, they can provide excellent catalysts for high-yield event-driven trades. For a publicly-traded company whose share price is riding upon whether or not there is infringement, the Markman decision could trigger considerable volatility in the stock.
We chose the name “Markman Advisors” because it borrows from this hearing that is absolutely unique to patent litigations, which is our expertise, while simultaneously being recognizable enough to investors as a reference to patent law. So far, the name has served us well.
SA: You are all USPTO-registered patent attorneys, how do you incorporate your litigation experience into your investment strategy to generate alpha?
MA: The short answer is that, as experienced patent-litigation attorneys, we know how to take a barometer-reading of what is happening in a given litigation. Patent litigation is not necessarily brain-science, but it is an arcane, esoteric and rather inaccessible discipline for those who have little experience with it. For a company whose future is hanging within the balance of a patent litigation, each event, each hearing, each brief, each decision by the court, each discovery dispute, each proposed claim construction, each pre-trial order—they all mean something. What we bring to the table is knowing what each event means, what’s important and what can be safely ignored.
To be frank, very few events are dispositive, whereas for many events, what is at stake is only a matter of leverage. The value we bring is knowing how to tell those events apart.
Take a very brief example. We briefly attended the trial in the case of ParkerVision (NASDAQ:PRKR) v. Qualcomm (NASDAQ:QCOM). As those following ParkerVision knew, if the jury found infringement, the stock was going to appreciate significantly. After the parties put on their respective cases, the jury began deliberating over the course of two days. During those deliberations, the jury asked the Judge a question. The Judge read the question out-loud in open court. The question pertained to a facet of indirect infringement. From this question alone, we knew immediately that the chances of the jury finding infringement were high. This is because we knew that the jury was likely following a verdict form, and that the questions on that form would only lead the jury members to answer questions about indirect infringement if they had already answered affirmatively about direct infringement. We made that prediction, and we were right. That specialized insight is directly born from our experiences litigating patents, drafting verdict forms, and having a keen understanding that indirect infringement is unavailable without direct infringement.
For each case, and for each company whose share price is acutely affected by a pending patent litigation, there is almost always a moment like the one during the ParkerVision trial when our specialized knowledge provides insight into where the case is going before the average investor. That’s one way we bring alpha.
SA: What is “litigation-based, event-driven” trading?
MA: For some sectors, event-driven trading revolves around an earnings report or an FDA decision on a clinical trial. For companies embroiled in a litigation that is being closely watched by the market, the “events” will be the events within the litigation itself.
So, what are the events? Patent litigations all have a number of milestone events. These include the Markman hearing, summary judgment motions, the trial, post-trial motions, the appeal, as well as other “events” that occur within that particular litigation where one of the parties scores some points, and the other party loses some points.
Take the example of Palo Alto Networks (NYSE:PANW), and its ongoing patent litigation against Juniper Networks (NYSE:JNPR). Juniper has sued Palo Alto for patent infringement, and the market is closely following the case because a large portion of Palo Alto’s product line is at stake.
During the litigation, there are a number of important milestones that will portend which party is gaining leverage in the case, in other words, which party is “winning.” Recently, the court’s decision on claim construction issues and summary judgment motions was an important event. That event, embodied in the court’s decision, moved the stock by 11% in one day, while some of the option contracts saw a 500% return in the course of a single afternoon.
The next “event” will likely be the trial itself. One of the facets of patent litigations that continually frustrates investors is how long it takes. A patent case can take two, three, sometimes upwards of four years. And even when the trial is finished, there is the appeal, which can take another 12 to 18 months. For event-driven traders, however, a company embroiled in a particularly sensitive patent litigation can present a plethora of high-volatility event-driven catalysts — regardless of which party eventually wins the case.
SA: Talk about the difference between what you call “Large-Cap Opportunities” and “Micro-Cap Opportunities,” in the context of your investment strategy.
MA: The principle difference between micro-cap and large-cap opportunities is that micro-caps are typically the plaintiffs and large-caps are typically the defendants. Micro-cap patent opportunities typically comprise patent-monetization companies in the business of enforcing patents through litigation. (We discuss these in more detail below.)
The company’s success hinges upon striking settlements and winning cases, and the company’s share price will appreciate in response to litigation events favoring those outcomes. By contrast, large-cap patent plays do not typically involve a company that is enforcing a patent, but rather a large company whose business is threatened by accusations of infringement. For instance, Palo Alto currently faces the threat of an injunction against selling most of its major product line if it loses its trial against Juniper Networks.
SA: How rare is it that a firm, which knows about patent litigation, is also well-versed in how the market reacts to such litigation? In other words, how unique is your approach to the market?
MA: Very rare. There are reasons for that. The community of patent-litigation attorneys is a rather small, close-knit one compared to most sectors of the legal market. And there exist a number of excellent, extremely competent patent attorneys. But most of them are working in a firm, and working on cases. That makes them exceptional patent litigation attorneys, but with little or no experience about how to read the market.
One of the things that we have done, and something we have been doing for quite some time, is study the market. We know how to litigate a patent case, but that is only half the equation. Investors also need to know how the market is going to react to a particular event within a patent litigation, what the market thinks of a Markman hearing versus an appeal versus a motion for leave to amend a complaint to add a claim directed to a new product.
By studying the market reactions to patent cases, we have learned that the market is not always rational, but it can nevertheless be somewhat predictable, which is really all that investors need.
For instance, we have noticed some stocks appreciate significantly on the actual day of the Markman hearing. The curious thing about this is that judges rarely if ever issue actual decisions on that date, they only hear argument on that date. Nevertheless, for a given case, based upon volumes leading up to the Markman hearing itself, trading the day of the Markman hearing can, in some cases, present lucrative opportunities.
SA: Tell readers a bit about what you call the “patent play sector.” What would you say its unique characteristics are?
MA: The patent play sector is unique for a very simple reason — it is driven by litigation. Companies across all sectors litigate, and it is not uncommon for a particularly large anti-trust or commercial dispute to impact a company’s share price. Yet, for publicly listed patent monetization companies, what they do — their revenue generating activity — is litigation, and in particular, patent litigation.
Given the uncertainties of patent litigation, both with respect to outcomes and timing, it can be difficult to slot these companies into typical quarterly assessments based upon earnings reports and so forth. Rather, the true assessment of a particular company will lie within how well things are going within a particular patent litigation. Knowing how to adequately assess that can present new challenges for some investors.
Another challenge for investors is distinguishing between those companies that present better short-term event-driven trades versus companies presenting better buy-and-hold opportunities. There is a spectrum of patent-monetization companies, and understanding that spectrum is important for investors. On one side, there exist big hitters who are attempting to score a large damages award based upon infringement of one portfolio of patents. Vringo (VRNG) is one such company, and its pre-trial and post-trial catalysts have presented numerous excellent trading event-driven trading opportunities.
On the other side of the spectrum are companies that are collecting a number of patent portfolios, and enforcing them in parallel, thereby diversifying the risk pinned on a given patent, while simultaneously seeking smaller settlements rather than a single big score. Acacia Research (NASDAQ:ACTG) established this model, and it is currently being pursued by other companies, including CopyTele Inc. (COPY) and Marathon Patent Group (NASDAQ:MARA). These latter companies fluctuate less based upon a single case, and for this reason, often present long-term buy-and-hold opportunities.
There also exist companies that are somewhat in between, such as Document Security Systems, Inc. (NYSEMKT:DSS), which is concurrently enforcing a number of different patent portfolios, but is doing so against some high-profile defendants — such as Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), and LinkedIn (NYSE:LNKD) — such that events within a given case can move the stock considerably.
SA: Does the unique nature of this sector create a significant amount of volatility? If so, does that create an opportunity to invest in a sector that is uncorrelated with the broad market?
MA: Absolutely. There are many hallmarks of the patent-play sector. One of them, which we discussed above, is that alpha can be obtained purely from publicly available information. Another important hallmark of patent-plays is that they are frequently uncorrelated to the broader market as a whole. The events and milestones of a given patent litigation will typically be derived solely from the scope of the patent, the technical aspects of the accused products, the availability of invalidating prior art, as well as other case-specific issues unrelated to the economy as a whole. For a company that is enforcing its patents, the company’s “performance” is not a function of marketing to consumers who are themselves affected by the economy.
As for the volatility, that seems to be inherent in a patent-play. When hundreds of millions of dollars are at stake, and the company that is being traded is a micro-cap, then there is sure to be a significant amount of volatility based on the outcome of the case, or even resolution of litigation milestones leading up to the case’s outcome. We have observed that a considerable portion of this volatility is a function of continued misconceptions about the patent-litigation process. Investors do not always appreciate that winning at trial does not mean that the money comes in the door the next day. There are conservative investors that choose to buy and hold their position throughout the tenure of a given litigation, but many traders actively go in and out around the litigation-event milestones we discussed above. This fuels the volatility, but it also presents lucrative short-term trading opportunities for investors with enough alpha to get ahead of the event.
SA: Can you talk about any cases you’re watching currently involving publicly traded companies? If so, do you have any predictions you want to share?
MA: We are currently watching over 20 patent cases, two of which include Avanir and Palo Alto. In the case of Avanir, we are expecting an important decision in their case against Par Pharmaceuticals that may result in extreme volatility for the stock.
In the case of Palo Alto, we have written about their litigation against Juniper and believe the market overreacted to the recent summary judgment and claim construction decisions, but the upcoming trial nevertheless presents a catalyst-opportunity for an event-driven trade.
One thing we can predict is that as more investors see the opportunity presented by patent monetization, there will be increasing rewards for those companies that successfully run their businesses. At the same time, as the market learns more about how patent litigation actually works, the standards that these kinds of companies will be held to will also be set higher.
In conjunction with Dan Ravicher, we will be hosting a symposium for institutional investors interested in patent-litigation driven investments at Cardozo Law School in New York City on April 1, 2014. At the symposium we will cover the ins-and-outs of trading event-driven patent-litigation, with an overview of some key case studies to illustrate the opportunities and challenges in the space. For more information, please email email@example.com.