Innovation and Stock Returns

Abstract

The main aim of this thesis is to determine the relevance of innovation for the average stock returns, thereby investigating if innovation is one the factors explaining the stock returns. Innovation has been identified as an important determinant of economic growth and has been incorporated in economic growth models. With respect to equity returns, one part of literature identifies innovation as source of increased risk given the uncertainty associated with its outcome while another part of literature finds high innovation to reduce technological risk of a firm. In this thesis, we find that there is a premium to high innovation particularly for small size stocks. The highest innovation stocks earn higher average returns than lowest innovation stocks and this effect is significant and prominent for small size stocks. This persists when innovation is accounted for along with other variables like book to market value, operating profitability and investment. Regressing innovation sorted portfolios against Fama-French 5 factors model generates positive significant alphas for high innovation portfolios, even when controlled for size. Based on this, an innovation factor is constructed that captures the difference between the average return on high and low innovation portfolios. This innovation factor is incorporated in the Fama-French 5 factors model as the sixth factor evaluating if the model better explains the average stock returns. The six factors model incorporating innovation factor is rejected based on the test statistic testing if the alphas produced by the model are jointly equal to zero. However, the six factors model produces lower values of test statistics and alpha based measures used for model comparison, implying an improvement over the existing model.