Here is an interesting fact that spans corporate finance and asset pricing: among U.S. public firms, innovation is mostly concentrated in a very small group of large corporations, and innovation “leaders” experience lower systematic risk than the “laggards.” Jan Bena and Lorenzo Garlappi, in their paper “Corporate Innovation and Returns,” investigate this fact by, first, proposing a winner-takes-all patent-race model, and then empirically showing that a firm’s expected return decreases in its innovation and increases in that of its rivals. When firms’ investments cannot be reversed, and major innovation breakthroughs are idiosyncratic events, the winner-takes-all nature of innovation means that leader firm’s decision to invest will end up eroding the laggard firm’s innovation option value. The laggard will thus become riskier. Jan and Lorenzo empirically test the model’s predictions and show that there is a negative effect of the share of innovation output on firms’ beta. This implies that there is a significant impact arising from the strategic interaction among firms competing in innovation on expected returns. One interesting implication of these results is that the pattern of within-industry heterogeneity of equity betas discovered in this paper challenges the commonly followed practice of using industry peer betas to estimate firms’ cost of capital.
Spotlight by Andrew Ellul
Photos courtesy of Jan Bena and Lorenzo Garlappi