The Knowledge Effect: Excess Returns Of Highly Innovative Companies via Gavekal Capital
By Steven Vannelli, CFA, and Eric Bush, CFA
Executive Summary
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:
- 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.
- 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.
Introduction
What drives stock returns? Answering this question has been a goal of investors ever since Harry Markowitz introduced his Modern Portfolio Theory in the 1950s. Later, William Sharpe’s Capital Asset Pricing Model illustrated that the market itself is the first and foremost element in explaining a stock’s performance. However, empirical research over the past several decades has identified many other effects beyond simply the market that exhibit a strong explanatory power of stock returns. These effects are persistent over time and apply to a broad range of stocks. Some of the more widely known are the small-cap effect, the value effect, and the momentum effect. In this paper, we identify a new anomaly, the Knowledge Effect. The Knowledge Effect is a pricing anomaly that leads to persistent excess returns among highly innovative companies.
The Knowledge Effect can be traced to two important roots. First, with introduction of the semiconductor, humankind was able to radically accelerate its knowledge production. The semiconductor has enabled humankind to multiply its intellectual strength in a similar way that the steam engine and electric motor enabled humankind to multiply its physical strength. Knowledge production takes the form of corporate investment in research and development (R&D), advertising and employee training. Corporations spend more on knowledge than they do on property, plant and equipment. The second important root for the Knowledge Effect is the dearth of information about corporate knowledge activities that has been amplified by the poorly timed implementation of conservative accounting practices at the start of the greatest period of knowledge production in human history. This information deficiency has led investors to make a systematic error in the way they assess the prospects of companies that invest significantly in knowledge. Ultimately, this systematic error is reflected in a persistent risk premium, or excess return, for companies that invest significantly in knowledge.
The Knowledge Effect was originally discovered by academic researchers, spearheaded by Baruch Lev, who studied 20 years of financial data and discovered an important association between a firm’s level of knowledge capital and its subsequent stock returns. Further research advanced the original findings and in 2005 Lev, building on his own earlier research as well as that of others, proved the existence of a market inefficiency traceable to missing information about corporate knowledge investments. This inefficiency has led highly innovative companies to deliver persistently positive abnormal returns in the stock market.
Gavekal Capital has developed the Knowledge Leaders Indexes as the broadest, longest running, real-time test of the Knowledge Effect. We have developed a proprietary process designed to overcome the informational shortcomings that afflict most investors. Our results suggest that there is an enormous opportunity for investors to capitalize on the Knowledge Effect in both developed and emerging markets.
Two Views On the Drivers of Stock Returns
There are generally two views regarding the factors that drive stock returns: an efficient market hypothesis view and a behavioral view.
The efficient market hypothesis asserts that all market participants are rational and asset prices immediately incorporate all relevant information. Based on this foundation, the rate of return earned is determined by the systematic risk, or market risk, of the stock. This concept was illustrated by William Sharpe in his Capital Asset Pricing Model (CAPM) which showed that a stock’s expected return is determined by the risk-free rate plus the systematic risk associated with the stock. The CAPM folded neatly into Modern Portfolio Theory (MPT) since according to MPT an investor is compensated only for taking on market risk, which cannot be diversified away, and is not compensated for the idiosyncratic risk of the stock, which can be diversified away. Any perceived excess return of a stock is simply due to a higher overall level of systematic risk. As we will see later on in the paper, the academic research on the Knowledge Effect identified this as one of the early possible explanations for the persistent abnormal returns of highly innovative companies.
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