Illiquidity, R&D Investment, and Stock Returns

We propose a dynamic model of research and development (R&D) venture, which predicts that the positive relation between the firm's R&D investment and the expected stock returns strengthens with illiquidity. Consistent with the model's prediction, empirical evidence based on cross-sectional regressions and double-sorted portfolios largely suggests a stronger and positive R&D-return relation among illiquid stocks. A further analysis shows that the important role of illiquidity in the R&D-return relation cannot be explained by factors, such as financial constraints, innovation ability, and product market competition. Collectively, our results suggest that stock illiquidity is an independent driver of the R&D premium.