Abstract
We find that innovative efficiency (IE), patents or citations scaled by research and development expenditures, is a strong positive predictor of future returns after controlling for firm characteristics and risk. The IE-return relation is associated with the loading on a mispricing factor, and the high Sharpe ratio of the Efficient Minus Inefficient (EMI) portfolio suggests that mispricing plays an important role. Further tests based upon attention and uncertainty proxies suggest that limited attention contributes to the effect. The high weight of the EMI portfolio return in the tangency portfolio suggests that IE captures incremental pricing effects relative to well-known factors. © 2012 Elsevier B.V.