In our age of computerized trading, linguistic algorithms are designed to focus on companies that are making news, analyze the actual news, and then proceed to trade accordingly. As a result, stock prices react with little delay to company-specific news, leading one to believe it has become impossible for individual investors to do better than computer-generated decisions. Not so. In our new study, my colleague Bernd Schlusche and I found that there may be room for retail investors to make money by trading on the news. Information about one company is often relevant to other firms, but because human and algorithmic traders alike are frequently unaware of the broader ramifications of news stories, there is often a substantial delay in the reaction of companies and investors — allowing clever human observers to outperform a typical trader.
Today, investors would be well advised to pay attention to a case currently before the Supreme Court. In Impression Products v. Lexmark International, the justices will decide whether Impression Products violated the law by buying Lexmark toner cartridges at a cheaper price abroad and reselling them at a higher price in the United States, a practice known in finance as price arbitrage. In a very similar case last year, Kirtsaeng v. John Wiley & Sons, the Court ruled that a buyer of a copyrighted product has the ownership right to that product, and is free to resell it at a higher price in the United States. The difference between the two cases comes down to whether the Court sees a major distinction between patented and copyrighted items. If the distinction between the two is found to be unimportant, the justices will follow the Kirtsaeng precedent and rule against Lexmark.
Why should investors pay attention to the Impression Products v. Lexmark International case and try to predict its outcome? Lexmark is no longer a publicly traded firm, and Impression Products never was. Investors should care nonetheless because the case has significance for many other firms.
Lexmark, just like John Wiley & Sons, charges less for its products in poorer countries. This business practice, known as price discrimination, is widely used by textbook publishers, drug makers, as well as software and equipment manufacturers. If the Court rules against Lexmark and removes legal barriers to cross-border price arbitrage, the business model of price discrimination will become unsustainable. Eventually, producers will be unable to continue their price-discrimination as arbitragers will force them to set the same price across borders. This will inevitably lead to diminished profits for the producers.
If the Court rules against Lexmark, some companies will see their valuations rise. E-commerce businesses, such as eBay and Amazon, would profit from the free flow of goods across borders, and firms that manufacture complex products with patented components would benefit from less burdensome patent laws.
But which specific firms will be affected by the ruling? The Court’s case files offer some clues. In recent years, it has become common practice for firms to try to influence key Supreme Court decisions by writing amicus briefs (friend of the court letters). A number of firms, including publicly traded companies, have revealed their stakes in the Lexmark case by supplying amicus briefs.
A diverse set of firms are supporting Lexmark. Separate briefs were filed by a coalition of printer manufacturers that includes Brother International, Canon U.S.A., Epson America, Hewlett-Packard, Samsung, and Xerox; technology firms, such as IBM, Nokia, Dolby Labs, Plantronics, Medtronic, and Qualcomm; as well as the trade associations of pharmaceutical firms, biotech firms, and medical device manufacturers. All these companies appear to make a lot of money by selling their products at different prices in different countries. But instead of directly arguing that the Court should protect a firm’s ability to set different prices in different counties, they use the amicus briefs to argue for strong patent protection which would prevent other firms from buying their products cheaply in a poorer country and reselling them at a higher price in a richer country.
The firms urging the Court to rule again Lexmark are just as varied. These firms include Costco, LG Electronics, Western Digital Corporation, and the Auto Care Association, a trade organization representing businesses that manufacture and sell motor vehicle parts and service and repair vehicles. Their briefs argue that patent restrictions hamper cross-border trade and create legal uncertainty when a firm’s supply chain includes patented components.
Investors would be wise to pay attention to the ruling. Our research found that a typical trader tends to overlook similarities between companies — leaving those who can correctly observe the parallels to make a profit by trading on the news. Especially when the name of the firm is not mentioned in the press.