Last year I created a screen on Portfolio123 that invests in companies in the Russell 3000 that spend heavily on R&D. (To access this screen, you need to either have a Portfolio123 account or start a free trial.) There were four rules in the screen, but the most important were:
- Expenditures on R&D that amount to 15% or more of market cap
- Less than 5% short interest as a percentage of shares outstanding
Since I created the screen on October 4, 2019, it has returned 66%, which is 105% annualized, entirely out of sample. It invested in approximately 30 stocks, rebalancing monthly with 0.25% slippage. With only those two rules, the same backtest invests in an average of over 60 stocks, while the return increases to 76%. If you backtest this two-rule system all the way back to 1999, you get a nice annualized return of 19% (compared to 6.35% for the S&P 500), and backtesting only ten years back gets you 28% (compared to 12.88% for the S&P). If you limit yourself to the 25 companies with the highest percentage of market cap spent on R&D, your ten-year annualized return goes up to 32%. Clearly, considering R&D expenditures when choosing stocks can make you quite wealthy.
Now for real-life investing, I don’t believe in simple stock-picking formulas with only two rules. At the same time as I created the R&D screen I created four other screens, all of which backtested well and all of which I had some real faith in. Only two of the five have performed well since October 4, 2019, and one has been a total disaster. We just happen to be in an environment in which R&D outperforms. How long will that last? It’s anyone’s guess.
I do, however, think that taking R&D expenses into account when picking stocks is a good idea. This article explores some things to consider.
I. R&D Expenses by Industry
What industries spend the most and the least on R&D?
Here are the industries that spend the most (in alphabetical order): automobile manufacturers, biopharma, computers (hardware and software), consumer electronics, consumer finance, entertainment, interactive media, manufacturing equipment, and telecommunications.
Here are the industries that spend the least: agriculture, banks, construction, distribution, energy, food and drink, freight, health-care providers, hotels and restaurants, insurance, mining, REITs, retail, tobacco, utilities, and waste management.
II. The Difference Between CapEx and R&D.
Now here’s the rub. When a biopharmaceutical company spends money researching and developing a new drug, that’s R&D. When an energy company spends money researching and developing a new place to drill or a mining company spends money researching and developing a new place to dig, that’s a capital expenditure. The FASB (Financial Accounting Standards Board) has made a generalized exception for extractive industries so that all activities unique to those industries are capitalized rather than being treated as R&D.
And when it comes to non-extractive industries, not all R&D is classified as R&D. If you build a data center, that can be capitalized. If you build a laboratory, that can be capitalized. Labor costs for running (as opposed to building) the data center and laboratory can’t be capitalized, though, so most R&D expenditures are actually salaries.
What is the difference between R&D and a capital expenditure? The FASB is clear: “At the time most research and development costs are incurred, the future benefits are at best uncertain. In other words, there is no indication that an economic resource has been created.” A capital expenditure leads pretty directly to sales while an R&D expense is entirely speculative. Therefore they are treated entirely differently by accounting rules. R&D expenses are deducted from income all at once, at the time that they are spent; capital expenditures are depreciated so that the cost is deducted little by little over a period of years.
III. R&D Ratios
I like to look at R&D to market cap as a kind of alternative value ratio. The kinds of companies this ratio favors are tiny ones, mostly in biopharma. But other people use R&D to sales or R&D to assets as alternative measures. In backtesting over the last ten years, R&D to market cap performs the best of these three measures, and R&D to sales performs the worst. The advantage of using market cap is that you’re taking into account the company’s price; the disadvantage of using sales in your denominator is that you’re punishing companies with strong sales and rewarding companies with weak sales.
IV. Capitalizating R&D Expenses
Aswath Damodaran, whose valuation methods and deep thinking about accounting have been tremendously influential, has long advocated capitalizing R&D expenses when valuing a company. His argument is as follows. One can classify all expenses as either operating expenses (which are deducted in full at the time they are incurred), financing expenses, or capital expenses (which can be capitalized and thus deducted over a longer period). Damodaran takes a very different approach to this distinction than does the FASB. “Capital expenditures are defined as those expenditures that are likely to create benefits over multiple periods,” he argues, while operating expenses, “at least in theory, provide benefits only for the current period.” R&D should therefore be classified as a capital expenditure and should be capitalized, whether or not an economic resource or asset has been created thereby.
Damodaran points out that prior to 1975, companies were allowed to capitalize R&D expenditures, and that outside the US, development costs are still allowed to be capitalized, though most companies do not do so.
There are strong arguments to be made both in favor of Damodaran’s position and in favor of the FASB’s. I tend to agree with the FASB. How many projects funded by R&D actually become commercially successful? Evidence suggests that it’s well under fifty percent. In addition, most R&D expenses are labor costs, and those are only capitalized if the labor is directly involved in the creation of a capital asset. Lastly, the FASB is always issuing “invitations to comment” and is concerned about keeping current with business standards, and they have not changed this particular accounting standard in 45 years. If there were a good reason to change it one would think they would.
On the other hand, it’s worthwhile considering how capitalizing R&D expenses would affect your valuation of a company.
Here’s what I do when I want to capitalize R&D expenses; you can adapt this depending on your estimation of the length of time by which to depreciate them.
First, take one-fifth of each of the R&D expenses over the four years prior to the most recent year and add those together. We’ll call this number R&D amortization.
In order to get adjusted net income, take the most recent year’s net income, add back this year’s R&D expenditures, then subtract R&D amortization.
In order to get income growth, you’d need to make this adjustment for each year’s net income, and calculate that accordingly.
You then have to add to total assets the amortized R&D. Add the entirety of the current year’s R&D expenditures, 80% of last year’s, 60% of the year before’s, and so on. For calculating adjusted ROA, asset turnover, and other asset-based ratios, this addition to total assets will be important.
V. What Companies Pass the Screen Today?
What companies in the Russell 3000 with less than 5% short interest are spending more than 15% of their market cap on R&D? As of the weekend of 6/28, there were 77 of them, 49 of which were healthcare stocks. The ten biggest are Ford (F), Western Digital (WDC), Hewlitt Packard (HPE), CommScope (COMM), Akebia (AKBA), Akcea (AKCA), Theravance (TBPH), Calix (CALX), Amneal (AMRX), and Hyster-Yale (HY). And the ten that are spending the largest percentage of their market cap on R&D are Solid Biosciences (SLDB), Xeris (XERS), Cooper-Standard (CPS), Cyclerion (CYCN), Commscope (COMM), Extreme Networks (EXTR), Five Prime (FPRX), Arbutus (ABUS), Eastman Kodak (KODK), and Fortress Biotech (FBIO).
Now not all of these are good investments. Personally, of all the stocks that pass the screen, I’d recommend Ribbon Communications (RBBN), Telenav (TNAV), and Checkpoint (CKPT) for the short term, and Endurance (EIGI), Hyster-Yale (HY), and Amneal (AMRX) for the long term. If—and this is a big if—R&D-powered stocks keep on outperforming like they have been lately, these companies may be a good starting point for an R&D-based value strategy.
Disclosure: I am long Ribbon Communications (RBBN).