Abstract
This study considers patent citation impact as a proxy for a leading indicator of technology firms' innovation capabilities. The author examines whether patent citation impact is associated with future earnings and whether this association is appropriately reflected in stock prices and analysts' earnings forecasts of patent-rich companies. The author reports results which indicate that change of patent citation impact is positively associated with future earnings up to five years in the future, particularly in the computer, electronics, and medical equipment industries. These are industries with relatively short time lags between technological advances and profit realization. The author also reports that investors and analysts do not seem to fully incorporate the implication of enhanced innovation capabilities for future earnings into stock prices and earnings forecasts. Based on this information, the paper develops a trading strategy that generates future abnormal stock returns.
In my view, this paper asks an important question. If a researcher could come up with an appropriate leading measure of innovation, then examining the reliability of that measure through its association with future benefits, and whether the implications of the measure are understood by market participants, is an interesting exercise. In my discussion, I will focus on (a) some of the issues with the patent citation index (the measure of innovation capabilities), (b) problems with the databases used to construct this measure which suggest that the results should be interpreted with caution, and (c) some additional comments on the mispricing and portfolio tests.