Do Patented Innovations Reduce Stock Price Crash Risk?*

• Published date: 01 March 2021
• Author: Hamdi Ben‐Nasr,Lobna Bouslimi,Rui Zhong
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/irfi.12265

Do Patented Innovations Reduce

Stock Price Crash Risk?*

HAMDI BEN-NASR

†

,LOBNA BOUSLIMI

‡

AND RUI ZHONG

§

†

College of Business and Economics, Qatar University, Doha, Qatar

‡

John Molson School of Business, Concordia University, Montreal, Quebec,

Canada and

§

UWA Business School, University of Western Australia, Crawley, Western Australia,

Australia

ABSTRACT

Using a large sample of US firms, we document a significantly negative rela-

tion between the number of patents (citations) and stock price crash risk.

Our findings are consistent with the arguments that patented innovation

activities send a high-quality signal and reduces proprietary information

costs, which lowers information asymmetry and enhance disclosure. Further,

we find that such impact of patented innovation on stock price crash risk is

more pronounced in firms with weak corporate governance and high infor-

mation opacity. Our findings provide new evidence on the real effects of pat-

ented innovation on crash risk in equity market.

JEL Codes: G14; G30; G32; M40; O31

Accepted: 13 March 2019

I. INTRODUCTION

Corporate innovations constitute an engine for creating value and boosting the

growth of a firm, which has a significant impact on corporate decisions and

financial markets, such as capital structure (Chang and Song 2014), stock

returns (Hirshleifer et al. 2013), cost of equity (Hegde and Mishra 2014), firm

market value (Hall et al. 2005), default risk and bond pricing (Hsu et al. 2015).

However, little is known about how patented innovation activities affect the

stock price crash risk. Managers have a tendency to release positive news and

hoard negative news because of career and compensation concerns (e.g., Jin

and Myers 2006; Hutton et al. 2009). Additionally, managers may invest in neg-

ative NPV projects to achieve empire-building objectives and have incentives to

keep these projects active as long as possible (Bleck and Liu 2007). Since hoard-

ing negative information prevents investors from adjusting their anticipation

* Rui Zhong acknowledge research grant from National Natural Science Foundation of China

(Project No.71501197). We appreciate the comments of anonymous reviewers of IFABS 2015 China

Conference and suggestions from Narjess Boubakri and Nilanjan Basu. Hamdi Ben-Nasr acknowl-

edges the financial support from Qatar University, QUUG-CBE-DFE-17/18-6.

© 2019 International Review of Finance Ltd. 2019

International Review of Finance, 21:1, 2021: pp. 3–36

DOI: 10.1111/irfi.12265

of stock price in a timely manner and the board of directors from liquidating a

bad project early, when hoarded negative information reaches a limit, the nega-

tive information is suddenly released to the market all at once and results in a

stock price crash (e.g., Jin and Myers 2006; Hutton et al. 2009). We extend the

literature on corporate innovations by examining the relationship between pat-

ented innovation activities (i.e., patents and citations) on firm-specific future

stock price crash risk.

We argue that granted patents and citations reduce the stock price crash risk

for firms that invest heavily in innovations related activities for the following

underlying reasons:

First, the research and development (R&D) expenses that represent intangi-

ble assets are associated with high proprietary costs (e.g., Bhattacharya and

Ritter 1983), which decreases the incentive for disclosure (Verrecchia 1983,

2001) because transparency may impede firms from hiding R&D activities. Pat-

ent protection reduces proprietary costs, which leads to more disclosure and

reduces information asymmetry in capital markets (e.g., Guo et al. 2004). Sec-

ond, according to the informational role hypothesis the patents are used by

managers as signals to gain the trust of shareholders (e.g., Bhattacharya and

Ritter 1983; Mann 2005; Cockburn and MacGarvie 2009). Consistent with this

view, prior literature shows that patented innovation is associated with a lower

cost of debt (e.g., Hsu et al. 2015), lower cost of equity financing (e.g., Hegde

and Mishra 2014) and easier access to public financing (e.g., Atanassov et al.

2007). These findings suggest that patented innovations help to build investor

confidence through signaling high quality, particularly if innovative firms

return to the market and try to finance the commercialization of the patents.

The aforementioned arguments suggest that the use of patent and citations (the

output of R&D activities) by firms investing heavily in intangible assets, which

reduces proprietary costs and sends a quality signal that builds investor confi-

dence, increases transparency and reduces information asymmetry. An exten-

sive empirical research (e.g., Jin and Myers 2006; Hutton et al. 2009; Kim et al.

2011a; Kim et al. 2011b; Kim et al. 2014; Callen and Fang 2015) shows that

stock price crash risk decreases if information transparency increases. The idea

is that it is more difficult for managers to hide negative news under high infor-

mation transparency and thus it is less likely to accumulate bad news and result

in stock price crashes in the future. Given that, we expect that patented innova-

tions mitigate stock price crash risk for firms that invest heavily in intangible

assets.

Using a large US sample of firms that invest heavily in intangible assets and

three proxies for stock price crash risk (i.e., the likelihood that a firm experi-

ences a crash during one or more weeks of a given year, negative skewness, and

down-to-up volatility), we document a negative relation between the cumula-

tive number of patent grants and citations and the likelihood of experiencing

stock price crashes in the future, after controlling for the common determinants

of stock price crash risk. We also find that the negative relation is more pro-

nounced for longer forecasting periods such as 2 or 3 years. Our results are

© 2019 International Review of Finance Ltd. 20194

International Review of Finance

consistent with the view that patent grants and citations reduce proprietary

information costs and signal high quality, which enhances information disclo-

sure and reduces information asymmetry. Our results are robust to several endo-

geneity tests (i.e., instrumental variable and the dynamic generalized method

of moments [GMM] approaches) and the introduction of additional control var-

iables that may drive patented innovation-related activities and stock price

crashes simultaneously.

Additionally, we examine the impact of information opacity on the rela-

tion between patented innovation and stock price crash risk. We show that

the negative relation between patented innovation and stock price crash

risk is more pronounced in firms with high information opacity. This find-

ing highlights the importance of patented innovations for reducing infor-

mation asymmetry, and thus maintaining the stability of future stock

prices, especially in firms with severe information asymmetry problems.

Moreover, we investigate whether the negative relation between patented

innovations and stock price crash risk is affected by the effectiveness of

corporate governance. We break down our sample into subsamples

according to the stake held by dedicated institutional investors and the

number of anti-takeover provisions. We find that the reductions of the

likelihood of experiencing stock price crashes are more prominent for the

firms with high number of anti-takeover provisions, suggesting that the

impact of patents and citations on the stock price crash risk is stronger for

firms with weak corporate governance. Finally, we examine whether the

degree of innovativeness at the industry level affects the relation between

patented innovations and stock price crash risk. We find that the negative

relation between patented innovations and stock price crash risk is more

pronounced in innovation-intensive industries.

Our paper contributes to the literature on both innovation and stock

price crashes in at least two aspects. First,instead of focusing on the impact

of innovations on corporate capital structure (Chang and Song 2014), stock

return (Hirshleifer et al. 2013), cost of equity (Hegde and Mishra 2014), firm

market value (Hall et al. 2005), default risk, and bond pricing (Hsu et al.

2015), notably this paper investigates how protecting investment in tangible

assets through patents and citations (patented innovation) affects tail risk as

measure of future stock price crash risk. Second,our study is built upon the

stock price crash risk literature (e.g., Chen et al. 2001; Jin and Myers 2006;

Hutton et al. 2009; Kim et al. 2011a, 2011b; Kim and Zhang 2016; Zhang

et al. 2016; Ben-Nasr and Ghouma 2018). We extend this strand of the lit-

erature by highlighting the importance of patents and citations in mitigat-

ing future stock price crash risk for firms that heavily invest in intangible

assets.

The rest of the paper is organized as follows. Section II reviews the literature

and constructs our testable hypothesis. Section III describes our data and

research designs. Section IV presents the empirical results and the robustness

tests. Section V concludes.

© 2019 International Review of Finance Ltd. 2019 5

Patented Innovation and Stock Price Crash Risk