Capturing the Value of Innovation

February 12, 2008

New global index is the latest to try to gain from intangible assets.

It could be argued that innovation is what drives the global economy. Recently indexes centered around innovation or patents have been launched by a few different firms, aiming to capture the value of this innovation.

The most recent such launch is the Standard & Poor’s BusinessWeek Global Innovation Index, which was rolled out just last week. Merchant banking firm Ocean Tomo, which specializes in intellectual property assets, launched the Ocean Tomo 300 Patent Index in October 2006, and index developer IndexIQ introduced its IndexIQ Most Innovative Companies Index about a year ago.

S&P BusinessWeek Global Innovation Index

The S&P BusinessWeek Global Innovation Index was developed in conjunction with BusinessWeek magazine using the publication’s annual list, The Most Innovative Companies Rankings, which it determines each year with The Boston Consulting Group.

“Innovation is commonly associated with business success, and the S&P/BusinessWeek Global Innovation Index will provide investors with a metric to track the share price performance of the world’s most innovative, publicly traded companies,” says Srikant Dash, head of Global Research and Design at Standard & Poor’s.

The rankings are determined through a survey that is sent to the top 10 executives at the 1,500 largest companies in the world asking them to name the most innovative company outside of their own industry group. The index includes the top-ranked 25 companies from the final list that meet certain requirements.

Components must be listed or have an ADR or GDR trading on the exchange of a developed market. They also must have a float-adjusted market capitalization of $500 million and a six-month average daily value traded of at least $3 million. Each component’s weighting is based on its position in the rankings and on a quantitative evaluation of its fundamentals.

The U.S. dominates the index with 19 of the 25 components, for a total weighting of 79.36%. Nine of the top 10 components are U.S. companies, including Procter & Gamble (8.85%), Apple (8.01%), 3M (7.43%), Google (6.68%) and General Electric (6.00%). The other countries represented include Korea, Finland and Germany with one company each; and Japan, with three companies and the second-largest country weighting at 12.03%. Not surprisingly, Information Technology receives the largest sector representation in the index, at 36.58%.

The index was up 19.01% for 2007 versus 11.38% for the S&P Global 100 Index and 5.49% for the S&P 500.

The IndexIQ Most Innovative Companies Index

The IndexIQ Most Innovative Companies Index is part of a group of indexes from IndexIQ that are designed to capture the value of intangible assets. Other indexes in the series measure customer loyalty, corporate governance, productivity and power. The Most Innovative Index does not have a publicly available methodology; however, it utilizes multiple fundamental factors in determining a company’s level of innovation. The factors considered are related to such areas as research & development.

“The factors are designed to not only gauge the level of a firm’s reinvestment in new products and services for instance, but also their effectiveness in turning that innovation into actual financial results,” said IndexIQ Chief Executive Officer Adam Patti in an email. He added that the methodology was completely quantitative and rules-based.

The index has 92 components, ranging in size from $0.35 billion to $215.71 billion, with a similar weighting in Information Technology as the new S&P index. However, the IndexIQ product is strictly a U.S. index, not an international index, and it utilizes a proprietary, fundamentally derived weighting scheme. Its top five companies include Google (with a 1.85% weighting), Weatherford International (1.83%), Garmin Ltd. (1.75%), ANSYS Inc., (1.74%) and FLIR Systems Inc. (1.74%).

The IndexIQ Most Innovative Companies Index was up 14.9% in 2007, outperforming the S&P 500, but underperforming the S&P BusinessWeek Global Innovation Index, which likely benefited from its inclusion of international companies, since international stocks outperformed domestic stocks last year.
The firm has filed for an ETF based on the index.

Ocean Tomo 300 Patent Index

The Ocean Tomo 300 Patent Index is a bit different from the other two in that it is focused mainly on patents, although as with IndexIQ, Ocean Tomo’s creation of the index was driven by the growing importance of intangible assets.

“Intangible assets are responsible for a larger and larger fraction of corporate value,” says Cameron Gray, manager of Ocean Tomo’s indexes business, adding that the practice of focusing on tangible assets as a gauge of corporate value is becoming obsolete.

“The view is that a lot of the growth in the U.S. and elsewhere, when manufacturing is outsourced, comes down to innovation and sales & distribution,” he says.
Gray, like IndexIQ’s Patti, notes the importance of a company’s ability to translate its intellectual property into profits, estimating that about two-thirds of the U.S. economy is dependent on patents, which are the most quantifiable of intangible assets.

The Ocean Tomo index has a complex but interesting methodology that is also transparent and rules-based. The firm divides the 1,000 most liquid stocks listed on the U.S. market into 50 style and size groups. Ocean Tomo has a proprietary patent ratings system that is used in developing an innovation ratio that determines a company’s selection to the index. The six stocks with the highest innovation ratios within each of the 50 groups are included in the index, which is weighted by market capitalization.

The Ocean Tomo 300 is the only index to currently have a product based on it. Claymore has launched exchange-traded funds (ETFs) on both the broad index and on one of its subindexes, the Ocean Tomo 300 Patent Growth Index. The Claymore/Ocean Tomo Patent ETF trades under the symbol OTP on the AMEX and has assets of roughly $10 million. The Claymore/Ocean Tomo Patent Growth Index ETF (AMEX: OTR).

A list of components was not immediately available, but OTP’s top five holdings were General Electric (with a 4.67% weighting), Microsoft (3.64%), AT&T (3.03%), Royal Dutch Shell (2.87%) and Procter & Gamble (2.67%). As with the two other indexes, Information Technology is the largest sector, with a 23.38% weighting.

The index was up 15.98% in 2007.

Innovation = Outperformance?

It seems logical that innovative companies would outperform companies that are less so. Indeed, the results from 2007 indicate that all three of the innovation-oriented indexes outperformed the S&P 500. Of course 2007 was also the year that growth outperformed value, so that could have something to do with it. Patti and Gray both said that their indexes tended to have growth tilts.

Of the three indexes, the S&P BusinessWeek Global Innovation Index seems the most subjective because it relies in part on the personal opinions of individuals (even if it is roughly 10,500 individuals) in formulating its component list. The methodology for the Ocean Tomo index is complex, but quite clearly laid out. And although the IndexIQ index’s methodology is not public, it is based on quantitative factors.

The S&P index is also the least broad, despite the fact that it is global in scope. With only 25 components and a worldwide focus, it is taking a far more narrow approach than the two other indexes. The IndexIQ Most Innovative Companies Index has 92 components, while Ocean Tomo’s 300-component index represents a large section of the U.S. market.

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