Abnormal Research and Development Investments and Stock Returns

Empirical evidence in the extant literature on whether investors in U.S. capital markets value corporate RD Chan, Martin, and Kensinger, 1990; and Zantout and Tsetsekos, 1994) using event study methods document inconclusive results (i.e. both positive and negative abnormal returns). For instance, Szewczyk, Tsetsekos, and Zantout (1996) investigate the role of investment opportunities and free cash flow in explaining R&D-induced abnormal returns. They document a significant positive relation between a firm's Tobin's Q and its stock price reaction to announcements of increases in R&D expenditures in support of investment opportunities hypothesis. Other literature studies the relation between R&D expenditures and stock returns. This literature also documents inconclusive results. Chan, Lakonishok, and Sougiannis (2001) examine whether the stock prices fully reflect firms' expenditures on R&D using data over the period of 1975-1995. They specifically study the relation between R&D spending and subsequent stock price performance by comparing the firms with R&D expenditure and firms with no R&D expenditure and document that “…firms engaged in R&D do not experience superior stock price performance, compared to firms with no R&D”. Accordingly they argue that “…the absence of any differences is consistent with the notion that the market price on average incorporates fully the benefits of R&D spending”. Eberhart, Maxwell, and Siddique (2004) investigate the long-term abnormal stock returns and operating performance following R&D increases and document significant positive abnormal stock returns during the five-year period following the increases and conclude that market initially undervalues R&D investment. More recently, Li (2011) reports that high R&D-intensive firms earn higher average stock returns than low R&D-intensive firms. Given the question of whether investors value R&D-investing firms efficiently and inconclusive findings in the literature, we investigate whether a portfolio with positive abnormal R&D investment changes perform better than market portfolio over the 1975-2011 period for all domestic, primary stocks listed on the NYSE, Amex, and Nasdaq stock markets. Our sample of firm-year observations includes cases of R&D investment increases and R&D investment decreases. Following the method in Titman, Wei, and Xie (2004) we examine the stock returns following the abnormal R&D investment changes. In our univariate analysis, we find that in all our samples positive RDI firms provide higher returns than negative RDI firms. This effect is higher among smaller (i.e. lower market capitalization), higher priced, higher past return stocks. However, it is not related to growth options or technological intensity. In our multivariate analysis, we form long–short portfolios of stocks sorted by RDI. Each year, we divide the sample into negative and positive groups and we compute the return in the following year on a zero-investment portfolio that longs the stocks with positive RDI and shorts the stocks with negative RDI. We repeat this process every year and hence obtain a time series of returns for our zero-investment portfolio. Then, we regress the time-series returns on factors (Fama-French three factors, Momentum, and Liquidity) known to affect the cross-section of returns. We do not observe any significant difference between the positive and negative RDI firms. Next, we examine profitability of an arbitrage strategy where we long stocks with positive RDI and shorts market portfolios (i.e. value-weighted, equally-weighted, and SP capital expenditures, number of employees, and market value of equity following (Li, 2011). We also replace the numerator R&D expenditures with R&D Capital following Chan, Lakonishok, and Sougiannis (2001). We compute R&D capital as the five-year cumulative R&D expenditures, assuming an annual depreciation rate of 20%. Our results show a positive RDI premium as we find significant intercept (alpha) values in all five panels. The alpha in the models ranges between 25 basis points per month to 87 basis points. Our findings indicate an annual economically significant positive RDI premium of that ranges from 3.0% to 10.5%. Overall, we conclude that, even after accounting for risk factors and scaling with alternative measures, we still find significantly positive abnormal stock returns for positive RDI stocks. We contribute to the literature in many ways. First studies in the literature (i.e. Eberhart et al. 2004) relating to RD (i) small and large (ii) high-tech and low-tech stocks, (iii) high-growth and low-growth stocks. We find that in all three groups of stocks that increases in RDI earn significantly higher abnormal stock returns compared to market portfolio. Specifically, small size, high-growth, and high tech stocks that decrease RDI earn higher returns. However, RDI effect prevails regardless of the size, growth, and technological endowments of the firms. Our study expands and complements the literature on the relation between RD Chambers, Jennings, and Thompson 2002; Chu 2007; Lin 2007; Li and Liu 2010; Li 2011). Our results also address the puzzle regarding RD Li, 2011), and high physical investment intensive firms earn lower average stock returns compared to low physical investment intensive firms (e.g., Titman, Wei, and Xie, 2004; Xing, 2008) since we use the method which is employed to examine the relation between the physical investment and stock prices. Specifically, our results point out that the puzzle is a result of the failure of the previous studies to employ comparable measures.