Technological innovation and stock returns: Innovative skill versus innovative luck

• Published date: 01 November 2023
• Author: Ben Angelo,Mitchell Johnston
• Date: 01 November 2023
• DOI: http://doi.org/10.1111/fire.12344

DOI: 10.1111/fire.12344

ORIGINAL ARTICLE

Technological innovation and stock returns:

Innovative skill versus innovative luck

Ben Angelo1Mitchell Johnston2

1PaulW. Parkison Department of Accounting,

Ball State University, Muncie, Indiana,USA

2Department of Economics and Finance,

University of Dayton,Dayton, Ohio, USA

Correspondence

Mitchell Johnston, Department of Economics

and Finance, University of Dayton,Dayton, OH

45469, USA.

Email: mjohnston2@udayton.edu

Abstract

Prior studies conclude that investors undervalue innovative

ability.These studies do not fully capture the prominent role

that industry and market trends playin contextualizing inno-

vations. We disaggregate the value generated by innovative

skill from the value generated by industry and markettrends

and find that innovative skill is positively associated with

profitability. Further, our results are consistent with a risk

explanation as innovative skill is negatively associated with

returns, consistent with investors using patent value to iden-

tify innovative skill and adjusting the riskiness of the firm

accordingly.

KEYWORDS

firm innovative skill, innovativeefficiency, market efficiency

JEL CLASSIFICATION

G12, G14

1INTRODUCTION

Firm innovation contains information relevant to future returns (Cohen et al., 2013; Hirshleifer et al., 2013, 2018)

and information regarding the fundamental characteristics of a firm (Bloom & Van Reenen, 2002; Hirshleifer et al.,

2018; Pandit et al., 2011). Surprisingly, many studies conclude that investors undervalue innovative ability (Cohen

et al., 2013; Hirshleifer et al., 2013, 2018). We argue that investors are likely to consider the quality ofa firm’s inno-

vation within the broader context of industry and market trends. Innovation occurs within a dynamic, competitive

environment(Aghion et al., 2005). Further, competition is a strong incentive for firms to develop distinct and new inno-

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in anymedium, provided the original work is properly cited.

© 2023 The Authors. The Financial Review published by WileyPeriodicals LLC on behalf of Eastern Finance Association.

Financial Review. 2023;58:811–832. wileyonlinelibrary.com/journal/fire 811

812 ANGELOAND JOHNSTON

vations relative to other firms in the same product market,while imitative innovation can be growth reducing (Aghion

et al., 2001). However,strong incentives also exist for firms to mimic the innovations of other firms (Blazsek & Escrib-

ano, 2010, 2016; Segerstrom, 1991). When product market competition is high, CEOs may overinvest in research

and development (R&D) (Abdoh & Liu, 2021). Further,co-opted boards, those with board members appointed by the

incumbent CEO,may foster innovation by mitigating career concerns over innovation risk (Nguyen et al., 2021). In this

paper,we separate the innovative value a firm generates through innovative skill from the value that a firm generates

by following industry and markettrends. Unlike existing measures of firm innovative ability, our measure of innovative

skill is negatively associated with subsequent returns.

Afirm’s ability to innovate is persistent and readily observable (Cohen et al., 2013). Surprisingly, a number of studies

suggest that the market undervalues innovativeability. Cohen et al. (2013) and Hirshleifer et al. (2013, 2018) all con-

clude that the market undervalues innovativeability despite a positive relation between innovative ability and future

profitability. This is a striking result since innovations improve firm profitability and protect a firm from a degree of

competition.

Innovation is an inherently complexand risky endeavor. Accounting regulations acknowledge this risk by requiring

firms to expenseR&D costs because “there is often a high degree of uncertainty about whether R&D expenditures will

provide any future benefits” (FASB,ASC 730-10-05-3). In this paper, we consider the role of market expectations of

innovationvalue on firm value. Accordingly, we only include firms that have been successful innovators, patent-issuing

firms in our sample.

We divide patent value into two distinct components: innovative skill and innovative luck. Innovative skill is the

idiosyncratic value a firm generatesthrough the innovative process. Innovative luck is the market expectations for the

value of innovation. Todistinguish innovative skill from innovative luck, we decompose the value of patents using an

approach similar to what Bertrand and Mullainathan (2001) used in their study of executivecompensation. Bertrand

and Mullainathan (2001) consider the impact of three exogenous sources of firm performance on executivecompen-

sation.1Executives receive exogenousbenefits—namely, increased compensation attributable to participating in an

industry with favorable market conditions. Similarly, in our study, firms receive exogenous benefits in the form of

increased patent valuation by participating in an industry with favorablemarket conditions. When firms issue patents,

they generatepositive knowledge spillover effects for competitor firms that increase the likelihood of patent issuance

by a competitor (Blazsek & Escribano, 2010, 2016). Firms may develop a technology that is a substitute or a comple-

ment to a competitor’s patent in an attempt to gain these positive spillover effects. We label these positive spillover

effects as innovative luck. Although it is difficult to envision a firm issuing a patent as an exogenousevent, the firm is

attempting to capture value generated by a competitor.It is this value, not the patent issuance, that is exogenous. We

assume that a single patent cannot significantly influence industry or market returns. Thus, innovative luck is exoge-

nous to the firm, while firm patent issuance is not. Welabel the incremental value beyond innovative luck generated by

a given patent as innovative skill. Innovative skill represents the patent value aboveor below market expectations. A

skilled firm will produce patents with positivevalues, while an unskilled firm will produce patents with negative values.

We hypothesize that highly skilled innovators should earn lower future returns relative to unskilled innovators.

Highly skilled innovatorsare less risky because they utilize the innovative process to generate value above and beyond

market and industry trends, while unskilled innovators merely aim to replicate the value created by competitors.

Consistent with highly skilled innovators being less risky, we find that more innovative skill is positively associated

with both higher profitability and less volatile profitability. This result is indicativeof the fact that our measure does

capture a degree of managerial skill as the higher profits at lower levels of volatility would likely manifest as a func-

tion of manager effort. However, we also provide evidencethat innovative skill is persistent through a Monte Carlo

simulation.

1The third exogenous source evaluated byBertrand and Mullainathan (2001) is the “overall economic fortune of a sector.” We consider this as the same

exogenousforce in our study, where the innovations of competitor firms in the same sector drive the exogenousvalue.