The “digital” premium: Why does digitalization drive stock returns?

To explore whether the rise of digital innovation across firms might point to the existence of a new risk compensation in asset pricing, we construct a text-based measure of the socio-technical phenomenon of digitalization, called digital orientation, by using the MD&A section of annual firm reports from 1996 to 2020. We find that firms with a high digital orientation (digital leaders) are systematically different along several key characteristics like valuation, sales growth, and profitability, forming a peer group of digitally leading firms across traditional industry boundaries. A digital orientation strategy, which is long (short) stocks with high (low) digital orientation, earns an equally weighted (value-weighted) monthly six-factor alpha of 0.41 % (0.28 %) per month, both statistically significant at 5 %. These results are robust to various sensitivity checks, including alternative constructions of the digital orientation measure, controls for industry membership, changes to the sample dataset, and the use of an alternative dictionary. Additionally, the results remain comparable if we construct an alternative investment strategy based on the portfolio holdings of funds with a digital innovation focus.