MSCI examines the impact from share buybacks on long-term value creation for investors, with findings that may challenge expectations. In particular, MSCI examines the impact of optimizing R&D spending, and found that R&D spending strongly aligns with the MSCI ESG ratings. In consultation with Professor Knott, the report notes that “Companies who were best at R&D [as measured by RQ] over the past 35 years returned approximately double the market return. Those who were weak at R&D substantially underperformed.”
How does your company determine how much to spend each year on R&D? Likely, a group of senior executives get together and offer their thoughts on what the figure should be for the next year. After a back and forth discussion focusing on the right amount for R&D, other corporate financial considerations are then put on the table that compete for monies that might go to R&D.
Now, with everything on table, the group decides what it will spend for R&D. So, one question is answered. What will we spend next year? But, the more important question is not answered. What is the right amount to spend on R&D? Each year management answers the “how much” question, but for decades management has never known if it is the “right amount” to spend.
Even companies that claim to have a long-term orientation worry about whether R&D is worth the investment. Sarah Williamson is the CEO of FCLTGlobal (formerly Focusing Capital on the Long Term), an organization cofounded in 2016 by BlackRock, CPPIB, Dow Chemical, McKinsey, and Tata Sons to encourage a longer-term focus in business and investment decision making. According to Williamson, a current concern among many institutional investors as well as corporations is that companies don’t get credit for long-term investments in R&D. This is both because the resulting knowledge might walk out the door, as employees join other firms or start their own, and because you can acquire firms who have the needed technology. If everyone followed that logic, however, there’d be little innovation to walk out the door or to acquire! Fortunately, neither of these concerns is warranted, and my research shows why companies, investors, and the nation will be better off if companies make long-term investments in R&D.
We know innovation drives corporate growth. As Strategy& reported in its 2015 survey of 1,757 executives, “innovation today is a key driver of organic growth for all companies — regardless of sector or geography.” According to that report, the top 1,000 R&D spenders invested $680 billion in R&D that year, up 5% from the prior year. Historically, R&D has been viewed as the engine of national economic growth as well.
Despite the importance of innovation to companies, as well as to the broader economy, despite the 250% rise in the number of scientists and engineers engaged in R&D, and despite all the experts dedicated to helping companies innovate, the money companies spend on R&D is producing fewer and fewer results. In fact, my research shows the returns to companies’ R&D spending have declined 65% over the past three decades.
Determining how much to spend each year on R&D and product development is an issue that has plagued management for decades. In last month’s column, a number of traditional methods used by R&D leaders to determine R&D spending levels were discussed. This month, we examine an approach that is barely five years old.
Determining how much to spend on R&D and product development each year is an issue that has plagued management for decades. It is a difficult question.
One of the big challenges has been tying R&D spending to results. Projects are funded, development occurs, products are launched, and commercialization ensues. Years pass before the data is in place to tie spending to results. Companies have tens to hundreds of projects going on at the same time. The relationship between spending and results is unknown, so many executives modulate R&D spending to mitigate variations elsewhere in the business without knowing the effect on R&D over time.
This has been a remarkable year for the markets. The S&P and the Dow indexes are up 18% and 19%, respectively. But this run-up isn’t based on solid business foundations. Quarterly profits have only increased 5% since 2012, but investors’ valuations of those profits (as measured by earnings per share) has increased 59% over the same period. What’s behind the disconnect? Some argue that profits are stagnant because of short-termism—that decades of focusing on current profits over long-run innovativeness has resulted, now, in companies that are hollowed out.
Dr. Anne Marie Knott is the author of “HOW INNOVATION REALLY WORKS: Using The Trillion-Dollar R&D Fix To Drive Growth.” She is a Professor of Strategy at the Olin Business School at Washington University, and prior to her position at Olin, Dr. Knott served as Assistant Professor of Management at the Wharton School of Business at the University of Pennsylvania. Her primary research area is innovation – both large-scale R&D and entrepreneurship, which stems from her previous career at Hughes Aircraft Company developing missile guidance systems. Her research has received two grants from the National Science Foundation and has been covered by CNBC, Forbes, BusinessWeek, and the Wall Street Journal. She has published numerous articles in Harvard Business Review and many other publications.
That bold statement was at the top of a letter I received, and it got my attention. I started to read about the reasons many organizations are struggling to innovate. It led me to the research by Anne Marie Knott, PhD. She’s a Professor of Strategy at the Olin Business School of Washington University. She was previously an Assistant Professor at the Wharton School. Her research is focused on innovation ranging from entrepreneurship to large-scale R&D. Her new book is How Innovation Really Works: Using the Trillion-Dollar R&D Fix to Drive Growth .
I followed up with her to talk about innovation, R&D, and what can be done about the current problem.
Why investment managers should care about the valuation of R&D
Most companies calculate their target R&D spend as a percentage of their sales, yet this method of calculation does not lead to optimal R&D productivity. In fact, its inaccuracy opens up an opportunity for investors, says Anne Marie Knott, a Professor of Strategy at Olin School of Business at Washington University in St. Louis, Missouri.
R&D carried out by Oshkosh Corporation, a company that designs and builds specialty trucks and truck bodies, provides more bang for the buck than that performed by Google, Netflix, and other denizens of Silicon Valley. In-house R&D typically produces better results than the outsourced variety. Research productivity varies markedly from company to company within an industry but differs little from industry to industry. And effective optimization of spending on R&D could increase the value of a group of major American firms by a 13-figure number.
For years people have recognized that industries cluster geographically, and that the clustering can lead to superior rms. For example, the best watches come from Switzerland, cars from Germany, and pharmaceuticals from the U.S. Back in 1880, economist Alfred Marshall noted that industrial districts bene t from labor market pooling and spillovers.
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The obvious takeaway for managers was that a rm should locate within its relevant industrial district to enjoy these bene ts. At the same time, many municipalities have poured billions of dollars into trying to create industrial clusters in order to trigger the higher wages and faster growth they stimulate. Some go so far as to adopt the silicon moniker for their initiatives (despite having no semiconductor activity): Silicon Prairie in Illinois and Silicon Alley in Manhattan.
The trouble is that rms don’t seem to bene t much from relocating to clusters and attempts by regions to create them somehow never pay o . So what’s wrong with the theory?
When lists are generated of the hottest companies and trends in technology, the dominant words have become predictable: mobile, viral, cloud, big data and wearable. These are the niches that will define the future. Noticeably absent: silicon, semiconductor and microprocessor—or, in other words, the foundation for the revolution in modern computing.
One of the bills before Congress this year makes R&D tax credits permanent at an estimated cost of $156 billion over the next decade. R&D tax credits were originally implemented as part of the Economic Recovery Tax Act (ERTA) of 1981 to reverse the dramatic decline in R&D that began in 1964. The twin goals were reviving economic growth and bolstering U.S. competitiveness against the rising threat from Japanese manufacturing.
They haven't delivered on their goal, and in an era of hotly debated corporate tax reform, this cut is easy to make: It's time to end R&D tax credits.
The CNBC RQ 50 is a new ranking of the most innovative companies in the market. From old-guard sectors, including industrials, oil and gas and defense to toy makers and some of Silicon Valley's elite, the R&D cultures within the RQ 50 companies prove that innovation isn't just about spending big, it's about a relentless long-term focus on R&D that optimizes return on innovation to shareholders. Read more about the RQ 50 methodology, created by Anne Marie Knott, professor of strategy at Washington University in St. Louis.
It's pretty widely accepted that people's innate intelligence doesn't change much. Youth, health, and a positive environment can help people make better use of their brains, but they can't do much to make the brains significantly better - at least on the weight of the evidence so far. But an organization's brains can change.
When hard times hit and revenues fall, R&D is always a tempting target for corporate cuts, because reductions yield quick increases in profit, and it has always been easy for executives to tell themselves that cutting research a bit today probably won’t hurt all that much over the long run.