Excess Returns To R&D Intensive Firms

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Review of Accounting Studies, 7, 133158, 2002 2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Excess Returns to R&D-Intensive Firms

DENNIS CHAMBERS
University of Illinois at Urbana-Champaign

ROSS JENNINGS
University of Texas at Austin

ROBERT B. THOMPSON II
American University
Abstract. Recent studies indicate that both current R&D investment levels and current or recent changes in R&D investment are positively associated with subsequent excess (risk-adjusted) stock returns. The tentative explanation offered for these results is that shares of R&D-intensive rms are mispriced because investors fail to see through earnings distortions caused by conservative accounting for R&D costs. However, an alternative explanation is that conventional controls for risk do not completely capture the riskiness of R&D-intensive rms, causing measured excess returns for these rms to be biased upward. This study provides evidence useful for distinguishing between the mispricing and risk explanations for R&D-related excess returns. Overall, our empirical results suggest that the positive association between R&D investment levels and excess returns is more likely to result from failure to control adequately for risk than from mispricing. On the other hand, our results do not rule out the possibility of a second source of excess returns that are due to mispricing and that are associated with changes in the level of R&D investment. Keywords: research and development, mispricing, market efciency, conservative accounting JEL Classication: M41, G14, O32
Previous research provides consistent evidence of a contemporaneous positive association between rms research and development outlays and both share prices and returns. This evidence suggests that investors view R&D outlays as investments that are expected to produce future benets, and that they take such benets into consideration when pricing shares. However, several recent studies also indicate that a strategy of investing in R&Dintensive rms earns excess (risk-adjusted) returns. Lev and Sougiannis (1996) and Chan et al. (2001) report a positive association between measures of the level of R&D investment and subsequent excess returns, while Lev et al. (2000) and Penman and Zhang (2002) report a positive association between current or recent changes in R&D investment and subsequent excess returns. These studies tentatively conclude that investors are misled by conservative accounting for R&D costs, which tends to understate earnings when R&D investment is increasing and to overstate earnings when R&D investment declines. An alternative explanation for excess returns to R&D-intensive rms is that these returns are compensation for risk-bearing. Under this explanation, either prior studies do not control completely for known risk characteristics, or there is an additional risk characteristic associated with R&D activities for which investors are being compensated. Following Fama and French (1992, 1993), previous studies control for systematic return behavior associated
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with rm size (market capitalization) and book-to-market ratio, both of which are thought to be indicators of equity risk. However, these controls are based on empirical results for large samples of rms and are unlikely to perfectly control for risk for all rms and in all time periods. In this study, we investigate whether the measured excess returns to R&D-intensive rms reported in previous studies are more likely due to mispricing by investors or to compensation for bearing risk. The evidence we provide contributes both to the general debate over the informational efciency of U.S. securities markets and to the related debate over the appropriateness of current nancial reporting policy for R&D activities. The excess returns reported in prior studies result from implementable trading strategies based on readily available information, and thus would represent a clear example of market inefciency if they are due to mispricing. At the same time, any inefciency that exists may be related to current R&D accounting rules, which require preparers to expense R&D outlays immediately even though these outlays are intended to create economic assets. If the resulting nancial statements mislead investors, the excess returns to R&D rms may be reduced or eliminated by alternative R&D accounting policies that better reect the expected future benets of R&D activities. Our analysis, based on all NYSE-, ASE-, and NASDAQ-traded rms over the period 19791998 that meet the minimal data requirements for the study, proceeds in three stages. First, we conrm the nding of Lev and Sougiannis (1996) and Chan et al. (2001) that there is a positive association between level of R&D investment and subsequent excess returns. We conduct additional analysis to conrm that excess returns to R&D-intensive rms are statistically signicant, that they are not induced by our controls for risk, and that they are not an artifact of our measure of the level of R&D investment. The second stage of our analysis examines whether excess returns associated with the level of R&D investment are consistent with compensation for risk-bearing. We nd that positive average excess returns to R&D-intensive rms persist for up to ten years when sample observations are aligned in event time, but vary greatly from year to year in calendar time. This behavior is consistent with the risk explanation. We also nd that variation in analysts forecasts of future earnings and variation in actual future earnings, both considered indicators of overall rm risk, are much larger for R&D-intensive rms than for rms with relatively low levels of R&D investment. The third stage of our analysis investigates whether mispricing explains the positive association between levels of R&D investment and subsequent excess returns. Overall, our evidence suggests that this is not the case. The mispricing scenario offered in Lev et al. (2000) and Penman and Zhang (2002) predicts that excess returns are negative (positive) in periods of growth (decline) in R&D investment because investors are misled by reported earnings numbers that are too low (too high). Consistent with this scenario, we observe a negative association between excess returns and contemporaneous changes in R&D investment. However, controlling for changes in R&D investment does not attenuate the strong positive association between excess returns and R&D investment levels. We also nd that analysts earnings forecasts are at least as optimistic for R&D-intensive rms as for those with little or no R&D investment, and that excess returns for R&Dintensive rms followed by many analysts are of about the same magnitude as those for rms followed by few or no analysts. Taken together, these results suggest that the positive
EXCESS RETURNS TO R&D-INTENSIVE FIRMS
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association between future excess returns and current R&D investment levels is not explained by mispricing. In the next section of the paper we review relevant prior research. Section two describes our sample, species variables used in the study, and provides various descriptive statistics. Section three documents the relation between R&D intensity and excess returns reported in prior studies. Sections four and ve present evidence related to the risk and mispricing explanations for excess returns to R&D-intensive rms, respectively. Section six summarizes our results and offers some concluding remarks.
1.
Prior Research
Numerous studies in economics, nance, and accounting suggest that investors view R&D expenditures as investments that are expected to produce future benets. One set of studies, using a variety of methodologies, indicates that rms market values are positively related to R&D outlays (Ben-Zion, 1978; Hirschey and Weygandt, 1985; Megna and Klock, 1993; Shevlin, 1991; Sougiannis, 1994; and Hand, 2001). Other studies provide evidence that changes in market values are positively related both to innovations in R&D expenditures (Bublitz and Ettredge, 1989) and to announcements related to R&D activity (Woolridge, 1988; Chan et al., 1990; and Austin, 1993). Finally, several studies provide evidence that capitalizing and amortizing R&D costs on a pro forma basis results in summary accounting measures that are more closely associated with security prices and security returns than those based on the current requirement to expense R&D costs when incurred (Loudder and Behn, 1995; Lev and Sougiannis, 1996; Monahan, 1999; and Chambers et al., 2002). Despite this evidence that current share prices reect expected benets from R&D activities, several recent studies suggest that prices may not fully reect the information contained in past R&D expenditures. These studies fall into two groups. The rst group reports a positive association between current measures (based on public information) of the level of R&D investment and future excess returns. Lev and Sougiannis (1996, 1999) report that a measure of unrecognized R&D assets based on current and past R&D outlays is positively correlated with security returns over the 12 months subsequent to release of current period accounting information. Similarly, Chan et al. (2001) provide evidence that rms with relatively high current R&D expenditures earn excess returns over the subsequent three years. The second group of studies reports a positive association between measures of current or recent change in the level of R&D investment and future excess returns. Lev et al. (2000) nd that future excess returns to R&D rms are positively related to several measures of the relative growth rate for R&D outlays in prior periods. Penman and Zhang (2002) report that rms whose ratios of unrecorded R&D assets to net operating assets have increased (decreased) in the current year earn positive (negative) excess returns in the following year. In measuring excess returns, all of these studies control for rm characteristics that are commonly thought to be associated with risk.1 The last two studies can be viewed as providing a direct examination of whether investors are misled by conservative accounting for R&D outlays. To the extent that R&D investments create economic assets, the current expense when incurred accounting treatment for R&D
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has the effect of understating earnings and related indicators of value when a rm increases its R&D investment, and the reversing effect of overstating earnings and related indicators of value when the rms R&D investment is decreased. Lev et al. (2000) and Penman and Zhang (2002) explicitly discuss this possibility and provide empirical results that suggest that investors are misled by current R&D accounting. The rst two studies, Lev and Sougiannis (1996) and Chan et al. (2001), can also be viewed from this perspective. However, they examine whether future excess returns are associated with the level of R&D investment, which is not necessarily related to the income statement bias of conservative accounting for R&D outlays. While these studies can all be interpreted to indicate that mispricing accounts for the excess returns to R&D-intensive rms, some of the evidence they present can be viewed as consistent with the risk explanation. For example, the combined evidence from these studies suggests that excess returns are associated with both the change in R&D investment, a direct measure of the income statement bias of conservative accounting for R&D, and with the level of R&D investment, which is a measure of more general R&D activity. This suggests that either the level of R&D investment and change in R&D investment are highly correlated, and both reect relevant bias in R&D accounting, or there are two separate sources of excess returns to R&D rms, one associated with nancial statement bias and the other with the extent of R&D activity. In addition, the R&D-related excess returns reported by Chan et al. (2001), Lev et al. (2000), and Penman and Zhang (2002) persist for three to ve years and show little sign of diminishing. This suggests that either these returns are due to risk, or they are due to mispricing that is both substantial and very slow to reverse. Thus, prior research does not provide clear evidence on whether excess returns to R&D-intensive rms are due to mispricing exclusively, or whether the risk explanation can account for all or part of the excess returns. To address this issue, we focus on the positive association between the level of R&D investment and subsequent excess returns documented by Lev and Sougiannis (1996) and Chan et al. (2001). We rst provide evidence on the extent to which this relation can be explained as compensation for risk-bearing. We then control for potential excess returns associated with changes in R&D investment and investigate the extent to which excess returns to the level of R&D investment can be explained by mispricing.2
2. 2.1.
Sample Selection and Variable Denitions The Sample
This study is based on rms in the Compustat PST, full coverage, and merged research annual databases for any year from 1979 to 1998. We identied 89,419 rm-years that satised a minimal set of Compustat data requirements.3 This main sample includes 13,442 rms distributed across 73 two-digit (442 four-digit) SIC codes. As we explain below, some of our analyses are based on analysts earnings forecasts from the I/B/E/S database, and these data are not widely available prior to 1984. These analyses are conducted using a reduced sample that consists of the 72,317 rm-years in our main sample from the period 19841998.
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2.2.
Descriptive Statistics
For purposes of subsequent analysis, we divide the rm-years in our main sample into two groupsthose with an unrecognized R&D asset in the current year (R&D rms) and those without an unrecognized R&D asset in the current year (non-R&D rms). Following Lev et al. (2000) and Chan et al. (2001), we estimate the net R&D asset (and related R&D amortization) that would have been reported if all R&D outlays were capitalized and amortized over ve years, rather than expensed immediately. Thus, the pro forma R&D asset at the end of year t (RDASSETt ) and R&D amortization for year t (RDAMORTt ) are given by RDASSETt = RDEXPt + 0.8(RDEXPt1 ) + 0.6(RDEXPt2 ) + 0.4(RDEXPt3 ) + 0.2(RDEXPt4 ) RDAMORTt = 0.2(RDEXPt1 + RDEXPt2 + RDEXPt3 + RDEXPt4 + RDEXPt5 ) where RDEXPt is the R&D outlay reported as expense for year t under current accounting rules.4 Table 1 reports the number of non-R&D and R&D observations for each year of our 20-year study period. Over the 20 years as a whole, 35,841 rm-years, or about 40 percent of the sample, are classied as R&D observations. The proportion of R&D rms in the sample varies across years, but has no obvious trend. For R&D rms only, Table 1 also reports year-by-year averages and medians of the ratio of R&D expenditures to sales and of the ratio of the pro forma R&D asset to reported total assets. These ratios tend to rise throughout the study period, indicating that R&D activities have become more signicant over the past two decades. Table 2 presents additional descriptive statistics for the R&D rms in our main sample. The rst two rows report selected percentiles of the distribution of reported R&D expense (RDEXP), scaled by current net income and current sales. These numbers indicate that R&D expenditures vary considerably across the sample, and are substantial in relation to earnings and sales for many rms in the sample. The third and fourth rows of the table report percentiles of the distribution of pro forma R&D amortization (RDAMORT), again scaled by current sales and current earnings. Scaled values of RDAMORT are generally smaller in magnitude than scaled values of RDEXP, suggesting that R&D outlays are growing through time for most rms in the sample. The last two rows of the table, which summarize the distribution of R&D assets (RDASSET) scaled by reported common stockholders equity and by total assets, suggest considerable variation across the sample in unrecognized R&D assets and indicate that such assets may be material for a large proportion of rms in the R&D subsample. 3. Relation between Excess Returns and R&D Activity
In this section we examine excess returns for groups of rms based on two alternative measures of R&D activity, the ratio of current period R&D assets to market value of equity (Lev and Sougiannis, 1996) and the ratio of current period R&D assets to current period sales.
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Table 1. Annual sample size and average and median of ratio of R&D expenditure to sales and ratio of pro forma R&D assets to total assets. R&D Expenditures to Sales R&D 1,233 1,270 1,388 1,427 1,658 1,721 1,716 1,801 1,846 1,813 1,767 1,751 1,816 1,958 2,147 2,255 2,418 2,731 2,763 362 Avg. 0.05 0.07 0.20 0.14 1.96 0.43 0.31 0.39 0.36 0.44 0.62 0.59 1.33 2.30 1.58 2.74 2.49 1.83 2.33 1.10 Median 0.01 0.02 0.02 0.03 0.03 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.05 0.05 0.05 0.05 0.06 0.07 0.06 R&D Assets to Total Assets Avg. 0.08 0.08 0.09 0.12 0.13 0.14 0.17 0.18 0.18 0.21 0.21 0.23 0.21 0.21 0.23 0.26 0.25 0.25 0.29 0.29 Median 0.05 0.05 0.06 0.08 0.08 0.09 0.10 0.11 0.11 0.11 0.12 0.12 0.12 0.13 0.14 0.13 0.13 0.14 0.15 0.15
Sample Size Year 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Non-R&D 1,771 1,871 2,042 2,109 2,333 2,377 2,379 2,530 2,717 2,626 2,597 2,598 2,674 2,800 3,680 3,957 3,960 4,128 4,055 374
Full sample19791998 Total Avg. 53,578 2,679 35,841 1,792 1.06 0.04 0.19 0.11
Reduced sample19841998 Total Avg.

For
43,452 2,897
28,865 1,924
1.26
0.05
0.22
0.12
observations in the R&D subsample only.
3.1.
Measuring Excess Returns
For each of the 89,419 observations in our main sample, we dene the investment date as the rst day of the fth month following the rms scal year end, and calculate excess returns for each of the three consecutive twelve-month periods following that date. As in previous studies that have reported excess returns to R&D-intensive rms, we measure excess returns using procedures described in Fama and French (1993). We construct 25 value-weighted, annually rebalanced portfolios that vary according to both market capitalization (Size) and book-to-market ratio (BVE/MVE).5 Monthly returns to a given Size-BVE/MVE portfolio serve as benchmark expected returns for observations in our sample that are similar in market capitalization and book-to-market to rms in that portfolio. On the investment date, we match a given sample rm-year to its Size-BVE/MVE control portfolio by comparing current levels of market capitalization and book-to-market for the observation to benchmark
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Table 2. Distribution of reported R&D expense, pro forma R&D amortization, and Pro Forma R&D assetsR&D subsample, 19791998. Percentile Variable R&D Expense/net income R&D Expense/sales R&D Amortization/net income R&D Amortization/sales R&D Assets/BV of owners equity R&D Assets/total assets 10 0.92 0.00 0.53 0.00 0.03 0.01 25 0.17 0.01 0.06 0.01 0.08 0.04 50 0.19 0.04 0.11 0.02 0.20 0.11 75 0.80 0.10 0.45 0.05 0.43 0.24 90 1.99 0.26 1.28 0.14 0.87 0.45
The table reports selected percentiles of the indicated distributions for 35,841 rms-years in the R&D rm subsample. R&D Expense is reported R&D expense for the current year. R&D Amortization is the amortization that would have been reported if R&D expenditures were capitalized and amortized over ve years beginning in the year after the expenditures were made. R&D Assets is the asset that would have been reported if R&D expenditures were capitalized and amortized over ve years beginning in the year after the expenditures were made.
portfolio cutoffs for the preceding June 30.6 To insure that risk adjustments are current, we update this assignment on June 30 of each subsequent year. The measured annual excess return for sample observation i in year t following the investment date is computed as:
12 12
ERit =
k=1
(1 + Rik )
k=1
(1 + R pk )
where Rik is rm is raw (cum-dividend) return for month k, and R pk is the month k return to the relevant Size-BVE/MVE benchmark portfolio.7
3.2.
Future Excess Returns and Measures of R&D-Intensity
Table 3 reports three years of average annual post-investment excess returns for non-R&D rm-year observations and for ve roughly equal-sized groups of observations based on the ratio of current period R&D assets to market value of equity (panel A) and on the ratio of current period R&D assets to sales (panel B). The groups are only roughly equal in size because they are formed using quintile cutoffs calculated in the prior year. The rst column of each panel reports average excess returns for non-R&D observations.8 For this group, returns are no larger than half of one percent in any of the three years following investment, suggesting that our procedures to control for risk have been reasonably effective for observations in this subsample. The remaining columns in panel A indicate that excess returns are increasing in the ratio of reported R&D assets to market value of equity. For each of the three years following the investment date, average excess returns increase monotonically across the ve groups. For the three years as a whole, the average annual excess return for group 5 is 6.9 percent,
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Table 3. Average annual excess returns for rm-years grouped by measures of R&D activity and capital expenditures19791998. A. Groups Based on R&D Assets/MVE Year Following Investment Date 1 2 3 Avg. Non-R&D 0.001 (0.546) 0.004 (1.378) 0.004 (1.335) 0.003 1 (Low) 0.018 (2.391) 0.027 (3.342) 0.012 (1.424) 0.019 2 0.004 (0.615) 0.008 (1.052) 0.014 (1.686) 0.001 3 0.022 (2.840) 0.024 (3.188) 0.023 (2.715) 0.023 4 0.028 (3.044) 0.052 (5.429) 0.046 (4.294) 0.042 5 (High) 0.078 (7.145) 0.070 (6.241) 0.060 (5.423) 0.069
B. Groups Based on R&D Assets/Sales Year Following Investment Date 1 2 3 Avg. Non-R&D 0.002 (0.604) 0.004 (1.414) 0.005 (1.548) 0.003 1 (Low) 0.003 (0.416) 0.001 (0.197) 0.010 (1.207) 0.002 2 0.007 (0.979) 0.012 (1.569) 0.016 (2.121) 0.011 3 0.024 (3.185) 0.031 (3.880) 0.037 (4.178) 0.031 4 0.058 (6.372) 0.038 (4.045) 0.032 (3.352) 0.043 5 (High) 0.025 (2.276) 0.036 (3.092) 0.041 (3.287) 0.034
C. Groups Based on Capital Expenditures/MVE Year Following Investment Date 1 2 3 Avg. CAPEX = 0 0.003 (0.273) 0.013 (1.111) 0.013 (1.306) 0.011 1 (Low) 0.006 (1.032) 0.004 (0.626) 0.007 (1.118) 0.002 2 0.019 (3.810) 0.022 (3.705) 0.013 (2.184) 0.018 3 0.023 (4.230) 0.007 (1.339) 0.017 (3.086) 0.016 4 0.001 (0.125) 0.010 (1.841) 0.017 (2.828) 0.009 5 (High) 0.021 (3.371) 0.007 (1.211) 0.012 (1.890) 0.000
R&D Assets is the asset that would have been reported if R&D expenditures were capitalized and amortized over ve years beginning in the year after the expenditures were made. MVE is the market value of equity at the end of the fourth month following the scal year end. Groups are formed on the basis of each ratio using quintile cutoffs calculated in the prior year. Returns are computed beginning on the investment date, which is the rst day of the fth month after scal year end. Excess returns are computed for each observation, for each year subsequent to the investment date, and are averaged across all rm-years in the same R&D group. The annual excess return is the difference between the rms actual return for that year and the return on the rms relevant control portfolio based on size and the ratio of book value of equity to market value of equity. We construct control portfolios as described in Fama and French (1993). Each June 30 we assign all stocks in the CRSP and COMPUSTAT data bases to one of ve groups based on market value of equity (Size). We then independently assigned all stocks to one of ve groups based on the ratio of their adjusted book value of equity to market value of equity (BVE/MVE), where book value of equity is adjusted to include our estimate of the rms R&D assets. In assigning rms to size groups, breakpoints are based on NYSE size quintiles. The intersection of these two grouping procedures yields 25 Size-BVE/MVE groups. For each Size-BVE/MVE group, we computed the average value-weighted return for each month during that JulyJune scal year.
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compared with 1.9 percent for group 1. Panel B reports a similar pattern, but with smaller excess returns, for groups based on the ratio of current period R&D assets to sales. These returns generally increase across the ve groups for each of the three years, with the exception of group ve whose average returns are smaller than those for group four in both the rst and second years after the investment date and on average across the three years.9 The t-statistics reported in Table 3 indicate that average excess returns for groups 35 are signicantly positive at the one-percent level. However, to the extent that sample observations are not independent, these t-statistics may be overstated. To address this possibility, we constructed an additional test of statistical signicance that does not depend on distributional assumptions about the sample. For each Compustat year during our study period, we chose Nt rm-years at random from the full sample, where Nt is the average number of rm-years in that years ve R&D groups. After combining these rm-years into a single group, we then computed average excess returns for each of the three 12-month periods following the investment date. We repeated this process 1,000 times to generate an empirical distribution of excess returns to samples that have the same sample size and the same time distribution as the R&D groups in Table 3, but which are otherwise formed solely on the basis of chance. The 5th and 95th percentiles of this distribution are 0.3 and 2.2 percent for the rst year, 0.1 percent and 2.3 percent for the second year, and 0.0 percent and 2.7 percent for the third year. Average excess returns reported in Table 3 that lie outside of these intervals can be viewed as unusual in the context of this distribution. By this criterion, all of the returns for groups 35 in panels A and B are signicant, except for the third-year excess return for group 3 in panel A, which is marginally signicant. 3.3. Sensitivity Analysis
In this section we examine two additional issues related to the excess returns reported in Table 3. First, we address the possibility that the results are induced by attempting to control for the Fama and French factors. To do this, we repeated the analysis using raw returns and found that the mean three-year return difference between groups ve and one based on the ratio of R&D asset to market value of equity was even greater (9.4 percent compared with 8.8 percent in panel A of Table 3). This suggests that the risk controls do not induce, but rather partly mitigate return differences between high and low R&D-intensity rms. Second, we address the possibility that the excess returns reported in Table 3 may be related more to the choice of deator than to the level of R&D activity. This is suggested by the fact that excess returns to R&D-intensive rms are larger when our grouping procedure is based on the ratio of R&D assets to market value of equity rather than on the ratio of R&D assets to sales. To address this possibility, we repeated the analysis after grouping R&D rms in the sample based on the ratio of current capital expenditures to market value of equity. This provides a check on whether deating any measure of investment by market value of equity induces a pattern of increasing measured excess returns. The results, reported in panel C of Table 3, indicate that there is very little association between this ratio and excess returns in future periods. For the averages across the three future periods, the excess returns are low in the extreme groups and slightly positive in the middle groups. This suggests that the pattern of increasing excess returns reported in panel A is not simply due to the equity value deator.
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3.4. Summary
The results reported in this section provide convincing evidence of a positive association between the level of R&D investment and post-investment excess stock returns, especially when R&D-intensity is measured by the ratio of unrecorded R&D assets to market value of equity (hereafter denoted as RDA). In the remainder of the study we examine whether the pattern of increasing excess returns to this measure of R&D-intensity is more consistent with a risk explanation or a mispricing explanation.10 4. Evidence on the Risk Explanation for Excess Returns to R&D Firms
The excess returns to R&D rms reported in Table 3 and in prior studies are residual rates of return that remain after controlling for size (market capitalization) and book-to-market ratio. These factors are known to be associated with average realized stock returns and are often interpreted as proxies for riskiness (Fama and French, 1992, 1993). However, they are unlikely to provide complete measures of risk for all rms and periods. This may be especially the case for R&D-intensive rms. For example, theoretical work by Berk et al. (2000) suggests that rms with high levels of R&D investment may be more risky than other rms, ceteris paribus. These authors argue that an investment in an R&D program is in essence a compound option to purchase a stream of operating cash ows, and hence should be more risky, other things equal, than an investment in the operating cash ows themselves. Under this view, R&D-intensive rms may be differentially risky in a way that is not contemplated in controls for size and book-to-market, and adjusting realized returns for those factors is unlikely to completely control for risk. To investigate whether excess returns to R&D-intensive rms are likely to result from inadequate control for risk, we examine (a) whether these returns persist over time, (b) whether they are more highly variable than excess returns to rms that are not R&D-intensive, and (c) whether measures of earnings uncertainty are correlated with R&D intensity after controlling for Fama and French risk factors. 4.1. The Duration of Excess Returns
If positive excess returns to R&D-intensive rms are compensation for risk, we would expect these returns to persist indenitely, provided that the risk characteristics of the sample rms are not changing signicantly over time. To investigate this, we divide all rm-years in the sample into non-R&D, low-R&D, and high-R&D groups on the basis of RDA, the ratio of unrecognized R&D assets to market value of equity. Non-R&D rm-years are those with an RDA of zero in the current year; low-R&D (high-R&D) rms are those in RDA groups 1 and 2 (3, 4 and 5) from Table 3. For each rm in each group, we calculate annual excess returns for each of the ten years following the investment date (the rst day of the fth month following scal year end), data permitting. The returns are aligned in event time and averaged across available observations within groups for each of the ten years following the investment date.11 These averages should be indicative of expected returns to investments in rms of varying R&D intensity that are well-diversied both across rms and time.
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Table 4. Average annual excess returns for high-R&D, low-R&D, and non-R&D rms over ten years following investment date19791998. R&D Activity Based on RDA Year Following Investment Date 1 2 3 4 5 6 7 8 9 10 Avg. years 15 Avg. years 610 Avg. years 110 Non-R&D 0.001 0.004 0.004 0.006 0.008 0.002 0.001 0.000 0.003 0.003 0.005 0.001 0.002 Low-R&D 0.011 0.018 0.001 0.007 0.014 0.019 0.024 0.004 0.004 0.012 0.001 0.006 0.002 High-R&D 0.044 0.049 0.043 0.035 0.037 0.041 0.043 0.035 0.036 0.037 0.042 0.038 0.040
RDA is the R&D asset that would have been reported for the current year if R&D expenditures were capitalized and amortized over ve years beginning in the year after the expenditures were made, divided by market value of equity at the end of the fourth month following the scal year end. For each year following the investment date (t + 1 through t + 10), excess returns are averaged across all observations for each group. For a given investment year, the high-R&D (low-R&D) group includes observations in RDA groups 3, 4 and 5 (RDA groups 1 and 2) in that year. See notes to Table 3 for description of grouping procedure. The non-R&D group includes observations with RDA equal to zero.
Table 4 reports average annual excess returns for each group for each of the ten years subsequent to the investment date, as well as cross-year averages for years 15, 610, and 110. The pattern of excess returns is remarkably consistent across the ten-year period for each group. For non-R&D and low-R&D rms, average returns vary little from zero in any of the ten years following investment. For high-R&D rms, in contrast, average returns are no less than 3.5 percent in any year and are similar in magnitude across the ten years, averaging roughly 4 percent for the rst ve years, the second ve years, and for the ten years overall. The persistence of positive excess returns to high-R&D rms for many years is consistent with a risk explanation for these returns. In contrast, persistent excess returns seem less consistent with a mispricing explanation. Over the ten years as a whole, the cumulative average excess return to high-R&D rms is about forty percent. If these returns arise from mispricing, the rms in the high-R&D group must have been undervalued on the investment date (on average) by at least forty percent, and correcting this undervaluation must have required at least ten years.
4.2.
Cross-Year Variation in Excess Returns
Portfolio theory suggests that investors are compensated through higher expected returns for prospective variation in investment returns that cannot be diversied away. Thus, if
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measured excess returns to R&D-intensive rms are actually compensation for bearing nondiversiable risk, we would expect to observe greater variation over time in excess returns to a well-diversied portfolio of R&D-intensive rms than to a well-diversied portfolio of rms with little or no R&D investment. We examine whether this is the case by computing, for each Compustat data year in the sample, average excess returns for the rst year following investment for non-R&D, low-R&D, and high-R&D rms. Average Compustat data year excess returns for these groups provide a reasonable approximation of calendar-time returns to three equal-weighted portfolios that vary systematically in R&D intensity, and which presumably include a sufcient number of rms to eliminate most diversiable return variation.12 Table 5 reports year-by-year average excess returns, the average of these returns across years, and the cross-year standard deviation of average excess returns for each of the three groups. The average excess return is near zero for the non-R&D and low-R&D subsamples, and 4.6 percent for the high-R&D subsample. Moreover, the cross-year standard deviation of portfolio excess returns for high-R&D rms is more than two-and-a-half times larger than that for either non-R&D rms or for low-R&D rms. This higher cross-year variation
Table 5. Year-by-year average annual excess returns for high-R&D, low-R&D, and non-R&D rms19791997. R&D Activity Based on RDA Year 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average excess return Cross-year std. deviation Non-R&D 0.013 0.006 0.013 0.015 0.045 0.020 0.004 0.008 0.015 0.026 0.013 0.013 0.094 0.015 0.048 0.029 0.047 0.009 0.025 0.009 0.032 Low-R&D 0.040 0.011 0.022 0.033 0.076 0.004 0.034 0.011 0.017 0.049 0.035 0.045 0.059 0.007 0.001 0.005 0.053 0.045 0.016 0.004 0.037 High-R&D 0.071 0.016 0.144 0.003 0.036 0.009 0.034 0.008 0.049 0.011 0.130 0.123 0.015 0.038 0.148 0.315 0.016 0.077 0.059 0.046 0.093
See note to Table 4 for denition of RDA and for measurement of excess returns. The table reports the average excess return for the rst year following the investment date for each COMPUSTAT data year in the study with available data (1979 through 1997). The high-R&D (low-R&D) group includes observations in RDA groups 3, 4 and 5 (RDA groups 1 and 2). See notes to Table 3 for description of grouping procedure. The non-R&D group includes observations with RDA equal to zero.
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for the high-R&D subsample is consistent with a risk explanation for this groups high excess returns.
4.3.
Earnings Forecast Dispersion and Earnings Variability
Prior research suggests that both dispersion in analysts earnings forecasts and postinvestment earnings variability can be viewed as indicators of risk.13 Thus, nding that these measures are higher for R&D-intensive rms than for other rms would be consistent with a risk explanation for excess returns to R&D-intensive rms. We investigate this possibility using the reduced 19841998 sample for which analysts forecasts are available (see Table 1). We begin by dividing observations from these years into non-, low-, and high-R&D groups as discussed in the previous section. We then delete from each group all observations with fewer than two one-year-ahead earnings forecasts available in the I/B/E/S database at scal year end. Each remaining observation in the high-R&D group is then matched with randomly selected observations from the low- and non-R&D groups that (a) are from the same year, and (b) have the same Size-BVE/MVE control portfolio assignment. Observations are retained only if a successful three-way match occurs. This procedure results in triplets of non-R&D, low-R&D, and high-R&D rms that differ in level of R&D activity, but are distributed similarly over time and have similar distributions of Fama-French risk attributes. There are 4,697 such triplets for which we have I/B/E/S data to calculate coefcients of variation of one-year-ahead earnings forecasts from the month preceding the scal year end. There are 3,839 triplets for which we have sufcient future earnings data to calculate coefcients of variation based on up to ve observations.14 The results of these analyses are reported in Table 6. Panel A indicates that analysts exhibit greater disagreement about year-ahead earnings for R&D-intensive rms than for others. At each percentile, the coefcient of variation for high-R&D rms is greater than that for either low- or non-R&D rms. Based on the sign test, the median difference is signicant at the 0.1 percent level for both comparisons. Similarly, panel B indicates that post-investment reported earnings is more highly variable for high-R&D rms than for the other two groups, and median differences for these two comparisons are also signicant at the 0.1 percent level. These results indicate that after controlling for Fama-French risk factors, the earnings of high-R&D rms tend to be more uncertain than the earnings of low- and non-R&D rms. To the extent that forecast variation and earnings uncertainty are indicators of risk, these results are consistent with a risk explanation for measured excess returns to R&D-intensive rms.
4.4.
Summary of Evidence on the Risk Explanation
The evidence presented in this section indicates that the pattern of increasing excess returns to R&D-intensity reported in panel A of Table 3 is associated with risk characteristics of R&D rms. Compared to rms with little or no R&D investment, R&D-intensive rms (a) earn excess returns that persist for up to ten years, (b) have future excess return variability that cannot be diversied away within a portfolio of rms with substantial R&D investment,
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Table 6. Coefcients of variation of analysts one-year-ahead earnings forecasts and future earnings for non-, low-, and high-R&D rms19841998. Percentile 10 25 50 75 90
A. Coefcient of variation of one-year-ahead forecasts Non-R&D rms Low-R&D rms High-R&D rms 0.017 0.019 0.023 0.030 0.036 0.043 0.056 0.071 0.080 0.118 0.132 0.164 0.243 0.251 0.340
B. Coefcient of variation of earnings over subsequent ve years Non-R&D rms Low-R&D rms High-R&D rms 0.117 0.149 0.184 0.213 0.246 0.327 0.417 0.470 0.725 1.017 1.086 1.792 3.010 3.201 4.654
Panel A is based on matched samples of 4,697 high-R&D rm-years, 4,697 low-R&D rm-years, and 4,697 non-R&D rm-years. The high-R&D (low-R&D) group consists of matched observations in RDA groups 3, 4 and 5 (RDA groups 1 and 2) for the current year (year t). See notes to Table 3 for description of grouping procedure. The non-R&D group consists of matched observations with RDA equal to zero in the current year (year t). Analysts forecast errors are measured as the difference between the average I/B/E/S forecast available at scal year end and actual earnings for the forecasted period, divided by share price at the end of the scal year. All included observations have at least two one-year-ahead forecasts available from I/B/E/S. To form matched samples, we began with high-R&D observations and matched them with both a low-R&D and a non-R&D observation from the same year and with the same Size-BVE/MVE control portfolio assignment. Observations were retained in the sample only if a successful three-way match was possible. Panel B is based on matched samples of 3,839 high-R&D, 3,839 low-R&D, and 3,839 non-R&D rm-years, formed using a similar matching procedure, but subject to the availability of earnings data for the ve years following the current year.
and (c) have greater variability of analysts forecasts and future earnings. The next section of the paper provides evidence on the extent to which the excess returns are also consistent with mispricing. 5. Evidence on the Mispricing Explanation for Excess Returns to R&D Firms
As discussed in Lev et al. (2000) and Penman and Zhang (2002), expensing R&D costs when incurred can have perverse effects on accounting protability measures when R&D investment is expected to generate future benets. In a period of growth (decline) in R&D investment, accounting earnings will tend to be understated (overstated) relative to earnings that would result from an appropriate policy of capitalization and amortization.15 If investors fail to see through the effects of this conservative accounting, returns will be lower than expected on average for rms increasing R&D investment, and higher than expected on average for rms decreasing R&D investment. In this section we conduct four separate analyses to determine the contribution, if any, of this form of mispricing to the positive association between level of R&D investment and subsequent excess returns reported in Table 3. We rst examine whether R&D rms earning the largest (smallest) post-investment excess returns exhibit a decreasing (increasing) R&D investment in the same period, as would be expected under the mispricing scenario outlined
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above. Second, we directly examine the association between changes in unrecognized R&D assets and post-investment excess returns. Third, we investigate whether analysts are overly optimistic (pessimistic) about the earnings of rms that are increasing (decreasing) their R&D investment. Finally, we examine the extent to which the excess returns to R&D rms documented in Table 3 vary with the extent of following by analysts. 5.1. Conservative Accounting and R&D-Intensity
If the pattern of excess returns reported in Table 3 is due to the form of mispricing described above, we expect that rms in RDA group 1 are generally increasing their R&D outlays and that rms in RDA groups 3, 4, and 5 are generally decreasing their R&D outlays. To address this possibility, we report in Table 7 the median ratio of the change in unrecorded R&D assets to market value of equity ( RDA) for each of the three years following the investment date. The results for all three years suggest that the relation between the level of R&D assets (which is positively associated with post-investment excess returns in Table 3) and subsequent changes in R&D assets is U-shaped. The smallest changes are reported for groups 1 and 5 and the largest changes are reported for groups 3 and 4. Thus, there is no evidence in Table 7 that the pattern of excess returns reported in Table 3 is due to large increases in unrecorded R&D assets for RDA group 1 and large decreases in R&D assets for RDA groups 3, 4, and 5. 5.2. Conservative Accounting and Excess Returns
Next, we examine the relation between post-investment excess returns and contemporaneous changes in R&D investment by forming groups that differ in the potentially distorting effect of changes in R&D assets ( RDA) while controlling for the rms actual performance in the same period.16 Our control for performance is based on adjusted return on net operating assets (ARNOA), which measures return on investment without the distorting effects of conservative accounting for R&D costs.17 Specically, we rst rank rms on the basis of
Table 7. Median RDA for R&D rm-years grouped on RDA19791998. Groups Based on RDA Year Following Investment Date 1 2 3 1 (Low) 0.004 0.003 0.002 2 0.017 0.015 0.012 3 0.024 0.020 0.016 4 0.025 0.020 0.015 5 (High) 0.013 0.007 0.006
The table reports median values for RDA for each group based on RDA. RDA is the change from beginning to end of the respective year in the R&D asset that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years divided by market value of equity at the beginning of the year. RDA is the R&D asset for year t that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years divided by the rms market value of equity at the end of the fourth month following the scal year end.
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ARNOA for scal year t + 1, and based on this ranking divide the sample into groups of ve observations each. We then rank the observations within each of the resulting groups by RDA for year t + 1, and combine observations according to these ranks. This procedure yields ve groups that are very similar in terms of actual performance during the year, but which differ on the basis of the increase or decrease in R&D investment. Group 1 consists of observations with relatively large increases in R&D investment during the year, and group 5 consists of observations with relatively small increases (or relatively large decreases) in R&D investment. Under the mispricing explanation, we expect excess returns to be increasing from group 1 to group 5. Table 8 reports descriptive statistics and average excess returns for the ve RDA groups. The rst column indicates that the median rm in group 1 increased its R&D investment by 7.0 percent of market value of equity, while the median rm in group 5 decreased its investment by 0.5 percent of market value of equity. The second column indicates that rms that increase their R&D investment are more R&D-intensive as measured by the ratio of R&D assets to market value of equity (RDA). In particular, note that the level of RDA for
Table 8. Medians of selected variables for R&D rm-years grouped by RDA Group 1 (Most positive) 2 3 4 5 (Most negative) RDA 0.070 0.038 0.016 0.003 0.005 RDA 0.190 0.105 0.070 0.054 0.068 ARNOA 0.079 0.079 0.079 0.079 0.079 RDA19791998. RRNOA 0.037 0.061 0.075 0.084 0.103 XRET 0.048 (5.046) 0.007 (0.697) 0.005 (0.611) 0.001 (0.200) 0.076 (7.852)
The table reports median values for RDA, RDA, ARNOA, and RRNOA, and the average value and (in parentheses) t-statistics for XRET, for each group based on RDA. RDA groups are formed by rst ranking on ARNOA within year and RDA quintile, and dividing the sample into groups of ve observations. Within each ve-observation group, rms are ranked on RDA and assigned to groups one (highest) through ve (lowest). RDA is the change from year t to year t + 1 in the R&D asset that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years divided by market value of equity at the end of the fourth month following scal year end. RDA is the R&D asset for year t that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years divided by the rms market value of equity at the end of the fourth month following the scal year end. ARNOA is the ratio of adjusted income for year t + 1 to adjusted net operating assets for year t + 1. Adjusted income is reported income plus R&D expense minus R&D amortization that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years. Adjusted net operating asset are reported net operating assets plus the R&D asset that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years. RRNOA is the ratio of reported income for year t + 1 to reported net operating assets for year t. XRET is excess returns for the rst year after the investment date, and is computed as the difference between the rms actual return for that year and the return on the rms relevant control portfolio based on size and the ratio of book value of equity to market value of equity (see note to Table 3 for more details).
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group 1 (0.190) is nearly twice the level for group 2 (0.105), which itself is larger than the level for the other three groups. The next two columns in Table 8 indicate that these ve groups are equivalent at the median in terms of adjusted earnings for year t + 1, but are very different in terms of reported earnings for year t +1. The median rm in each group has an adjusted return on net operating assets (ARNOA) of 7.9 percent, while the median reported return on net operating assets (RRNOA) varies from 3.7 percent for group 1 to 10.3 percent for group 5. Thus, the grouping procedure successfully captures R&D-related accounting-induced differences in performance across the ve groups. If investors are misled by this distortion, we expect that excess returns will increase as we go from RDA group 1 to RDA group 5. The nal column of Table 8 reports average year t + 1 excess returns for the ve RDA groups. Excess returns for rms in RDA groups 2 through 4 are all very small, as might be expected under the mispricing scenario when accounting distortions are not extreme. Also consistent with the mispricing scenario, the average excess return for group 5 observations is large and positive (7.6 percent). Firms in group 5 are those who have reduced R&D investment in the current year, and whose reported earnings is overstated as a consequence. Note also that the median RDA for observations in group 5 is relatively small. This suggests that the excess returns to group 5 do not have the same underlying cause as the excess returns to high RDA groups we reported in Table 3. Finally, we observe that the average excess return for group 1 observations is also large and positive (4.8 percent). This is inconsistent with the mispricing scenario, which predicts negative excess returns for this group. However, note that this group has the largest ratio of R&D asset to market value of equity, which suggests that positive excess returns to the level of R&D assets may be obscuring the potential for negative returns to the change in R&D assets. To further investigate the relation between excess returns associated with the level of R&D investment (reported in Table 3) and those associated with changes in R&D investment (reported in Table 8), we divide the observations in each RDA group into ve RDA groups based on the original RDA cutoffs that were used in constructing Table 3. Table 9 reports average excess returns for each of these 25 groups for the rst year following the investment date, as well as the excess return difference between groups ve and one for both RDA (nal row) and RDA (nal column). The excess returns reported in the 25 cells of Table 9 provide evidence of two independent sources of excess returns. First, as the nal row of the table indicates, for each RDA group except the third, the average excess return for observations in RDA group 5 is larger than that for observations in RDA group 1, with differences ranging from 2.8 percent to 8.5 percent. Thus, excess returns are larger (smaller) for rms that decrease (increase) R&D investment in the current year, after controlling for contemporaneous performance, regardless of the level of their R&D investment. This pattern is consistent with the mispricing scenario. Second, the nal column of the table indicates that for each RDA group, the average excess return for observations in RDA group 5 is larger than that for observations in RDA group 1, with differences ranging from 1.7 percent to 19.9 percent. That is, rms with substantial levels of R&D investment earn higher excess returns than those with little R&D investment, regardless of whether they are currently increasing or decreasing their investment. This pattern is not predicted by the mispricing explanation, but is consistent with a risk explanation for measured excess returns.
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Table 9. Average annual excess returns for R&D rm-years grouped on the basis of both RDA and 19791998. Level of R&D Activity (RDA) RDA Group 1 (Most positive) 2 3 4 5 (Most negative) (5 1) 1 (Low) 0.002 (0.036) 0.081 (3.024) 0.025 (1.525) 0.018 (1.493) 0.029 (2.305) 0.028 2 0.015 (0.585) 0.028 (1.708) 0.014 (1.120) 0.014 (1.077) 0.039 (2.750) 0.055 3 0.057 (2.631) 0.002 (0.124) 0.004 (0.303) 0.019 (1.148) 0.049 (1.971) 0.008 4 0.030 (1.796) 0.007 (0.399) 0.013 (0.527) 0.017 (0.872) 0.107 (3.443) 0.077 5 (High) 0.081 (5.013) 0.118 (3.564) 0.008 (0.216) 0.002 (0.065) 0.166 (5.944) 0.085
RDA
(5 1) 0.079 0.199 0.033 0.017 0.137
The table reports the average value and (in parentheses) t-statistics for XRET, for each group based on RDA and RDA. The groups are formed by rst ranking on ARNOA within years, and dividing the sample into groups of ve observations. Within each ve-observation group, rms are ranked on RDA and assigned to RDA groups one (highest) through ve (lowest). Those ve RDA groups are then crossed with the ve RDA groups used in Table 3. RDA is the change from year t to year t + 1 in the R&D asset that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years divided by net operating assets. RDA is the R&D asset for year t that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years divided by the rms market value of equity at the end of the fourth month following the scal year end. ARNOA is the ratio of adjusted income for year t + 1 to adjusted net operating assets for year t + 1. Adjusted income is reported income plus R&D expense minus R&D amortization that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years. Adjusted net operating asset are reported net operating assets plus the R&D asset that would have been recorded if rms were capitalizing and amortizing R&D outlays over ve years. XRET is excess returns for the rst year after the investment date, and is computed as the difference between the rms actual return for that year and the return on the rms relevant control portfolio based on size and the ratio of book value of equity to market value of equity (see note to Table 3 for more details).
Apart from the direction of excess return differences for high and low RDA rms, the mispricing explanation also predicts negative excess returns for rms that increase their R&D investments (e.g., RDA groups 1 and 2), and positive excess returns for rms that decrease their R&D investment (e.g., RDA group 5). In Table 9, negative returns for RDA groups 1 and 2 are evident only when the level of R&D investment is low. For RDA group 5, returns are positive at all levels of RDA, as predicted by the mispricing scenario, but at the same time are monotonically increasing in RDA. Taken together, these patterns also suggest two independent sources of excess returns in the sample data. To provide additional evidence on whether excess returns to R&D rms are associated both with the level of R&D investment and changes in R&D investment, we estimate a regression of excess returns on changes in R&D investment and levels of R&D investment that captures the two-way classication in Table 9 while simultaneously controlling for
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contemporaneous performance: XRET t+1 = a0 + a1 G RDA,t+1 + a2 G RDA,t + a3 G ARNOA,t+1 + 0.257 0.073 0.168 0.421 (30.60) (6.94) (15.75) (40.39) (1)
In this regression, XRETt+1 is the excess return for rm i for the rst year following the investment date. G RDA,t+1 , a variable that takes on values ranging from zero to one, is determined by sorting sample observations (within years) from highest to lowest on RDA, partitioning the sorted observations into ve RDA groups (labeled zero through four), and dividing the resulting group ranks by four.18 Analogous procedures were followed to determine values for G RDA,t and G ARNOA,t+1 . By construction, G RDA is decreasing in RDA, while G RDA and G ARNOA are increasing in their underlying variables. This regression is designed to isolate the association between RDA and excess returns while controlling for RDA, and vice versa. If the relation between XRET and the independent variables is linear, however, an estimated slope coefcient from the regression can be interpreted not simply as a conditional correlation, but also as a measure of the excess return to a zeroinvestment portfolio that is weighted to exploit information in the associated independent variable that is orthogonal to information contained in the other independent variables.19 Estimation results for regression (1) are reported above. The coefcient estimate for G ARNOA is positive and highly signicant, as would be expected if excess returns are strongly inuenced by current performance. The coefcient estimate for G RDA of 0.073 (t = 6.94) indicates that after controlling for the level of R&D investment and for contemporaneous performance, excess returns are associated with contemporaneous changes in the level of R&D investment. Consistent with the mispricing scenario, the positive coefcient estimate indicates that excess returns would have been earned by buying (selling short) rms that are decreasing (increasing) their R&D investments. The magnitude of the coefcient estimate is generally similar to the excess return differences reported in the last row of Table 9. Similarly, the coefcient estimate for G RDA of 0.168 (t = 15.75) indicates that after controlling for changes in R&D investment and for contemporaneous performance, excess returns are positively associated with the level of R&D investment reected in RDA. The magnitude of this coefcient estimate is generally consistent with excess return differences reported in the nal column of Table 9. Overall, these results suggest that measured excess returns to R&D rms are inuenced both by the level of R&D investment and by changes in R&D investment. We also estimated a second version of regression (1) that includes a ranked, standardized variable (G AFE ) that captures contemporaneous analysts earnings forecast errors. The underlying forecast error is the difference between the consensus one-year-ahead forecast available from the I/B/E/S database at the end of the preceding scal year and actual earnings for the current year, scaled by price at the end of the scal year.20 G AFE is constructed to take on values from zero (most negative difference between actual earnings and forecast) to one (most positive difference between actual earnings and forecast). This variable should account for much of the mispricing reected in G RDA , or mispricing from any other source, and should also account for much of the performance reected in G ARNOA , and its inclusion should reduce the contribution of these two variables to the regression. In contrast, the
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inclusion of G AFE should have little effect on the coefcient estimate for the RDA group variable (G RDA ) if that variable is not related to mispricing. Because earnings forecasts are not widely available in the I/B/E/S database prior to 1984, we restrict this analysis to rm-years in our sample from the period 19841998. We estimated the regression both with and without the forecast error variable for all rms with available forecast data. For the regression that does not include the forecast error variable, the estimated coefcients for G RDA (0.096, t = 6.14) and G RDA (0.139, t = 8.66) are similar to those reported above for the full sample. After including the forecast error variable, the coefcient estimate for G RDA falls to 0.008 (t = 0.51), while the estimated coefcient for G RDA (0.136, t = 9.47) remains about the same. This pattern of results suggests that the excess returns associated with RDA are unlikely to be related to mispricing.21 5.3. Future Excess Returns and Analysts Forecasts
Under the mispricing scenario, conservative accounting for R&D investments causes analysts and investors to be surprised by lower-than-expected earnings when rms increase their investment in R&D, and to be surprised by higher-than-expected earnings when rms decrease their investment in R&D. Under these conditions, one should observe relatively optimistic earnings forecasts (negative forecast errors) in periods of positive RDA and relatively pessimistic forecasts (positive forecast errors) in periods of negative RDA.22 Similarly, if the positive association between excess returns and the level of R&D investment is due to mispricing, we should see earnings forecasts that are relatively pessimistic (positive forecast errors) for high-RDA rms. To investigate this possibility, we estimate the following regression: AFEt+1 = c0 + c1 G RDA,t+1 + c2 G RDA,t + c3 G ARNOA,t+1 + 0.091 0.036 0.012 0.129 (38.04) (13.36) (4.43) (50.37) (2)
In regression (2), AFEt+1 is measured as the difference between actual year t +1 earnings and the consensus I/B/E/S forecast at the beginning of year t +1, scaled by price at the beginning of year t + 1. The independent variables are the same as those in regression (1). If earnings forecast errors are relatively more positive for rms whose R&D investment is declining ( RDA group 5), as the mispricing scenario suggests, we would expect a positive coefcient estimate for G RDA . Similarly, we would expect a positive coefcient for the performance measure G ARNOA because rms with good performance are more likely to have pessimistic forecasts that underestimate their performance. Finally, a positive coefcient estimate for G RDA would suggest the possibility that RDA is also related to mispricing. Estimation results for regression (2), based on rm-years with available forecast data from the period 19841998, are reported above. Consistent with the mispricing scenario, the estimated coefcient for G RDA is positive and signicant, indicating that analysts tend to underestimate earnings in periods when R&D investment is declining and to overestimate earnings when R&D investment is increasing. In contrast, the small negative coefcient estimate for G RDA indicates that analysts tend slightly to overestimate earnings for rms with high levels of R&D investment, and is not consistent with a mispricing explanation
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for excess returns associated with RDA. Similarly, the coefcient estimate for G ARNOA is signicantly positive, consistent with relatively pessimistic forecasts for rms whose performance in the current period was good. 5.4. Future Excess Returns and Investor Following
In this section we examine whether excess returns associated with the level of R&D investment are more pronounced for rms that are not closely followed by analysts, as would be expected if the excess returns are due to mispricing. To measure extent of following by analysts, we use the number of one-year-ahead earnings forecasts reported in the I/B/E/S database in the last month of the rms scal year. Because earnings forecasts are not widely available in the I/B/E/S database prior to 1984, we restrict this analysis to the 72,317 rm-years in our main sample from the period 19841998. We divide this subsample on the basis of RDA into high-R&D (groups 35 from Table 3), low-R&D (groups 12 from Table 3), and non-R&D rms. To capture following by analysts, we divide each of these subsamples into observations for which the number of analysts oneyear-ahead forecasts reported in the I/B/E/S database at scal year end is (a) zero, (b) one to ve, and (c) greater than ve. Sample sizes for the resulting groups and subgroups are reported in panel A of Table 10.
Table 10. Sample sizes and average annual returns over three years following investment date for high, low, and non-R&D rms, for subsamples stratied by extent of following by analysts19841998. R&D Activity Based on RDA Sample A. Sample sizes Total 19841988 sample Number of I/B/E/S one-year-ahead forecasts 0 15 >5 B. Average 3-year excess returns Total 19841998 sample Number of I/B/E/S one-year-ahead forecasts 0 15 >5 0.002 0.008 0.053 43,452 11,438 17,427 Non-R&D Low-R&D High-R&D
24,369 9,555 9,528
5,871 2,519 3,048
10,057 3,961 3,409
0.000 0.009 0.002
0.027 0.014 0.011
0.052 0.062 0.047
The table reports average annual excess returns over ve years subsequent to the investment date. See the note to Table 4 for details of the measurement of excess returns. The high-R&D (low-R&D) group consists of matched observations in RDA groups 3, 4 and 5 (RDA groups 1 and 2) for the current year (year t). See notes to Table 3 for description of grouping procedure. The non-R&D group consists of matched observations with RDA equal to zero in the current year (year t). Number of I/B/E/S One Year Ahead Forecasts indicates the number of one-year-ahead earnings forecasts in the I/B/E/S database in the last month of the previous scal year.
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Panel B of Table 10 rst reports average annual excess returns over the three years following the investment date for all observations in the high-R&D, low-R&D, and nonR&D groups. Excess returns for the high-R&D observations are somewhat higher, and those for low- and non-R&D observations are about the same as, the average of years one through three reported in Table 4 for the longer period 19791998. The next three rows report 3-year average annual excess returns for the high-, low-, and non-R&D observations after subdividing these observations according to extent of following by analysts. The mispricing scenario suggests that we should nd the smallest excess returns for observations with the greatest following by analysts and largest for observations with no analyst following. Contrary to this expectation, the excess returns are large and positive for all levels of analyst following and do not seem to vary systematically with analyst following.
5.5.
Summary of Evidence on the Mispricing Explanation
This section of the paper examines whether the positive association between measured excess returns and the level of R&D investment can be explained by a simple mispricing scenario. Overall, we nd no evidence that this is the case. We do nd evidence of a pattern of excess returns that is consistent with the mispricing scenario, but four separate analyses indicate that this pattern is independent of the positive association between excess returns and level of R&D investment. First, we nd that median increases in R&D investment are no different for high-RDA rms than for low-RDA rms. Second, after controlling for contemporaneous changes in the level of R&D investment, we nd that high-RDA rms earn substantially greater future excess returns than low-RDA rms. Third, after controlling for contemporaneous changes in R&D investment, we nd that analysts forecasts are more optimistic for high-RDA rms than for low-RDA rms. Finally, we report that excess returns for high-RDA rms are not related to the extent of analyst following. Each of these results is inconsistent with a mispricing explanation for the positive association between post-investment excess returns and the level of R&D investment documented in this and previous studies.
6.
Summary and Conclusions
Several previous studies indicate that publicly available measures of both the level of rms R&D investment and of current or recent growth in R&D investment are positively associated with excess (risk-adjusted) returns in subsequent years. This study examines two alternative explanations for these ndings. The rst is that conventional controls for risk used in previous studies as the basis for measuring excess returns do not completely capture the riskiness of R&D-intensive rms. Under this explanation, the pattern of excess returns reported in previous studies actually reects compensation for risk-bearing. The second explanation is that excess returns to R&D rms are due to mispricing. Under this explanation, R&D-intensive rms earn negative (positive) excess returns in periods of increasing (decreasing) R&D investment because investors fail to see through the earnings effects of conservative accounting for R&D costs.
155
To provide evidence useful for distinguishing between these explanations, we conduct a variety of analyses based on a large sample of rms from the period 19791998 that includes both R&D-intensive rms and rms with little or no R&D investment. We nd that the positive association between level of R&D investment and subsequent excess returns persists for at least ten years following investment, that excess returns are much more highly variable through time for R&D intensive rms than for rms with little or no R&D investment, and that both analysts forecasts of future earnings and actual future earnings are more highly variable for R&D-intensive rms than for others. In addition, although we nd a positive association between excess returns and contemporaneous changes in R&D investment, as predicted by the mispricing scenario, our evidence suggests that this pattern is independent of excess returns related to the level of R&D investment. Overall, these ndings indicate that the positive association between excess returns and R&D investment levels reported in previous studies is more likely to result from failure to control adequately for risk than from accounting-induced mispricing. If this is the case, the valuation consequences of R&D-related mispricing may be smaller than a strictly mispricing interpretation of earlier results would suggest. Our results also suggest that the Fama-French three-factor model, a common basis for measuring excess returns and for estimating cost of capital, may substantially underestimate expected returns for R&Dintensive rms. Given the growing importance of R&D activities in the general economy, this is an important area for further research.
Acknowledgments The authors are grateful for useful comments made by Augustine Duru, Leslie Hodder, workshop participants at New York University and the 2001 Review of Accounting Studies Conference, two anonymous reviewers, Xiao-Jun Zhang (the discussant) and Richard Sloan (the associate editor). We are grateful for the use of analyst forecast data provided by I/B/E/S.
Notes
1. Though the exact methods vary, each study controls for general market movements as well as systematic return behavior related to size and book-to-market ratio (Fama and French, 1992, 1993). 2. A third possible explanation is that investors erroneously overvalued R&D-intensive rms during the period for behavioral reasons unrelated to accounting. If this were the case, excess returns earned over the last two decades would be expected to reverse in the future. However, this R&D bubble explanation can only be examined in the context of a longer time series of data that extends into the future. 3. We included an observation in the sample at this stage if certain Compustat and CRSP data were available (month of scal year end, assets, sales, earnings, common dividends, common stockholders equity, market value of equity at end of the scal year and at the end of the fourth month after scal year end, and at least some returns during the year beginning with the fth month following the scal year end), subject to the further requirements that the current scal year was a full year and that the rms year end book value of equity was positive. The last of these requirements, which eliminated 12,610 observations from the sample, is imposed because we compute excess returns using Fama and French (1992, 1993) size and book-to-market control portfolios whose construction excludes negative book equity rms. 4. Compustat either reports the amount of R&D expense for the rm, or provides codes that indicate that R&D expense is either missing or immaterial. In the latter two cases, we set R&D expense to zero.
156
5. The controls to compute excess returns are implemented on a JulyJune scal year basis. To compute benchmark portfolio returns for a given scal year, all stocks in the intersection of the CRSP and COMPUSTAT databases are assigned to one of ve groups on the basis of market value of equity at the prior calendar year end (Size), and are independently assigned to one of ve groups on the basis of their ratio of book value of equity to market value of equity (BVE/MVE) at the rms accounting year end in the prior calendar year. Breakpoints for determining Size and BVE/MVE group membership are quintiles of their respective distributions for NYSE rms at June 30. These grouping procedures yield 25 Size-BVE/MVE groups. For each of the 25 groups, we compute the value-weighted return for each month during the period July 1 though June 30. This procedure was repeated for each annual period ending June 30. 6. In computing the book-to-market ratio used to match sample observations with control portfolios, book value is the sum of common stockholders equity at year end, deferred tax liability at year end, and net imputed R&D assets at year end. The rst two terms of the sum follow Fama and French (1993); the nal adjustment was also made by Chan et al. (2000). However, our results are not sensitive to inclusion of net R&D assets as part of book value. 7. We computed returns for delisted rms as follows. During the delisting year we cumulate actual returns for these rms up to the point of delisting (including the delisting return, if any), and then substitute the rms control portfolio return for the missing returns during the remainder of that year. Delisted rms were excluded from the computation of excess returns in the years after their delisting. 8. Average excess returns for non-R&D rms differ slightly from panel A to panel B, as 317 non-R&D observations with zero sales were eliminated from the sample in constructing panel B. 9. Chan et al. (2000) conduct similar analyses based on current period R&D expenditures (rather than the R&D asset) divided by market value of equity and sales, and nd results that are very similar to those reported in Table 3. For the ratio of R&D expenditure to market value of equity, they report average annual returns over three years of 5.4 percent for group 5 and 1.8 percent for group 1. We repeated our Table 3 analysis for this ratio, and found average annual returns over three years of 7.0 percent for group 5 and 1.7 percent for group 1. 10. The fact that the denominator of the R&D-intensity measure that best captures the propensity of R&D rms to earn excess returns is the market value of equity is not evidence in and of itself for either the mispricing or the risk explanation. A low market value that increases this ratio could occur either as a result of stocks that are mispriced and valued too low, or as a result of high risk in which future dividends are discounted using a higher expected rate of return. 11. Because of data constraints, the annual excess returns are averaged across a declining number of sample years. The year 1 excess returns are based on all 20 years in the study period, from 19791998, while the year 10 excess returns are averaged over the 11 years in the study period, 19791989, for which ten years of excess returns are available. 12. For the high-R&D (low-R&D) groups the number of observations varies from 637 (440) to 1,577 (1,023) across the 19 years in the study period. For the non-R&D group the number of observations varies from 1,668 to 3,603. The fact that the non-, low-, and high-R&D portfolios contain different numbers of rms in a given Compustat year raises the issue of whether these portfolios are large enough to eliminate diversiable risk. However, we nd that cross-year standard deviations of portfolio returns are virtually the same as those in Table 5 when results are based on half of the sample selected at random. 13. For discussion of dispersion of analysts forecasts as an indicator of risk see Barron and Stuerke (1998), Brown (1998), and Han and Manry (2000). For discussion of variance of earnings as an indicator of risk see Beaver, Kettler and Scholes (1970). 14. Average excess returns to the high-, low-, and no-R&D rms in these subsamples are similar to those reported in Table 4 for the full sample. 15. Note that growth (decline) in R&D investment, as measured by increases (decreases) in the magnitude of unrecognized R&D assets, occurs when new R&D expenditures during a period exceed (are less than) R&D amortization. These are the same conditions that cause reported earnings based on immediate expensing to be smaller than (larger than) adjusted earnings based on capitalization and amortization. 16. RDA is computed as the change in R&D asset from scal year t to scal year t + 1, while excess returns are computed for the interval from the fth month of scal year t + 1 through the fourth month of scal year t + 2. While these two intervals are not exactly contemporaneous, the choice of return interval insures that the R&D asset at the end of scal year t is known by the market prior to the the start of the return interval, and that the R&D asset at the end of scal year t + 1 is known by the market prior to the end of the return interval. This
157
approach differs from previous studies, which in general grouped rms on the basis of past R&D investment behavior, assuming that the past accounting distortions would be reversed in the future, and then examined excess returns over subsequent years, without specifying when the reversal was likely to occur. In contrast, we examine groups that differ in terms of the accounting distortions that occurred in the same year the excess returns are measured. 17. ARNOA is the ratio of adjusted earnings for year t + 1 to adjusted net operating assets for year t. Adjusted earnings is reported earnings plus reported R&D expense (RDE) minus our computation of R&D amortization (RDAMORT), i.e., the earnings that rms would have reported if they had capitalized and amortized earnings over ve years. Adjusted net operating assets is net operating assets as computed in Penman and Zhang (2001) and Nissam and Penman (2000) plus the R&D asset that rms would have reported if they had capitalized R&D costs and amortized these costs over ve years. 18. This grouping differs from that used in Tables 8 and 9 in that it is based only on RDA. 19. Both the design of this regression and the interpretation of the regression coefcients are based on Abarbanell and Bushee (1998). 20. Actual earnings was taken from the I/B/E/S database when available, which was the case for about 98 percent of the sample observations, and from the Compustat database otherwise. 21. The behavior of the coefcient estimate for G ARNOA was also as expected. Without (with) the forecast error group variable the coefcient for G ARNOA was 0.346 (0.083), and the associated t-statistic was 23.11 (4.93). The coefcient estimate for G AFE , the forecast error variable, was 0.469 (t = 29.77). 22. Note that prior research suggests that analysts forecasts a year or more in advance of the earnings announcement tend to be optimistically biased on average. Thus, a forecast could be relatively more pessimistic simply by being less optimistic. See Richardson et al. (1999) for recent evidence on this issue.
References
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Excess Returns To R&D Intensive Firms

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Excess Returns to R&D-Intensive Firms

University of Illinois at Urbana-Champaign

University of Texas at Austin

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

Sample Selection and Variable Denitions The Sample

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

Reduced sample19841998 Total Avg.

observations in the R&D subsample only.

Measuring Excess Returns

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

Future Excess Returns and Measures of R&D-Intensity

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

Cross-Year Variation in Excess Returns

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

Earnings Forecast Dispersion and Earnings Variability

Summary of Evidence on the Risk Explanation

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

(5 1) 0.079 0.199 0.033 0.017 0.137

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

24,369 9,555 9,528

5,871 2,519 3,048

10,057 3,961 3,409

0.000 0.009 0.002

0.027 0.014 0.011

0.052 0.062 0.047

CHAMBERS, JENNINGS AND THOMPSON

Summary of Evidence on the Mispricing Explanation

Summary and Conclusions

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

EXCESS RETURNS TO R&D-INTENSIVE FIRMS

CHAMBERS, JENNINGS AND THOMPSON

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