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Innovative Efficiency and Stock Returns

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper, “Innovative Efficiency and Stock Returns,” published in the Journal of Financial Economics (JFE), delves into the enthralling realm of innovative efficiency (IE) and its influence on future stock returns.

Authored by Hirshleifer, Hsu, and Li, the study intricately unravels how IE, measured by patents or citations scaled by R&D, serves as a potent positive predictor of future returns even after factoring in firm characteristics and risk. Additionally, the paper sheds light on the IE-return relation, linking it to the loading on a mispricing factor.

Notably, the high Sharpe ratio of the Efficient Minus Inefficient (EMI) portfolio accentuates the substantial role played by mispricing. The study’s tests, based on attention and uncertainty proxies, compellingly point to the significant contribution of limited attention to this effect, further solidifying the nuanced relationship between IE and stock returns.

Abstract Of Paper

We find that innovative efficiency (IE), patents or citations scaled by R&D, is a strong positive predictor of future returns after controlling for firm characteristics and risk. The IE-return relation is associated with the loading on a mispricing factor, and the high Sharpe ratio of the Efficient Minus Inefficient (EMI) portfolio suggests that mispricing plays an important role. Further tests based upon attention and uncertainty proxies suggest that limited attention contributes to the effect. The high weight of the EMI portfolio return in the tangency portfolio suggests that IE captures incremental pricing effects relative to well-known factors.

Original paper – Download PDF

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Author

David A. Hirshleifer
Marshall School of Business, USC; National Bureau of Economic Research (NBER)

Po-Hsuan Hsu
National Tsing Hua University – Department of Quantitative Finance; National University of Singapore (NUS) – Asian Bureau of Finance and Economic Research (ABFER)

Dongmei Li
University of South Carolina – Darla Moore School of Business – Department of Finance

Conclusion

The comprehensive exploration of “Innovative Efficiency and Stock Returns” in the Journal of Financial Economics (JFE) culminates in illuminating insights into the intricate dynamics of innovative efficiency (IE) and its profound impact on future stock returns.

Authored by Hirshleifer, Hsu, and Li, the study compellingly establishes IE, measured through patents or citations scaled by R&D, as a robust positive predictor of future returns, even accounting for firm-specific attributes and risk. Significantly, the IE-return relation is notably linked to the loading on a mispricing factor, as evidenced by the high Sharpe ratio of the Efficient Minus Inefficient (EMI) portfolio, accentuating the pivotal role of mispricing.

Furthermore, the study’s discerning tests, built on attention and uncertainty proxies, further underscore the substantial contribution of limited attention to this effect, underscoring the remarkable influence of IE on stock returns, capturing incremental pricing effects in comparison to established factors.

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FAQ

What is the main finding of the research paper regarding the relationship between innovative efficiency (IE) and future stock returns?

The main finding of the research paper is that innovative efficiency (IE), measured by patents or citations scaled by R&D, serves as a strong positive predictor of future stock returns. Even after considering firm-specific characteristics and risk, the study establishes that IE has a robust and positive relationship with future stock returns.

How does the study connect innovative efficiency (IE) to the mispricing factor, and what role does mispricing play in the IE-return relation?

The study connects innovative efficiency (IE) to the mispricing factor by demonstrating that the IE-return relation is associated with the loading on a mispricing factor. The high Sharpe ratio of the Efficient Minus Inefficient (EMI) portfolio suggests that mispricing plays a crucial role in this relationship. This indicates that the mispricing factor is an important driver in the connection between IE and stock returns.

What additional insights does the research provide regarding the influence of limited attention on the relationship between innovative efficiency (IE) and stock returns?

The research provides insights into the influence of limited attention on the IE-return relation through tests based on attention and uncertainty proxies. The study suggests that limited attention contributes significantly to the effect, emphasizing the role of attention-related factors in shaping the relationship between innovative efficiency and stock returns. This adds a nuanced layer to the understanding of the dynamics at play in the context of IE and its impact on stock returns.

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