“Knowledge Leaders” Produce Higher Returns: Gavekal Capital

A May 7th white paper from Gavekal Capital focuses on the “Knowledge Effect.” Authors Steven Vanelli and Eric Bush offer a broad definition of the phenomenon: “The Knowledge Effect is a pricing anomaly that leads to persistent excess returns among highly innovative companies.”

More on the Knowledge Effect

The Knowledge Effect is created by the convergence of two key events. The first key event was the introduction of the semiconductor, which is enabling humans to greatly accelerate our knowledge production. Vanelli and Bush note: “The semiconductor has enabled humankind to multiply its intellectual  strength in a similar way that the steam engine and electric motor enabled humankind to multiply its physical strength”

They also highlight that modern knowledge production takes the form of corporate investment in research and development, marketing and employee training. In fact, it turns out that U.S. corporations today spend more on knowledge than they do on real estate, plants and equipment all together.

The second key event behind the Knowledge Effect is the lack of real information about corporate knowledge activities. This problem has been exacerbated by the implementation of very conservative accounting practices at the beginning of the greatest period of knowledge production in human history. This lack of accurate information has led investors to make a systematic error in their assessments of the prospects of “Knowledge Leader” firms.

Vanelli and Bush argue that this systematic error is reflected in a persistent risk premium (excess return) for firms “that invest significantly in knowledge.”

History of the Knowledge Effect

The Knowledge Effect was developed by academic researchers led by economist Baruch Lev, who analyzed two decades of financial data from public firms and discovered a clear relationship between the level of knowledge capital and stock returns. Lev, building on his own research and that of others in the field, demonstrated a market inefficiency caused by missing information regarding knowledge investments. Moreover, this inefficiency has led Knowledge Leaders to produce positive abnormal returns relative to other stocks.

Gavekal’s Knowledge Leaders Indexes

Knowledge Leaders

Knowledge Leaders 2

The Knowledge Leaders Indexes are the broadest, longest running, real-time test of the Knowledge Effect. The results of Gavekal Capital’s proprietary selection process for the KLIs highlight the huge opportunities for investors to take advantage of  the Knowledge Effect in markets across the globe.

Knowledge leaders versus knowledge followers

Lev also discovered that R&D spending is not all the same. His research showed that there were identifiable Knowledge Leaders and Knowledge Followers in almost every sector. Knowledge Leaders “introduce new and innovative products”, and  Knowledge Followers “mimic or react to the products of the Leaders.” Vanelli and Bush describe Knowledge Leaders as “pushing innovation forward”, while Knowledge Followers are “just trying to keep up with the innovational spill-over effects created by Knowledge Leaders”.

Knowledge Leaders

Knowledge Leaders are more R&D-intensive than Knowledge Followers, so theoretically they should enjoy a higher but constant level of future abnormal returns to compensate for the risk in their high R&D investment strategy.

Knowledge Leaders

In fact, Lev determined that Knowledge Leaders indeed had higher “future market share, future sales growth and future return on assets” than followers, indicating that “[Knowledge] Leaders have sustained future profitability”. Last but not least, Lev also discovered that the risk measures stock return volatility and earnings variability were lower for Knowledge Leaders than for Knowledge Followers.

Knowledge Leaders

Knowledge Leaders

See full white paper below.