Technology and return predictability

Abstract

This paper finds significant predictability in stock returns across technology-linked firms. Using patent-holding information to identify firms’ technological linkage, we show that a long–short equity trading strategy sorted on lagged returns of technology-linked firms yields monthly alphas of around 105 basis points. The findings are robust to a number of specifications and are not driven by industry predictability, customer-supplier relationships, and strategic alliances. We provide supportive evidence that investors’ limited attention to technological linkages contributes to the return predictability across technology-linked firms. Our study uncovers technological relatedness as an important information linkage between firms. Valuation Insight: The market appears to under-react to value-relevant information about technologically similar firms (firms that have a high degree of cross-cited patents). A strategy of holding firms that have relatively high returns in the previous month and shorting technologically similar firms with low returns generates abnormal returns in the subsequent month in excess of 12% a year. This suggests that, when a value-relevant shock in one type of technology favors one firm over another, the value impact manifests in stock prices slowly over time.