Taking the Road Less Traveled? Market Misreaction and Firm Innovation Directions

Abstract

We propose that public investors react differently to patent issuance depending on its novelty, and these misreactions exert real impacts on the firms' future innovations. First, using textual analyses of patent documents to measure patent novelty, we find that investors underreact to the issuance of path-breaking innovations while overreact to the trend-following ones. (Non-)novel issuance predicts a return drift (reversal) of around 1% in two years. Novel patent issuance predicts lower risk but positive forecast errors, consistent with a non-risk-based novelty mispricing mechanism. A bounded-rationality model, where investors cannot figure out the true novelty of a patent at issuance due to cognitive limits, explains the empirical patterns well. Second, using exogenous distraction shocks, such as earthquakes, we present causal evidence that following disappointing returns, novel firms shift innovation directions from novelty-seeking to copycatting. The findings highlight that investors' misreactions to patent novelty impact firms' future innovation directions by steering them away from higher-valued, groundbreaking research.

Keywords: stock market misvaluation, innovation novelty, behavioral finance, market efficiency, innovation direction

JEL Classification: D84, G02, G12, G14, G31, O31