The Effects of Innovation

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Is more innovation good for stocks? Given the success of Apple after the release of new products such as the iPhone or surging stock price of electric car manufacturer Tesla Motors, it may seem obvious that new innovations lead to better investment returns. But for the stock market overall, or even an entire sector of the market, that’s not necessarily the case.

The reason is that the gains from innovation for one company often come at the expense of other companies. Apple’s success in selling iPhones and iPads, for example, resulted in lower sales for competitors such as Blackberry, Dell, Hewlett Packard, and Nokia. And innovation can force everyone in a sector to have to spend more on research and development to keep pace, leading to lower profits for other companies even if their sales don’t decline.

Furthermore, the gains from innovation sometimes go to companies that aren’t listed on the stock market (such as smaller startups), so stock market investors don’t benefit. Until its initial public offering in 2012, for example, the increases in Facebook’s value from the growth of its social network only went to private investors such as venture capitalists. But its growth may still have hurt publicly-traded internet companies, such as Google and Yahoo!, which had to compete with Facebook.

That doesn’t mean innovation is “bad”. Innovation is almost certainly good for the people who get to use the new products, and for the economy as a whole. But just like when companies raise prices to increase their profits, what’s good for consumers may not always be good for the stock market.

What Just Happened to Google’s Stock?

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If you own stock in Google, you may have noticed something a bit odd: what used to be shares in GOOG stock on Thursday became shares in both GOOG and GOOGL, each worth about half as much as the GOOG shares used to be worth. What happened?

What happened was basically some financial trickery by Google founders Larry Page and Sergei Brin to make sure that they retain control of the company. Ordinarily when someone owns a stock, the financial investment comes with the right to vote on issues such as who should be on the company’s board of directors. As companies issue more shares of stock over time—perhaps to give stock grants to their employees or fund acquisitions of other companies—the voting power of the founders decreases.

Google’s founders didn’t want this to happen to them, so they split their stock into shares that have voting rights (GOOGL) and shares that don’t (GOOG). Now when they issue more stock, they can simply issue more of the ones without voting rights so that their voting power isn’t affected.

For investors in Google (and the many other companies that use similar ploys, such as Facebook and LinkedIn) this change may not be good news. Many executives have a tendency to grow their company and therefore enhance their power even if it’s not in the best interests of their shareholders (the technical term for this practice is “empire building”). Critics might contend, for example, that the money used for Google’s attempts to build self-driving cars or Facebook’s $19 billion acquisition of the messaging company WhatsApp could have been better utilized by simply returning it to shareholders.

Google’s tactics do have defenders, however: some argue that by not having to worry about losing control of their company to activist investors who are too focused on the short-term, cementing control of a company’s voting rights can allow founders to stay focused on the company’s long-term goals. So far investors seem to be buying this argument: Google, Facebook, and LinkedIn have substantially outperformed both other technology stocks and the broader S&P 500 index since the start of last year. Whether they’ll continue to outperform as the companies grow and the founders retain full control remains to be seen.