Innovation Search Strategy and Predictable Returns : A Bias for Novelty

Because of the intangible and highly uncertain nature of innovation, investors may have difficulty processing information associated with a firm’s innovation and innovation search strategy. Due to cognitive and strategic biases, investors are likely to pay more attention to novel and explorative patents rather than incremental and exploitative patents. We find that firms focusing on exploitation rather than exploration tend to generate superior subsequent 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 market also seems unable to accurately incorporate innovation strategy information. 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.