Investing Around R&D – Looking For the Companies Losing the Least

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

March 18th, 2013

Investing Around R&D – Looking For the Companies Losing the Least

 

  • R&D within Industrials and Basic Material sectors generates adequate returns on investment for few, if any. For others it is at best a necessary cost of doing business, but more often a significant waste of money.
  • For many companies, the more they spend on R&D, the lower PE value the market gives them. However, it is almost always difficult to isolate causes; is it poor R&D effectiveness or poor capital allocation, or some ill-timed or ill-advised acquisition.
  • Companies spending a large percentage of available cash on R&D and showing declining trends in return on capital are clearly getting something wrong. Companies showing improving trends in return on capital are clearly getting something right, but this may not be R&D as these trends can be seen for high spenders and low spenders alike.
  • We would focus on companies with improving return on capital trends, and those that appear as attractively valued – DD, HUN, JOY and CAT. Within this group we prefer the companies with lower R&D spend as a percentage of earnings, as they have the ability to return more cash to shareholders – JOY.
  • We would avoid companies at the other end of the spectrum, regardless of their R&D spend. We would be particularly concerned about companies spending a lot per patent they file, as this tends to correlate with declining returns on capital – DOW, UTX and JCI.

Exhibit 1

Green = Attractive Value; Red = Expensive

Italicized = High Cost Per Patent

Blue = Highlighted positively in our
13 for 13 report

Overview

Earlier this month we wrote a piece about the
effectiveness (or lack thereof) of R&D
programs within the Industrials and Basic Materials Sectors. Conclusions are hard to draw, and the work did not look at stock valuations and hence had no investment ideas. The main findings were as follows:

  • Companies in these sectors do not get a valuation boost as a consequence of having an R&D program and in many cases are penalized for it.
  • It is hard to identify any sector or any company within a sector where you can conclude that the R&D program is adding real value.
  • There are examples of where it is a necessary evil to keep pace with competition.
  • For almost every company that might claim that the R&D program is needed to offset declines in other business we can find a company in a similar business with lower R&D spending and with limited on no business decline, thus countering the argument.
  • Some R&D programs appear to be more efficient in driving both patent filings and return on capital growth than others.
  • There is an inverse correlation between the amount of R&D spend per patent filed and the trend growth in return on capital – supporting the inefficiency idea.

Following on from this work, we have looked at who to invest in or who to avoid, simply from an R&D perspective, but taking into account that “there is a price for everything”.

Companies spending a lot on R&D and still experiencing a decline in their trend return on capital should be avoided, as either the R&D program is completely ineffective, or they are doing something else significant to destroy returns.

While our work leads us to focus on companies with improving return on capital trends, these fall into two buckets, those with higher R&D spending and those without. We have to screen for those seeing an improving trend because of exposure to US natural gas, but for the most part these companies are not high R&D spenders and most are attractively valued so do not appear in the list in Exhibit 1.

R&D Versus Return On Capital – All Bases Covered!

When we compare spending on R&D with return on capital we get a totally uncorrelated picture – Exhibit 2.

Note, that we are not using cash on cash returns – we are using the definition that we have used in all of our research to date:

Return On Capital = Net Income + Tax Adjusted Interest Charges

Total Assets – Current Liabilities

In our definition we are therefore excluding the R&D spending from the numerator and the cumulative R&D spend from the denominator.

What we see are companies in every quadrant – those generating good return on capital growth, with or without high R&D spend and those generating poor return on capital growth again with or without the R&D. There are plenty of examples in each group and in the Exhibit we have only labeled the stand-outs.

Given the difficulty in attaching the cause of the return on capital trend on one factor – R&D efficiency, capital spending efficiency, M&A, etc., we focus on the companies with improving return on capital trends, regardless of their R&D strategy. On the flip side, if your are spending a lot on R&D and your return on capital is still declining, you are clearly doing something wrong. Generally, the companies with a declining return on capital and spending a lot on R&D have a high cost per patent filed – see next section.

Exhibit 2

Source: Capital IQ and SSR Analysis

Costs per Patent Issued – Suggest an Inefficiency

As we suggested in the initial research, companies spending more per patent filed tend to have lower return on capital growth. While not conclusive, it would tend to suggest that some companies have more effective R&D programs than others – Exhibit 3. While we would be naturally cautious about any company with declining returns on capital, we would be more so for companies that look like they have ineffective or inefficient R&D programs as this may in part drive the declines and may be causing us to over-estimate normal earnings in our valuation analysis.

Exhibit 3

Source: Capital IQ, Cobalt IP and SSR Analysis

Valuation – Our Screens Suggest That a Few Are Miss-Valued Today

If we look at the valuation and skepticism screens that we detail in
our monthly work
(Exhibit 4) we can find some companies that have positive return on capital trends and look attractively valued today – see Exhibit 1. We cannot find examples of companies that have declining return on capital trends and also look expensive. The only comment that we would add to the conclusions above, would be around MMM, which we highlighted as a pick for
2013 back in early January
. We had not completed this R&D work at the time we published or top picks for 2013. Had we done so we would likely not have included MMM in the list.

Exhibit 4

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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