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How creative destruction affects stocks

(MoneyWatch) Historically, small-cap stocks have outperformed large-cap stocks, and value stocks have outperformed growth stocks. These size and value premia weren't well explained by the capital asset pricing model. The subsequent Fama-French three-factor model left open the question of what the fundamental risks behind the size and value premiums were.

The academic literature contains many rational (risk-based) and irrational (behavioral) explanations. But a 2010 paper by economists Joachim Grammig and Stephen Jank introduces business theorist Joseph Schumpeter's idea of creative destruction -- the idea that innovation that causes old inventories, technologies, skills and equipment to become obsolete -- into asset pricing theory as an explanation for the size and value premiums.

Grammig argues that small-cap and value firms are less likely to survive technological revolutions. And since investors must be compensated for the risk of creative destruction, small-cap and value stocks must have ex-ante risk premiums to attract investors.

Grammig found that the returns of small-cap and value stocks are negatively related to invention growth, resulting in an economically significant risk premium. Small-cap value stocks have the highest exposure to creative destruction risk and offer an additional 6.2 percent expected excess return per year. Large-cap growth stocks, on the other hand, provide a hedge against creative destruction, resulting in an expected excess return of -2.4 percent annually. This suggests that invention growth may be the real risk factor (a risk that can't be diversified away) captured by the Fama-French model.

The key variable in the authors' model is invention activity -- which he approximates by the percentage change of patents issued and patent activity growth. Data on newly issued patents came from the United States Patent and Trademark Office. They found that small-cap value firms have the strongest negative exposure to patent activity growth, one that was statistically significant (t-statistic of -2:3). This suggests that that these stocks "possess a high baseline destruction probability -- a technology shock hits these firms' expected payoffs the hardest."

On the other hand, the Grammig and Jank also found that large-cap growth firms have positive and statistically significant (t-stat of 2:8) exposure to patent activity growth, and their stocks generally show strong earnings growth and high profitability ratios, making them the most likely to persist throughout the technological revolution. "Relatively speaking, large growth stocks might even profit from the weakness of their competitors and gain market power."

In summary, the authors found that the process of creative destruction entails a considerable risk that is priced by the stock market. The risk explains the size and value premiums well -- it's significant from both a statistical and an economic point of view.

The study also contributes to the side of the "ledger" that favors the value premium as a risk, rather than a behavioral, story.