Innovation Search Strategy and Predictable Returns

Abstract

Because of the intangible and highly uncertain nature of innovation, investors may have difficulty processing information associated with a firm’s innovation search strategy. Due to cognitive and strategic biases, investors are likely to pay more attention to unfamiliar explorative patents rather than incremental exploitative patents. We find that innovative firms focusing on exploitation rather than exploration tend to generate superior subsequent short-term operating performance. Analysts do not seem to detect this, as firms currently focused on exploitation tend to outperform the market’s near-term earnings expectations. The stock market also seems unable to accurately incorporate information about a firm’s innovation search strategy. We find that firms with exploitation strategies are undervalued relative to firms with exploration strategies and that this return differential is incremental to standard risk and innovation-based pricing factors examined in the prior literature. This result suggests a more nuanced view on whether stock market pressure hampers innovation, and may have implications for optimal firm financing choices and corporate disclosure policy. This paper was accepted by David Simchi-Levi, finance.

A bird in the hand is worth two in the bush: Technology search strategies and competition due to import penetration

“…None of the coefficients of interest appears to have an effect in the analysis with delisted firms. These findings resonate with the results of a recent study by Fitzgerald et al (2020), which shows that firms focused on technological exploitation obtain better short‐term performance, measured as both return on assets and operating cash flow, which arguably improves their chances of survival in the event of a competitive shock.…”

“…The viability of exploration as a strategy to deal with this sort of environmental change may be limited, because its more distant benefits get discounted at a higher rate, even as the greater upfront costs deplete corporate resources and accelerate organizational demises. According to Fitzgerald, Balsmeier, Fleming, and Manso (2021), firms that focus on exploitation rather than exploration tend to generate superior short‐term operating performance, and Ferreira, Manso, and Silva a. C. (2014) establish a key role of firm tolerance to early failures when they explore new ideas. As Miller and Friesen (1983: p. 223) argue, “extensive risk taking, forceful proactiveness and a strong emphasis on novelty can be very hazardous when competitive or economic conditions are becoming more taxing,” so firms operating in competitive environments that engage in higher degrees of exploitation tend to achieve better performance (Jansen et al, 2006).…”

“…First, we only have data about listed firms, covered by Compustat. Although Compustat data have been used extensively in prior research (e.g., Fitzgerald et al, 2020; Uotila, Maula, Keil, & Zahra, 2009), privately held corporations might react differently to competition, due to their concentrated ownership structure and/or greater tolerance to failure (Ferreira et al, 2014). Second, patenting activity is not distributed uniformly across sectors, which determines the structure of our data.…”

Patenting activity or innovative originality?

“…We find a positive and significant association between PATENT DUMMY t −1 on RETURNS t suggesting firms with patents receive higher future stock price returns than those without patents. Furthermore, this suggests that the investor inattention hypothesis extends to all patenting activities and not just for the quality of the patent as identified in prior studies (Cohen et al ., 2013; Hirshleifer et al ., 2013; Fitzgerald et al ., 2019). In column (4), we include both INNORIG t −1 and PATENT DUMMY t −1 in the full sample, and we find no significant association between INNORIG t −1 and RETURNS t .…”

“…Prior literature finds that current stock prices do not reflect all value relevant information regarding a firm’s innovation activity (Hirshleifer et al ., 2013; Cohen et al ., 2013; Fitzgerald et al ., 2019). In particular, Hirshleifer et al .…”