R&D and performance persistence: Evidence from the United Kingdom

There is compelling evidence from both the United States and United Kingdom suggesting that R&D investment is positively related to operating and/or market performance. This study extends prior research on R&D and valuation by further examining the sustainability or persistence of operating growth and market performance as a result of R&D investments.We use a large dataset of U.K. companies during the period 1990–2003 and our findings confirm the relation between R&D intensity and consistent growth in Sales and Gross Income, but only in the cases when a firm needs to engage in R&D activity because of the industry in which it operates. Moreover, our evidence indicates not only a positive relation between R&D intensity and subsequent risk-adjusted excess returns among firms that engage in R&D as testified by prior literature, but we also show that R&D intensity improves persistence in excess stock returns: the highest R&D-intensity firms are found to earn higher risk-adjusted excess returns more consistently than the sample median return, compared to lower R&D-intensity firms, as well as firms with no R&D. We interpret this finding as consistent with at least some form of market mispricing.     

The Impact of Corporate Diversification on the Long-Term Stock Return of R&D Increase Announcements

Prior studies have tested the long-term performance of research and development (R&D) spending, but the results are inconclusive. This study extends this line of research and explores the impact of corporate diversification on the long-term stock returns on R&D increase announcements. After controlling for the important variables in explaining the performance of R&D increases, a significantly negative association is found between the degree of corporate diversification and the long-run stock returns on R&D increase announcements. This result suggests that the costs of corporate diversification dominate the benefits regarding corporate diversification, and highlight the important effect a firm's diversification strategy has on the market valuation of R&D innovation.     

The valuation of R&D expenditures in Japan

The difficulty to measure the long‐term benefits of R&D expenditures and the distortions induced by R&D accounting suggest that R&D‐intensive firms could be undervalued. Using several methods commonly applied to detect the abnormal returns associated with mispricing, we find little evidence that the value of R&D investments has been underestimated in the Japanese stock market. Given that R&D accounting rules in Japan are similar to those in United States, the results appear to reject the hypothesis that accounting biases are the cause of the undervaluation of R&D investments observed in the United States.     

The Stock Market Valuation of Research and Development Expenditures

We examine whether stock prices fully value firms' intangible assets, specifically research and development (R&D). Under current U.S. accounting standards, financial statements do not report intangible assets and R&D spending is expensed. Nonetheless, the average historical stock returns of firms doing R&D matches the returns of firms without R&D. However, the market is apparently too pessimistic about beaten-down R&D-intensive technology stocks' prospects. Companies with high R&D to equity market value (which tend to have poor past returns) earn large excess returns. A similar relation exists between advertising and stock returns. R&D intensity is positively associated with return volatility.     

The Relation Among Targets' R&D Activities, Acquirers' Returns, and In-Process R&D in the US

Abstract:  Using a sample of 129 mergers and acquisitions (M&As) in the US between publicly traded acquirers and targets in research and development (R&D) intensive industries over the period of 1994-2004 and a size- and industry-matched sample, we examine the relation among targets' R&D activities, the probability of acquirers' writing-off in-process R&D (IPRD), and acquirers' returns around the time of M&A announcements. We find that firms acquiring targets with higher R&D investments tend to write off some of the acquired R&D assets upon the completion of the M&As. We also find that the median cumulative abnormal return during the three days around M&A announcements for acquirers with subsequent IPRD write-offs is −2.73% while the return for acquirers without IPRD write-offs is −0.60%. This suggests that acquirers' stock returns around M&A announcements are much lower when investors expect acquirers to expense IPRD. The results are consistent with our conjecture that acquirers tend to write-off IPRD when they acquire overvalued targets. We also find that IPRD write-offs do not increase earnings or stock returns of acquirers after M&As, which is inconsistent with an earnings management hypothesis.     

Mispricing and risk of R&D investment in European firms

We study whether R&D-intensive firms earn superior stock returns compared to matched size and book-to-market portfolios across several financial markets in Europe. Mispricing can arise if investors are not able to correctly estimate the long-term benefits of R&D investment or whether R&D firms are more risky than others. The results confirm that more innovative firms can earn future excess returns. Stocks listed on continental Europe markets and operating in high-tech sectors are more prone to undervaluation. This can be caused in the first case by information asymmetries that are more severe in bank-based countries. No evidence is found for a different risk pattern of R&D-intensive stocks.     

The Usefulness of Book-to-Market and ROE Expectations for Explaining UK Stock Returns

Abstract:  The fundamental valuation perspective on stock returns suggests that book-to-market will be positively related to returns if market value of equity equals future expected cash flows discounted at the expected return and book value proxies for future cash flows. Building on this perspective, we develop a log linear model which includes expectations of future BM and ROE in addition to current BM as explanatory variables for future stock returns. We show that these three variables explain a significant part of UK cross-sectional stock returns and that they remain highly statistically significant after including additional risk proxy variables. This supports relevance of fundamental valuation based firm characteristics for explaining stock returns and indicates their potential usefulness for predicting future stock returns.     

The Association of R&D and Capital Expenditures with Subsequent Earnings Variability

Abstract:  We estimate the association of investments in R&D and in physical assets (CAPEX) with subsequent earnings variability. We estimate these relations in different time periods and across industries. We find that R&D contributes to subsequent earnings variability more than CAPEX only in relative R&D-intensive industries – industries in which R&D is relatively more intensive than physical capital. In physical assets-intensive industries, we do not find similar relations. The findings suggest that with respect to subsequent earnings variability, fundamental differences between investment information about R&D and CAPEX exist. However, they are mainly noticeable in firms that operate in relatively R&D-intensive industries. The evidence also suggests there was a shift in the relations between R&D and CAPEX over time. Our findings contribute to the debate on accounting for R&D expenditures.     

Risk,Mispricing, and Value Investing

We evaluate the stock return performance of a modified version of the book-to-market strategy and its implications for market efficiency. If the previously documented superior stock return of the book-to-market strategy represents mispricing, its performance should be improved by excluding fairly valued firms with extreme book-to-market ratios. To attain this, we classify stocks as value or glamour on book-to-market ratios and accounting accruals jointly. This joint classification is likely to exclude stocks with extreme book-to-market ratios due to mismeasured accounting book values reflecting limitations underlying the accounting system. Using both 12-month buy-and-hold returns and earnings announcement returns, our results show that this joint classification generates substantially higher portfolio returns in the post-portfolio-formation year than the book-to-market classification alone with no evidence of increased risk. In addition, this superior stock return performance is more pronounced among firms held primarily by small (unsophisticated) investors and followed less closely by market participants (stock price <$10). Finally, and most importantly, financial analysts are overly optimistic (pessimistic) about earnings of glamour (value) stock, and for a subset of firms identified as overvalued by our strategy, the earnings announcement raw return, as well as abnormal return, is negative. These last results are particularly important because it is hard to envision a model consistent with rational investors holding risky stocks with predictable negative raw returns for a long period of time rather than holding fT-bills and with financial analysts systematically overestimating the earnings of these stocks while underestimating earnings of stocks that outperform the stock market.     

Explaining the Short‐ and Long‐Term IPO Anomalies in the US by R&D

Abstract:   Financial scholars who research the initial underpricing and long‐term underperformance of IPOs generally attribute these phenomena to information asymmetry and investors' misevaluations. Here, we identify, on a sample of 2,696 US IPOs issued during 1980–1995, a widespread source of information asymmetry and valuation uncertainty—the R&D activities of issuers—and document that these activities significantly affect both the initial underpricing of IPOs (R&D is positively correlated with underpricing) and their long‐term performance (R&D is positively related to long‐term performance). Given the pervasiveness and constant growth of firms' R&D activities in modern economies, our identification of R&D as a major factor affecting IPO's performance contributes to the understanding of this important economic and capital market phenomenon.