The Knowledge Effect: Excess Returns of Highly Innovative Companies

Abstract

In this paper, we identify the Knowledge Effect, the tendency of stocks of highly innovative companies to experience excess returns. It results from investors’ systematic errors in evaluating companies that invest large sums of money in producing knowledge. The origins of the Knowledge Effect can be traced to two factors: 1. A surge in the pace of knowledge production catalyzed by the release of the first commercially available semiconductor in 1971. Due to the cumulative nature of knowledge, this acceleration has resulted in an exponential increase in humankind’s total knowledge. 2. A mandate by the US Financial Accounting Standards Board in 1974 which ruled that companies must expense knowledge investments in the period incurred. This deprived investors of relevant financial information on corporate knowledge spending at the dawn of this massive surge in the pace of knowledge production.The Knowledge Effect is grounded in academic literature. It was first discovered in a series of studies in the 1990s where NYU’s Baruch Lev analyzed 20 years of financial data and discovered an association between a firm’s level of knowledge capital and its subsequent stock performance. Further research advanced the findings, and in 2005, Lev proved the existence of a market inefficiency attributable to missing information about corporate knowledge investments. This phenomenon leads highly innovative companies to deliver persistent abnormal returns.Gavekal Capital captures the Knowledge Effect using a proprietary process designed to overcome the informational shortcomings of traditional financial statements. Our methodology capitalizes corporate knowledge investments, measures firm performance on a knowledge-adjusted basis, and selects investments on the basis of knowledge intensity.