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The majority of a firm's assets, such as inventories or equipment, are physical, and their value can be easily recorded into the books. On the other hand, the firm also owns assets like workforce skill or production methods that are less tangible and have uncertain value. One of the aptest examples of such intangible assets are expenditures on Research & Development.
One of the research papers investigating whether the market appropriately accounts for firms' expenditures on R&D has been conducted by Chan et al. (1999). In this research, the authors have found that two similar firms, one with significant R&D expenditures and the other with absent R&D, might appear to be equally expensive when considering traditional measures such as price-to-earnings or price-to-book ratios. However, the market tends to underestimate the future opportunities associated with the first firm's R&D spending relative to the growth opportunities of the second. Simply relating the amount of the past 5 years' R&D expenditures to the firm's market equity value, the researchers show that stocks of firms with a high amount of R&D expenditures relative to their Market cap earn greater average returns in the future.
Fundamental reason
Under the efficient market hypothesis, the investor should be able to recognize the value of less-tangible assets. However, in conditions of an inefficient market, the presence of such intangible assets could possibly lead to mispricing. One of the reasons for possible mispricing lies in the US GAAP and IFRS accounting standards. Under these standards, the costs of R&D must be expensed in the same fiscal year as they occur and therefore could significantly influence the reported earnings of a company in the current year. However, the R&D expenditures usually represent a long-term investment that implies a possible future revenue and cash flow.
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Market Factors
Confidence in Anomaly's Validity
Period of Rebalancing
Number of Traded Instruments
Notes to Number of Traded Instruments
Complexity Evaluation
Financial instruments
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Notes to Indicative Performance
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Notes to Estimated Volatility
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Notes to Maximum drawdown
Sharpe Ratio
Regions
Simple trading strategy
The investment universe consists of stocks that are listed on NYSE NASDAQ or AMEX. At the end of April, for each stock in the universe, calculate a measure of total R&D expenditures in the past 5 years scaled by the firm's Market cap (defined on page 7, eq. 1). Go long (short) on the quintile of firms with the highest (lowest) R&D expenditures relative to their Market Cap. Weight the portfolio equally and rebalance next year. The backtested performance of the paper is substituted by our more recent backtest in Quantconnect.
Hedge for stocks during bear markets
No – Although the strategy has a low beta of 0.006, the strategy suffers during bearmarkets.
Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)
Source paper
Louis K. C. Chan, Josef Lakonishok and Theodore Sougiannis: The Stock Market Valuation of Research and Development Expenditures
Abstract: We examine whether stock prices fully reflect the value of firms’ intangible assets, focusing on research and development (R&D). Since intangible assets are not reported on financial statements under current U.S. accounting standards and R&D spending is expensed, the valuation problem may be especially challenging. Nonetheless we find that historically the stock returns of firms doing R&D on average matches the returns on firms with no R&D. For companies engaged in R&D, high R&D intensity has a distinctive effect on returns for two groups of stocks. Within the set of growth stocks, R&D-intensive stocks tend to out-perform stocks with little or no R&D. Companies with high R&D relative to equity market value (who tend to have poor past returns) show strong signs of mis-pricing. In both cases the market apparently fails to give sufficient credit for firms’ R&D investments. Our exploratory investigation of the effects of advertising on returns yields similar results. We also provide evidence that R&D intensity is positively associated with return volatility, everything else equal. Insofar as the association reflects investors’ lack of information about firms’ R&D activity, increased accounting disclosure may be beneficial.