Market Myopia , Market Mania , or Market Efficiency ? An Examination of Stock and Bond Price Reactions to R & D Increases and Subsequent Performance

We examine a sample of 1,115 firm-year observations where firms (with publicly traded stocks and bonds) increase their research and development (R&D) expenditures. We find some evidence that bondholders are harmed by R&D increases (due to a rise in firm risk), but we still find positive abnormal firm returns (i.e., the combination of abnormal stock and bond returns) around R&D increases. Moreover, the market’s positive response to these increases is warranted apparently by the subsequently positive (long-term) abnormal operating performance that our sample firms experience. The abnormal firm returns around R&D increases are also higher for firms with subsequently better abnormal operating performance. These findings provide new evidence of the market’s ability to look ahead, and incorporate some of the long-term benefits from an R&D increase. These results, however, do not rule out the possibility that the market undervalues the long-term benefits of R&D increases (i.e., the myopic market hypothesis) or overvalues them (i.e., the manic market hypothesis). In fact, consistent with the myopic market hypothesis, we find positive long-term abnormal firm returns following R&D increases. Therefore, these increases appear to be even better investments than the market expects at the time of the increase. Market Myopia, Market Mania, or Market Efficiency? An Examination of Stock and Bond Price Reactions to R&D Increases and Subsequent Performance Are financial markets myopic? If so, then previous studies (e.g., Woolridge (1988), Chan, Martin, and Kensinger (1990)) posit that stock prices should decline around announced increases in research and development (R&D) expenditures. An R&D increase lowers a firm’s current earnings (and cash flows), and any potential increase in future cash flows is ignored by the definition of myopia used in these studies. Therefore, an R&D increase provides an ideal test of this version of myopia. With their findings of significantly positive abnormal stock returns around R&D increase announcements, these studies conclude that the market is not myopic. More recent work, however, offers a broader definition of myopia where the market undervalues, but does not necessarily ignore, long-term cash flows (e.g., Abarbanell and Bernard (2000), Porter (1992)). With this definition, a myopic market may still respond positively to an (unexpected) R&D increase but the response is lower than it should be under the null of the efficient market hypothesis (EMH). Therefore, the myopic market hypothesis predicts that a firm is undervalued after an R&D increase. Conversely, stock market responses to R&D increases may reflect an overvaluation of long-term cash flows. For example, Jensen (1993) tracks the operating performance of firms with R&D investments, as of 1989, and argues that many of these investments have a negative NPV. If Jensen’s results are representative of R&D investments across time, then the positive stock price reactions to R&D increases reported in previous studies are not consistent with the EMH, but with what we call the manic market hypothesis. This hypothesis is the mirror image of the myopic market hypothesis; that is, a manic market gives a higher response to an R&D increase than it should compared to the response provided by 1 We use the terms R&D investment and R&D increase interchangeably because we are focusing on unexpected increases in a firm’s investment policy. As discussed in more detail below, an R&D increase is our measure of an unexpected R&D investment. 2 If an R&D increase has a negative net present value (NPV), then the negative reaction to the increase is larger in magnitude with a myopic market than with an efficient market. 2 an efficient market. Hence, the manic market hypothesis predicts that a firm is overvalued after an R&D increase. Shareholder wealth may also rise around an R&D increase not because of an increase in firm value, but because R&D investments increase the riskiness of the firm’s assets. As Galai and Masulis (1976) demonstrate, an increase in firm risk causes a wealth transfer from bondholders to shareholders, ceteris paribus. In other words, R&D increases may be detrimental to bondholders because they represent a typical asset substitution problem. On the other hand, any rise in a firm’s profitability (which raises a firm’s value), resulting from the R&D increase, is beneficial to the firm’s shareholders and (risky) bondholders, ceteris paribus. Limiting the analysis to stock returns does not reveal the net effect of an R&D increase to a firm’s bondholders, and consequently does not reveal the effect of an R&D increase on a firm’s overall value. In short, the evidence against myopia reported in previous studies is not necessarily inconsistent with the more recent and broader definition of myopia (or mania). This evidence is also not necessarily consistent with the EMH, or representative of how a firm’s value changes when its R&D is increased. There are, in particular, three primary questions unanswered in the literature: Does firm value rise around R&D increases (does the market think these increases have a positive NPV? ), or do positive stock price reactions to these increases reflect merely a wealth transfer from bondholders? Do R&D increases lead to better long-term operating performance (are they positive NPV projects? ), and does the market recognize (at least partially) these long-term benefits at the time of the increase? Are the financial markets efficient, myopic, or manic in valuing the long-term benefits of R&D increases? Our answers to these questions represent our three primary contributions to the literature. First, we report significantly positive average and median abnormal stock returns around R&D increases. With the average and median abnormal bond returns close to zero, the abnormal firm returns (i.e., the combination of a firm’s stock and bond returns) are significantly positive on average, and for the 3 median. The rise in firm value shows that the market thinks the average and median R&D increase is a positive NPV project for the firm, not just the stock. Though the rise in firm value appears to offset any rise in firm risk (so the net effect of an R&D increase is not negative for the average and typical firm’s bondholders), there are firms in our sample where the abnormal stock return is positive, but the abnormal bond return is negative, and great enough in magnitude, such that the abnormal firm return is negative. These results show that abnormal stock returns are not always a sufficient statistic for the measurement of abnormal firm returns, and bolster our reason for incorporating bond returns in our analysis. Second, we report that our typical sample firm has significantly better operating performance following their R&D increase. This result suggests their R&D increases are positive NPV projects, consistent with the market’s typically positive reaction to these increases. Moreover, the market responds more favorably to R&D increases that produce relatively better subsequent operating performance. These findings provide new evidence of the market’s ability to look ahead (though the evidence is not strong in every case), and incorporate some of the long-term benefits from an R&D increase. Nevertheless, the results do not rule out the possibility of market myopia or market mania because they do not demonstrate whether the market values efficiently (i.e., it does not undervalue or overvalue) these long-term benefits. Third, we examine the long-term abnormal firm returns for our sample firms following their R&D increases because the EMH, market myopia, and market mania hypotheses provide mutually exclusive predictions about these long-term returns. If the market is myopic, and so the firm is Only one previous study examines abnormal bond returns around announced increases in R&D (Zantout (1997)). He examines abnormal bond returns for 23 R&D announcements, and finds them to be insignificant. His bond data consist of bond prices from the exchanges, however, and Warga and Welch (1993) demonstrate how these prices can lead to an underestimation of bond valuation effects around a corporate event. Moreover, he does not examine abnormal firm returns. There are several differences between our study and Jensen’s (1993) study, and so we should not expect to replicate perfectly his findings. For example, his sample period, sample selection procedure (e.g., he does not choose firms based on whether they have increased their R&D), and measurement of expected operating performance are all substantially different from standard methods that we use in our study. In short, Jensen’s results are just one part of a comprehensive paper on corporate governance. Whatever the explanation is for the differences in our results, we should not find the kind of results we do if R&D increases are negative NPV projects, and so we conclude that they are beneficial. 4 undervalued following an R&D increase, then the subsequent long-term abnormal firm returns (i.e., the abnormal firm returns for the five-year period following the R&D increase) should be positive. If the market is manic, and so overvalues the firm following an R&D increase, then the subsequent abnormal firm returns should be negative. The EMH predicts zero abnormal returns. We report strong support for the myopic market hypothesis with our findings of positive long-term abnormal firm returns following our sample firms’ R&D increases. In other words, our sample firms’ R&D increases are even better investments than the market expects at the time of the increase. In the next section, we provide some additional discussion of previous work in this area. We discuss the sample selection procedures, and present some descriptive statistics in Section II. Section III contains our methods, and Section IV our empirical results. We summarize the paper in Section V. I. Related Literature Previous studies use