Predicting Investment Shock Waves
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Finance & Accounting Innovation Feb 2, 2012

Predicting Investment Shock Waves

How technological innovations affect risk premiums

Based on the research of

Dimitris Papanikolaou

Major technological advances have the power to shake up the marketplace. As investment shocks, technological innovations do not affect all firms equally. Some firms benefit, while others lose market share. Because of these risks, investors demand a premium for investing in companies that appear unable to adapt to new technologies, argues Dimitris Papanikolaou, an assistant professor of finance at the Kellogg School of Management.

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Papaniko­laou cites the rise of the Inter­net as an exam­ple of an inno­va­tion that pro­duced major win­ners and losers in the mar­ket­place. Com­pa­nies that were able to imple­ment the invest­ment shocks and adapt to the Web envi­ron­ment — Ama­zon, for exam­ple — found a new struc­ture and were able to take advan­tage of the major inno­va­tion. Oth­er firms were not able to adapt, and some even­tu­al­ly went out of busi­ness, such as Bor­ders. Peo­ple buy stock in a firm, and then the next Inter­net arrives, and they don’t know how the firm will fare in that envi­ron­ment,” Papaniko­laou says.

The dif­fer­ence in the abil­i­ty of com­pa­nies to take advan­tage of new advances makes a big dif­fer­ence for investors. For exam­ple, investors who bought equi­ty in a bricks-and-mor­tar book­store in the 1990s would have found that their invest­ment strat­e­gy did not pay off — many book­stores did not adapt to the rise of the Inter­net. That gave Ama­zon an oppor­tu­ni­ty to take sub­stan­tial mar­ket share. As an investor in those types of firms, I’m afraid that stock prices will go down and demand a high­er risk pre­mi­um,” Papaniko­laou says.

In order to ben­e­fit from an inno­va­tion, a firm must have the means to adopt or imple­ment it.

He adds that the idea of invest­ment shocks has helped schol­ars under­stand long-term growth, and that con­cept has been incor­po­rat­ed into many mod­els used to pre­dict how stock prices will fluc­tu­ate. His mod­el is a type of real busi­ness cycle mod­el,” in which mar­ket fluc­tu­a­tions are large­ly explained by shocks to the busi­ness envi­ron­ment. The prob­lem with some of these mod­els, Papaniko­laou says, is that they attempt to account for the impact of tech­no­log­i­cal inno­va­tion by using dis­em­bod­ied shocks.” In oth­er words, these mod­els assume that the abil­i­ty to adopt or ben­e­fit from inno­va­tion is auto­mat­ic and equal across all firms. In the real world, of course, this is not the case — in order to ben­e­fit from an inno­va­tion, a firm must have the means to adopt or imple­ment it.

For exam­ple, take the case of bet­ter com­put­ers. Peo­ple who use mod­els with dis­em­bod­ied shocks assume that the ben­e­fits from the new machines fall equal­ly on all com­pa­nies. But as Papaniko­laou explains, My old lap­top is still very slow — it doesn’t go any faster because Intel released a new proces­sor. In order to ben­e­fit from this inno­va­tion, I need to go out and buy this new com­put­er. It’s not going to mag­i­cal­ly land on my desk.” That is why his mod­el accounts for the fact that firms will imple­ment tech­no­log­i­cal advances dif­fer­ent­ly, which is an impor­tant fac­tor in under­stand­ing how they will fare in the wake of an invest­ment shock that affects the whole market.

Val­ue vs. Growth

Anoth­er impor­tant fac­tor in Papanikolaou’s mod­el is the dif­fer­ence between val­ue firms and growth firms. Based on the results from his mod­el, Papaniko­laou argues that invest­ment shocks ben­e­fit pro­duc­ers of cap­i­tal goods rel­a­tive to pro­duc­ers of con­sump­tion goods, and with­in each sec­tor, ben­e­fit firms with oppor­tu­ni­ties to invest rel­a­tive to those that lack growth oppor­tu­ni­ties.” This results in low­er risk pre­mi­ums for growth firms as com­pared to risk pre­mi­ums for val­ue firms, because they act as hedges for shocks to real invest­ment oppor­tu­ni­ties,” he reports in the recent paper.

He explains that when a val­ue firm — a firm whose mar­ket val­ue is low­er than the val­ue of its assets — owns sub­stan­tial phys­i­cal assets, the risk is increased that the firm may not be able to effi­cient­ly adapt to the next big thing. For exam­ple, although Block­buster owned a lot of stores that rent­ed video­tapes, its mar­ket val­ue was rel­a­tive­ly low because the mar­ket per­ceived that Block­buster would have trou­ble adapt­ing to the Internet.

Papaniko­laou notes that this fear about Block­buster turned out to be well found­ed — Net­flix came along and stole its mar­ket share. Block­buster as we knew it is now out of busi­ness. When investors buy a val­ue stock like Block­buster, they run the risk that a Net­flix will come along and take that company’s mar­ket share. There­fore, investors require a high­er rate of return to buy stock in a com­pa­ny like Blockbuster.

Anoth­er thing Papaniko­laou argues, based on his mod­el, is that when inno­va­tions emerge, the econ­o­my diverts resources to new invest­ment and away from cur­rent con­sump­tion. This hap­pens because in the short run, we must all pay a cost to ben­e­fit from inno­va­tion. As a result, if I invest in a val­ue firm like Block­buster, whose val­ue drops when my con­sump­tion drops, I am unhap­py. In con­trast, I like growth firms like Net­flix, because they do well when I choose to divert resources away from con­sump­tion,” Papaniko­laou says.

Under­stand­ing what cre­ates stock mar­ket move­ments is very impor­tant, Papaniko­laou believes. The over­all chal­lenge, he notes, is to link stock mar­ket prices to the state of the econ­o­my, rather than view­ing the stock mar­ket as some­thing that fluc­tu­ates ran­dom­ly. His model’s find­ings are a piece of that puzzle.

Relat­ed read­ing on Kel­logg Insight

Valu­ing Pos­si­bil­i­ties: Invest­ment behav­ior and stock returns may mea­sure growth opportunities

Liq­uid­i­ty Rules: Man­age inno­va­tion or risk repeat­ing history

About the Writer

Beverly A. Caley, JD is an independent writer based in Corvallis, Oregon, who concentrates on business, legal, and science topics.

About the Research

Papanikolaou, Dimitris. 2011. “Investment Shocks and Asset Prices.” Journal of Political Economy. 119(4): 639-685.

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