Corporate Innovation and Its Effects on Equity Returns

This paper provides a rational explanation for the performance of price momentum strategies, based on the concept of corporate innovation. We define corporate innovation as the proportion of a firm's change in gross profit margin not explained by the change in the capital and labor it utilizes. We show that an aggregate measure of corporate innovation is priced in the cross-section of equity returns, and eliminates the priced information in the momentum factor. This measure is similar in nature to total factor productivity (TPF). Corporate innovation-based portfolio strategies exhibit very similar characteristics and performance to those of rpice momentum strategies. In addition, the returns on corporate innovation-based strategies can explain a substantial proportion of the time-series variation in price momentum strategies. The economic explanation for the performance of price momentum provided here is also consistent with long horizon return reversals and the performance of long-horizon contrarian strategies.