Capital Investment, Innovative Capacity, and Stock Returns

We study the dynamic implications of capital investment in innovative capacity (IC) on future stock returns, investment, and profitability by modeling the unique effects of IC investment on uncertain option generation/exercise and post-exercise revenue. The model highlights the diverse effects of IC investment on expected returns in different post-investment regimes and generates the novel prediction that, under the neoclassical assumption of non-increasing revenue returns, IC investment is positively related to subsequent cumulative stock returns with a lag. The model also predicts a positive effect of IC investment on future investment and profitability. We find strong empirical support for these predictions