Why Are They Leaving Money On the Table?

I want to commend a fascinating post by Jim Manzi to your attention. In the post Jim considers the findings of business prof Anne Marie Knott that American companies are drastically under-spending on R&D:

Knott claims that if just the top 20 American corporations had followed her recommendations, they would have collectively increased their market capitalization by more than $1 trillion. Consider this assertion for a moment The current total market capitalization of the top 20 U.S. public companies is a little over $4 trillion. Knott claims that she has outsmarted the entire system of management teams, investors, equity analysts, hedge funds, large-scale private equity firms and everyone else who is trying to change management practices to increase share price, and knows how to increase the total value of the most-closely followed companies in the world by almost 25 percent….by building a regression model using publicly-available data.

Dr. Knott has found, for example, that Dow Chemical would have maximized its total market capitalization if it had spent an additional 10% on R&D and Apple would have maximized its total market capitalization by spending an eye-popping five times what it actually spent.

Jim correctly responds:

I’m confident that exactly the effect Knott describes is real. Some companies are better at managing research, and they will spend more, all else equal, and create greater returns for it.

But causality also runs in the opposite direction. For example, when management teams rationally foresee a good year coming, they tend to relax spending discipline. So we will see R&D spending go up in year X, and profits rising in year X+1. The expectation of future profits cause R&D spending to rise today This effect is unobserved in Knott’s model, because we have no data on executive anticipations. Some other variables will proxy for it, but the correlation between the actual unobserved variable and the proxy won’t be close to 1.

Further, there are many confounding variables. For example, different firms that are called competitors will actually face different landscapes of potential R&D opportunities, independent of R&D effectiveness. IBM and HP, as examples, have different mixes of end-use markets, different customer bases, different installed technologies and so on that means that each is looking at a different list of potential relevant projects when deciding what to fund. This changes over time. Who were Apple’s competitors in 1995? 2000? 2010? Who will be their competitors in 2015? This is referenced conceptually in Knott’s paper, but how do we segregate this effect from RQ and everything else when the model has no data on it.

However, I think that many, many companies don’t see R&D the way that Jim suggests. So, for example, in an early post here I examined the financial reports of a number of large pharmaceutical companies over a period of several years and found that R&D expenses increased, roughly, at the rate of inflation while marketing and lobbying spending increased with revenues. Or, said another way, R&D is viewed as overhead and restrained.

Dr. Knott’s findings do dovetail nicely with a recurring theme here, that R&D spending in the U. S. is far too low. Imagine, just for the sake of argument, that Dr. Knott’s findings are correct and that big companies were, in fact, behaving correspondingly. Tens or even hundreds of billion more would have been spent on R&D. That would have increased the incentives for students to pursue careers in science and technology rather than, say, finance. Or, to pick a worst-case scenario, art history.

11 comments… add one

  • Icepick

    Would Apple have really benefitted from spending five times as much on R&D? Where were they going to find five more Steve Jobs to oversee things?

  • sam

    “Or, said another way, R&D is viewed as overhead and restrained.”

    That means, I guess, that they see R&D departments as cost centers. Something about that strikes me as a little irrational. Can’t really articulate why it so strikes me, but it does.

  • I have to say I’m a bit skeptical about the specific results of the study, even though I agree that firms should probably spend more on R&D.

    Also, I think that tech companies like Google tend to simply buy small companies that have already done the R&D in an area they’re interested it. That seems to be the goal of a lot of small tech companies – come up with something cool and then sell to the Google’s of the world.

  • Maxwell James

    I wonder how much this is a result of accounting standards. For instance look at Microsoft. There’s a decent argument to be made that R&D is really part of COGS for them, but like most companies they treat it as an expense, which from a stock market perspective makes their margins look bigger. But it also contributes to the perception of R&D as a cost center rather than an integral part of doing business.

  • like most companies they treat it as an expense, which from a stock market perspective makes their margins look bigger

    I think that something alone these lines is exactly why it’s treated as it is. That’s another way of saying that they’re sacrificing capital growth for near term monetary return to stockholders. We’ve come a long way since the business of America was business.

    Many years ago I worked for a company that had a very cockamamie scheme for attributing costs and revenues. When sales sold something they were credited with the revenue but production never got credited when product shipped. That meant that sales was a profit center while production was a cost center. The logical implication of that would be to eliminate production.

    I pointed out the obvious—that when product shipped it should be treated as a cost to the sales department and revenue to production and that at the same time production should be paying a royalty to R&D. I was managing R&D at the time. As you can imagine I wasn’t tremendously popular with sales.

    However, production did hire me (literally, hire—they paid my wages for the duration of the project) as an internal consultant when they ran into a snarl.

  • That seems to be the goal of a lot of small tech companies – come up with something cool and then sell to the Google’s of the world.

    I ended up owning (as a result of debt for equity swaps) two companies whose entire business plans were to be acquired by Microsoft. To be honest I’ve always found such plans suspect. I’m mistrustful of people who want to take the money and run.

  • sam

    “That meant that sales was a profit center while production was a cost center”

    FWIW, that seemed to have been the model in every publishing enterprise I worked for.

  • steve

    Mandel has published a lot on this. We trail much of the world in R&D spending, as a percentage, except in the biosciences. Take away public research money, which is happening, and we are really hurting. I have always assumed this is due to the very short term focus of our companies, along with the emphasis on very high CEO pay compared with the rest of the world.

    Steve

  • sam

    “That would have increased the incentives for students to pursue careers in science and technology rather than, say, finance. Or, to pick a worst-case scenario, art history.”

    That reminded me that one cannot really predict how things will turn out. Nabokov Theory on Butterfly Evolution Is Vindicated

    Yeah, that Nabokov.

  • Drew

    “For instance look at Microsoft. There’s a decent argument to be made that R&D is really part of COGS for them, but like most companies they treat it as an expense, which from a stock market perspective makes their margins look bigger.”

    I’m hoping this comment was a simple brain cramp, for capitalizing something into inventory vs period expensing is really just a timing issue, and fools no serious financial analyst.

  • Drew

    “Many years ago I worked for a company that had a very cockamamie scheme for attributing costs and revenues. When sales sold something they were credited with the revenue but production never got credited when product shipped. That meant that sales was a profit center while production was a cost center. The logical implication of that would be to eliminate production.”

    C’mon, Dave. The question is whether the financial statements of the company correctly captured costs, which should have been capitalized into inventory after production, and matched them to revenues per GAAP. And I don’t know many sr managers or salesmen who would conclude or desire no production, that nothing to sell thingy….

Leave a Comment