Market bubbles blur the value of innovation

Companies are driven by innovation, but what is the true worth of a new technology? Overinflated company values during market bubbles–like the dot-com era–can obscure the value of a new advancement. That is, until the bubble bursts.

New Carlson School of Management research shows a new patent issued during a bubble period raises the stock prices of its creator’s company by 40 percent more than the innovation’s true value. 

That’s one of the key findings in the paper Assistant Professor Erik Loualiche has co-written with University of California Los Angeles Associate Professor Valentin Haddad and Federal Reserve Bank of Richmond Economist Paul Ho. The research, forthcoming in the Journal of Financial Economics, explores the disconnect during bubble periods between an innovation’s impact on the stock market and its real economic worth. 

Loualiche and his colleagues analyzed more than a million patents issued by U.S. firms across 49 industries during bubble episodes from 1962 to 2017; measured the stock market response; and studied the impacts on the firms’ sales, profits, and productivity up to five years later. 

“During market bubbles, investors tend to be overconfident about an innovation, causing the asset prices of the innovating company to soar much more than what their new technology is actually worth,” said Loualiche.

Meanwhile, the authors also found there is an underreaction to the asset prices of competing firms. Their market values remain largely unaffected despite the competitor seeing stock market gains from new technology.

“For the company that didn’t create a new innovation, it’s a missed opportunity but not a net loss in the stock market–at least not right away,” said Loualiche. “In a market bubble, investors don't fully realize the displacement, so the value of the competitors is actually not going to suffer as much as it should have.”

The researchers theorize the disconnect between the stock value and the true worth is fueled by disagreement among investors over which specific firms will succeed rather than the innovation itself. For example, investors disagree more about the viability of Uber vs. Lyft rather than the idea of rideshare technology. As investors pour money into their chosen rideshare company, the asset prices of each continue to grow despite the eventual outcome of a “winner” and a “loser.”

According to Loualiche, the research provides insights into how people make their investment decisions.

“This suggests that investors might be making some of their decisions by playing favorites, especially if there is relatively little information early on for an emerging technology,” said Loualiche. “Investors might rely on their priors and it may not be an entirely fact-based decision.”

For companies looking to take advantage of a wave of innovation, he says specialization may be the key.

“If you want to maximize how much money you are going to raise, it's better to pursue a specific emerging technology rather than diversify your activities,” said Loualiche. “That way it caters to the investors who will be really excited about what you're doing.”