Monday, February 4, 2013

No One Believes in Plans: The R&D Anomaly

From "Does the Stock Market Underreact to R&D Increases?" by Allan Eberhart, William Maxwell, and Akhtar Siddique,

"We examine a sample of 8,313 cases, between 1951 and 2001, where firms unexpectedly increase their research and development expenditures (R&D) by a significant amount. We find consistent evidence that our sample firms are undervalued following their R&D increases as manifested in the significantly positive long-term stock returns that our sample firms' shareholders experience. We also find consistent evidence that our sample firms have significantly positive long-term abnormal operating performance following their R&D increases. Our findings suggest that R&D increases are beneficial investments, and that the market is slow to recognize the extent of this benefit (consistent with investor underreaction)."
It could be investor underreaction, the phenomenon whereby investors are "anchored by salient past events". There is plenty of research showing that investors underreact to all sorts of news: good earnings, bad earnings, share repurchases, financial distress, dividend initiations, stock splits and reverse splits, and so forth.

But there's another hypothesis for an underreaction to research and development expenses, a theory we touched on last week: no one believes in plans. We have people like William Bernstein arguing that the long-run real rate of return on capital is one percent, if you're lucky. This is the indeterminate world idea that Peter Thiel talks about,
"In a determinate world, there are lots of things that people can do. There are thus many things to invest in. You get a high investment rate. In an indeterminate world, the investment rate is much lower. It’s not clear where people should put their money, so they don’t invest. [...] Indeterminacy has reoriented people’s ideas about investing. Whereas before investors actually had ideas, today they focus on managing risk. [...] In an indefinite world, investors will value secret plans at zero. But in a determinate world, robustness of the secret plan is one of the most important metrics. Any company with a good secret plan will always be undervalued in a world where nobody believes in secrets and nobody believes in plans. The ability to execute against long-term secret plan is thus incredibly powerful and important."
Underreaction to research and development is perfectly consistent with Thiel's idea. And public markets currently put a huge premium on predictable, non-divertable cash flows and more attractive (lower) multiples on cash flows that are seemingly uncertain.

10 comments:

Stagflationary Mark said...

I would add that one plan the market seems to love is the idea of taking on more debt to buy back shares of a company.

So much so that we are just about out of AAA rated companies even as we're told that companies are flush with cash.

Of course, the median company may or may not be flush with cash (especially if all that existing debt is considered). All that cash is not exactly evenly distributed. Where have we heard this before?

Nearly one-third of homeowners own their homes free and clear. I'm one of them. Didn't stop the subprime crisis from unfolding though. Sigh.

Just a thought.

As a side note that's on topic, I believe in plans. I'd feel more comfortable investing in a company that was spending on research and development than one that wasn't.

CP said...

Well, that can be a pretty good arb given how low interest rates are.

If you believe in plans, why is your whole portfolio TIPS??

Stagflationary Mark said...

CP,

Well, that can be a pretty good arb given how low interest rates are.

In hindsight, would the Japanese say that about the aftermath of their housing bubble in the 1990s? It's not like their stock market rose to record heights even when interest rates fell to zero and pretty much stayed there.

If you believe in plans, why is your whole portfolio TIPS??

Having nearly my entire portfolio in TIPS and I-Bonds is and was my long-term plan. I'd say the plan has worked out quite well so far, much to the dismay of Jeremy Siegel.

Just because you don't believe in my plan doesn't mean it isn't one. I bought with intent to hold to maturity and that's exactly what I'm doing. In other words, I'm sticking to my plan.

CP said...

Right, but there are still some profitable businesses.

I think a decent bet would be mean reversions. Interest rates rise and profit margins fall, since both are at extremes.

Owning TIPS may be a plan, but it is an indeterminate world "anti-plan" in the sense that Thiel was talking about plans.

Stagflationary Mark said...

CP,

I understand your point here but consider that my plan fits in well with my long-term goals.

1. I'm retired. No job to fall back on.
2. I don't need to swing for the fences.
3. I will not be twice as happy from here if I was to double my money.
4. As of 2004, I'm a permabear.

I've got a long-term TIPS and I-Bond ladder in place that has substantially higher real yields than investors today could get. That was my plan *before* the crisis hit, not after. I'm just sticking to my plan.

Granted, I could sell the TIPS for a nice profit right now but that would be breaking my plan. So far, it is playing out almost exactly as I thought it would. Real yields have died and over the long-term they could get much worse. Sigh.

CP said...

I'm not saying it's a bad plan (although I don't think it's a good plan), just that it's an anti-plan in the Thiel sense.

What would make you sell the TIPS?

Stagflationary Mark said...

CP,

I'd be forced to selll at least some TIPS if inflation skyrocketed just to pay the taxes on the inflationary gains. I would not be a happy camper. I'd still be doing better than many though. At least I'd have inflationary gains to be taxed.

I'd be tempted to willingly sell some TIPS if CNBC actually placed TIPS rates at the top of the TV screen. I'm not holding my breath. Bloomberg actually removed TIPS rates from this web page. One wonders why. In any event, doesn't strike me as the sort of thing we'd see at the peak of a bubble.

I'd definitely sell TIPS if I thought long-term TIPS were in a bubble. It is my opinion that they aren't. I'm comfortable holding them to maturity. At these low real yields I don't expect much clearly, but I also don't require a greater fool. Most bubbles are based on needing greater fools.

Just opinions of course.

CP said...

Would you buy tips today?

Stagflationary Mark said...

I bought 0.0% I-Bonds yet again in January to help meet expenses 30 years from now (in theory).

CP said...

I'd rather be all in on CNRD or STP puts than I Bonds.