By John B. Guerard Jr. and and Andrew Mark
How important is research and development as a source of value-added in identifying fundamentally attractive companies? In 2004, GlobeFlex Capital set out to quantify the answer. The quest was triggered by the reality that from 1971 to 2003, companies across the board substantially increased R&D expenditures, almost tripling R&D spending as a percentage of sales. Furthermore, the rate of increase was ramping up, with R&D spending more than doubling from 1985 to 2003.
R&D expenditures represent discretionary expenses that company management hopes will develop new products and enhance existing products, thereby leading to increased sales and to the generation of greater future profits. Was the market rewarding companies for these expenditures? Should traditional portfolio managers be analyzing R&D as a source of value-added in identifying fundamentally attractive companies? Do firms that spend heavily on R&D earn higher risk-adjusted returns for stockholders?
Our overall goal was to determine if stockholder wealth would be enhanced by incorporating an R&D measure into traditional stock selection, and if so, by what degree. In this analysis we used a two-step process: (1) we created stock portfolios with an above-average exposure to positive earnings estimate revisions by sell-side analysts; and (2) we then filtered the stock portfolios to include only the stocks with the greatest R&D expenditures.
Our research found that if an investor constructs a diversified portfolio focusing on stocks with high relative R&D expenditures, performance returns are significantly better than a portfolio with a neutral stance on R&D. We further concluded that using an R&D filter enhances stockholder wealth better than the more commonly used capital expenditure or dividend analyses. The relative return potential for money managers emphasizing R&D was particularly interesting given that most corporations allocate more of their resources to capital expenditures than to R&D. (Results of the capital expenditure and dividend research are in a technical publication available upon request.)