Beatles tracks are widely pirated on P2P networks. Even Paul McCartney doesn’t object to people downloading Beatles music illegally. The suits at EMI need to learn that having a tiny percentage of something is better than having a lot of nothing.

Patents are notoriously difficult to value but it is clear that patents are becoming a viable asset class in themselves. Taking the cue from many other asset classes, could there be a way to “securitize” a portfolio of assets? This could be a fun and challenging opportunity to address. One approach is Nathan Myhrvold’s Intellectual Ventures, a “venture fund” that invests in patents by acquiring those invented by others and developing some internally. There are many in the technology industry who fear Intellectual Ventures will evolve into the best funded and organized patent troll.

Below is an essay I wrote for an investment newsletter published in February 2007 distributed to high net worth clients.

Patent Bridge is Falling Down

Horror of horrors! We almost lost service for our Blackberry communication devices early last year. Also known as Crackberries for their users’ incessant finger-pounding of emails during company meetings, on the subway, and even on vacations, a patent infringement lawsuit filed against parent company Research In Motion (RIMM), threatened to sever the umbilical cord between the gadgets and their addicted users. NTP, Inc., a patent holding company, claimed that RIM infringed NTP’s wireless email patents. Legions of squinty-eyed telecommuters were relieved when RIM finally settled with NTP by paying an extortionary sum of over $600 million.

The Blackberry episode underscores the growing importance of an emergent business model. Disdainfully described as “patent trolls” by detractors, patent holding companies assemble portfolios of patents and wait for other companies to develop infringing products. Profits are then won in the courts and not in the arena of market competition. This form of intellectual blackmail has the potential of drastically altering the economic landscape and the development of innovative new products.

Innovation is the Holy Grail. Harvard Business School professor Clayton Christensen assured us of that universal truth with the publication of a couple of business bestsellers. Large corporations pursue innovation with a newfound zealousness. However, the editors of this publication submit that the innovator’s dilemma is no longer about large corporations’ inability to recognize and take advantage of disruptive technology; it is now about navigating the field of patent landmines.

Who takes the risk? Innovation is inherently a risky endeavor. Impactful advances in technology seldom occur at low cost. Invention, experimentation, testing, and prototyping can require large sums of capital. Furthermore, product evangelism often dwarfs the cost of research and development. Thus, the founding fathers created a patent system to reward the risk taker and incentivize risky behavior resulting in benefits to society in the form of improved goods. They must now be spinning in their graves. Patent trolls are, in essence, excellent risk arbitrageurs, because they have found a way to extract profit without undertaking the bulk of the risk. In the case of NTP v. RIM, although Research In Motion incurred the cost of developing the Blackberry device and bringing it to market, the patent troll almost succeeded in removing a winning product from the marketplace. Who loses? Ultimately, the consumer.

How does one spot a patent troll? Like the monsters of childhood tales, they hide and wait under a bridge until someone attempts to cross. Trolls then exact a toll from the weary traveler for use of the bridge. Only in the real world, the bridge or asset was built or developed by the traveler! Patent trolls are, in the words of the legal cognoscenti, “nonpracticing” patent holders. They have no intention of ever developing and commercializing their patents.

“But we are all patent trolls!” Panglossian defenders of the current patent system point to the huge patent portfolios of large corporations like General Electric (GE), International Business Machines (IBM), Intel Corporation (INTC), and even mundane consumer goods powerhouse Procter & Gamble (PG). In this world of limited resources and talent scarcity, even the most imposing corporate behemoths can ill afford to commercialize all their patents. Yet when the blue chips’ patents are infringed, they pursue legal recourse as vigorously as any litigant. Defenders of the status quo place the burden of diligence on manufacturers. All who aspire to make the next iPod (AAPL), Blackberry, Viagra (PFE), or toaster oven must search the United States Patent and Trademark Office archives for all prior art – just as it has always worked for the last two centuries. They have a point. If manufacturers are not thorough with their homework, why shouldn’t they be sued?

The problem is not whether large or small inventors are practicing or not. The editors submit that the problem is what we call the Goldilocks Paradox. Currently, too many overly broad patents are being awarded. When that occurs, it becomes very difficult to innovate around such widely defined intellectual property. When patents are too narrowly defined, it becomes very easy for competition to design around them.

“Yum yum, these patents are not too broad and not too narrow, they’re just right!” To get to this happy equilibrium, we humbly suggest a remedy. To curb trolling behavior, set a time horizon for making infringement claims. The deliberate strategy employed by patent trolls of waiting for another company to develop a market for a product to then sue for damages is diametrically opposite of the approach taken by most large corporations armed to the teeth with attorneys. After a certain amount of time, claims will either have no merit or will win reduced compensation. We believe this would put a significant chill on trolling behavior and allow everyone to get on with the business of making our lives better.

For all the Blackberry users out there, cling tightly to your beloved devices. On May 1, 2006, Research In Motion was sued by another patent troll, Visto. Ah, as Candide implied, “All is for the best in this, the best of all possible worlds.”

A couple weeks ago, I wrote about my pessimism regarding the technology sector. The market had seemed to interpret the surprisingly good results reported by Big Blue (IBM), Google (GOOG), and even Yahoo! (YHOO) as reasons for unleashing optimism and a bargain hunting shopping spree for stocks of publicly traded technology companies. Maybe the recessionary environment and the woes faced by banks and the American consumer would not negatively impact corporate budgets for technology. My skepticism rests on the ability of secondary technology companies to weather the economic slowdown. In other words, I think there is going to be a bifurcation of the technology sector, with blue chips performing in line with expectations and second tier players getting hit hard by purchasing slowdowns.

How has my skepticism aligned with reality? As usual, I’m wrong more often than I’m right. Over the past week, Apple (AAPL), Amazon.com (AMZN), and Microsoft (MSFT) all reported earnings greater than expectations. These blue chips however warned of weaker results in the foreseeable future. For the week, Apple stock rose 5%, Amazon ticked up 1%, Microsoft ticked down 1%, and Yahoo! fell a whopping 6%. Yahoo’s weak showing had a lot to do with Microsoft reiterating its reluctance to increase its bid for Jerry Yang & Company. These mixed results mask a surprisingly strong showing by the Nasdaq Composite Index which rose 0.8% for the week. This implies that a lot of the secondary technology issues performed better than other sectors of the economy. Industrials in the Dow Jones Industrial Average rose only 0.3% and the blue chips in the S&P 500 did slightly better with a 0.5% rise. We’ll get an even better reading on the technology sector as bellwethers like Blackberry maker Research In Motion (RIMM), Cisco Systems (CSCO), Hewlett-Packard (HPQ), and Dell (DELL) report their earnings in the upcoming weeks. In the meantime, I’ll be looking for a lot of smaller technology companies to run into a brick wall.

Macro

The media just started latching onto the rising cost of food story. All throughout Ben Bernanke’s easing of credit and interest rates, which in the short run looks like a success, I worried about his staying power because of inflation. The Federal Reserve is stuck between a rock and a hard place because of the conflicting forces of inflation and the slowing economy. Everyone knew about oil’s incessant march to record prices, but few worried about food prices. Recently, The Economist ran a cover story on the food crisis. Much of the blame rests with increased planting of corn for biofuels instead of wheat for food. The unintended consequences of government initiatives and regulations bolstering or subsidizing the use of ethanol are now materializing in record food prices. The head of the United Nations warned that the dearness of food could cause political and social instability. Asian countries are in a mini-panic because of the skyrocketing price of rice, the staple input of Asia. Riots have erupted in Egypt and even the prime minister of Haiti was forced to resign over food shortages. Crises bring opportunities, so rumors of American food conglomerates craving foreign food companies abound as executives weigh their next move in response to the food crisis. Will we want to drive more or eat more? That is a very basic question.

Micro

Interactive Intelligence to Announce First Quarter Operating Results – Interactive Intelligence (ININ) provides software applications used by contact centers or call centers. ININ has some award-winning products. One of the most interesting to me is their Interaction EasyScripter, which is software that allows for management of “scripts” for call center agents. Companies that rely on call center agents to sell products or perform customer service should find EasyScripter very useful. I’m considering using EasyScripter or something similar in the sales efforts of the startup I’m involved in. The company reports earnings after market close on Monday and analysts expect 8 cents of earnings per share for Q1 this year. ININ is one of the second tier technology companies that will test my thesis, that blue chip technology companies will do fine through the economic downturn while the smaller technology companies suffer from budget cuts. Full Disclosure: I currently have a long or short position in ININ in one or more of my private investment partnerships.

Decker surges on higher outlook – We can’t always focus just on technology and food. Let’s take a look at fashion for a bit, albeit low fashion. Decker Outdoor Corporation (DECK), the maker of those annoying UGG boots took short sellers on a 21.55% ride after reporting earnings growth of 18% for Q1 2008. DECK has other product lines, but the primary driver of growth is the UGG boots line. Always be skeptical about fashion fads. Take a look at the stock charts of CROCS (CROX) and Heelys (HLYS) for an illustrative warning.

Focused Strategy Helps Chipmaker Rise Above Sector’s Slump – Back to technology, I just had the power brick on my Hewlett-Packard Pavilion laptop fail on me. Replacement power bricks are unbelievably expensive. Why can’t laptop manufacturers standardize on power bricks and power cords so we can all buy a one-model-fits-all commoditized power unit? The Universal Serial Bus (USB) port has worked so well for consumers. Power Integrations (POWI) makes a tidy business supplying the chips that control power bricks.

Citi upgrades Sohu.com – I pay great attention to the China tech sector and, recently, the Chinese passed the United States for the most Internet users. Sohu.com (SOHU) is China’s version of Yahoo!, an Internet portal company. Sohu.com, unlike Yahoo!, is growing by leaps and bounds. Also unlike Yahoo!, Sohu.com has figured out online gaming. Going forward, its online game, TianLong Babu, will be a strong contributor to the bottom line. If you think World of Warcraft and online gaming has had a big impact on the American gamer, just keep your eye on what massive multiplayer online games (MMOGs) will do in China and the rest of Asia.

Netgear shares tumble after profit drops on US, UK woes – I love Netgear (NTGR) products. Netgear powers my home network. However, it seems that Cisco System’s Linksys division is taking market share by sparking an industry-wide price war. Wireless networking, once the next big thing, has become a commodity. Aside from a few gifted companies like Apple and Cisco, hardware makers often fall prey to the commoditization trap. It happens sooner rather than later. Netgear reported Q1 earnings dropped 20% and promptly saw its stock take a 16.74% dive.

Shares of Synaptics drop after fiscal 3Q profit slides – Synaptics (SYNA) specializes in touchscreen technology. It used to do a lot of business with Apple supplying technology for iPod user interfaces. The long term growth of electronic equipment with touch interfaces like the iPod, iPhone, and the flood of iPhone competitors soon to come bodes well for this company. Cell phones and smart phones will have increasingly intelligent touch interfaces. Even automobile dashboards will become flattened digital touch interfaces rather than today’s analog dials and switches.

Tight US immigration forces outsourcing: Bill Gates – Microsoft (MSFT) chairman, and no longer the wealthiest guy in the world, makes some interesting points about our immigration policy regarding skilled workers. At SocialOptimize, we’ve been outsourcing some of our work to Guatemala and the Philippines.

Google could be superseded, says web inventor – Tim Berners-Lee shares some wisdom about the semantic web. He talks about how a new company in the future could exceed everything Google (GOOG) has done up to this point. Wouldn’t Google just buy that company?

Japanese government investigates sparking iPod nano – Apple’s (AAPL) stock does not seem to be hurting too bad from this news today. Let’s see if there is a big recall.

TiVo to bring YouTube videos to TV screens – YouTube, the phenomenal video sharing website that Google owns, with all its inane user generated videos, will now be pumped into your TiVo (TIVO). The convergence of YouTube and the Boob Tube is upon us.

Wiki boss ‘edited for donation’ – Jimmy Wales denies all wrongdoing. Say it ain’t so Jimmy!

Linux Market to Triple by 2012 – We’ve been hearing about the ascendancy of Linux for at least a decade it seems. Red Hat (RHT) shareholders cross your fingers this prediction comes true.

Puretracks DRM-free music store hitting BlackBerry platform in April – Engadget, a very popular blog owned by Time Warner’s (TWX) AOL unit, reports on a new service that should make Blackberry users (RIMM) happy. Those darned iPhone and iPod users keep bragging about their iTunes. What now?