Identifying Winners: Innovation Impact and Abnormal Returns

Abstract

This thesis examines the link between innovative firms and operational performance as well as stock market performance. To examine this relation, we introduce a new variable, Innovation Impact (II), which is investigated as an anomaly across U.S. firms from 2013-2020. In essence, II measures the impact of patents produced. Specifically, we measure the patents produced each year and the accompanying citations that those patents receive the following two years. We argue that a firm’s ability to innovate is an important indicator of future performance in relation to both operational improvements and stock market returns. Moreover, we argue that investors are unable to process the information available in II. Consequently, due to the complexity associated with intellectual property (IP), investors undervalue highly innovative companies, resulting in short-term mispricing that investors can leverage to achieve abnormal returns. Specifically, the thesis is structured into three parts: (1) Contextual information, (2) the relation between II and operational performance, and (3) the relation between II and stock market returns. In the first part of the thesis, we investigate the field of intellectual property rights and explore existing academia for return predicting variables. Furthermore, we construct an investable universe of innovative U.S firms utilized for both parts (2) and (3). In the second part of the thesis, we perform a cross-sectional and time series analysis to analyze the relation between II and operational performance. Finally, we investigate if a positive relationship exists between II and stock market returns and if II provides incremental information to existing stock market factors. We do not find supporting evidence that a correlation between II and operational performance can be established. Specifically, our findings are ambiguous in establishing a trend between II and firm financials. Despite of this, we establish a positive relationship between II and stock market returns. Our findings indicate that a portfolio of high-II companies, delivers a positive alpha, which is significant at a 5% level, when controlling for known stock market factors. Finally, we find that a hedge portfolio, which takes a long and short position in the extreme terciles of II, can provide positive excess returns, albeit not statistically significant when controlling for known stock market factors.