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Needham Growth Factor 8/2: “Putting Active Share To Work”

CFO Jim Giangrasso looks at how High Active Share can differentiate funds from their benchmarks, and low turnover allows portfolio companies to execute on their business plans with less regard for short-term events or quarter-to-quarter blips. He also focuses on the importance of a company's attention to R&D and how R&D leaders tend to outperform as stocks in the years after their spending on R&D.

To read the piece in its entirety, please click here: The Growth Factor

Putting Active Share to Work: Excessive Return Tendencies of Innovative Companies

In The Growth Factor Vol. 19, "Patient Capital Outperformance: High Active Share Managers Who Trade Infrequently," we described two factors that explain The Needham Funds' long-term outperformance vs. its benchmarks: High Active Share of over 100% combined with low turnover (but past performance does not guarantee future results). High Active Share differentiates our Funds from their benchmarks, and low turnover demonstrates the patience we allow our portfolio companies to execute on their business plans with less regard for short-term events or quarter-to-quarter blips.

Another factor that contributes to potential outperformance is investing in companies spending on research and development (R&D). Professors Baruch Lev, Suresh Radhakrishnan and Mustafa Ciftci published "The Stock Market Valuation of R&D Leaders" in 2005. It is one of a number of studies which show that investing in R&D leaders contributes to outperformance.

As growth investors, we believe that understanding R&D spending and a company's new product pipeline is vital to achieving outperformance over a period of time.

Accounting Treatment of R&D Leads to Mispricing (It's an Information Problem)

Ever since the FASB (Financial Accounting Standards Board, the accounting industry's standard setting body) released Statement of Financial Accounting Standards No. 2 in 1975, companies have charged all costs related to their R&D activities against current period earnings, despite the fact that R&D endeavors may benefit future periods and therefore might be deducted against the revenue they generate. In contrast, other expenditures that provide future benefits, such as buildings and capital equipment, are capitalized (treated as an asset on the balance sheet) and depreciated or amortized against earnings over time in future periods using some rational method. The treatment of R&D costs as an expense rather than an asset is inconsistent with the FASB's own definition:

"Assets are probable future economic benefits obtained or controlled by aparticular entity as a result of past transactions or events... The common characteristic possessed by all assets is "service potential" or "future economic benefit."1

The accounting profession justifies this inconsistency with an override:

"To be recognized [in financial reports], information about the existence andamount of an asset, liability, or change therein must be reliable. Reliabilitymay affect the timing of recognition [of assets]. The first available information about an event that may have resulted in an asset... is sometimes too uncertain to be recognized."2

Not all R&D endeavors bear fruit and therefore cannot always be clearly tied to future revenue. So the accounting profession has sacrificed the matching of expenses with future benefits for the sake of reliability and certainty.

Innovation & Excess Returns

Several academic studies over the past two decades have concluded that the most innovative companies who are R&D leaders (as measured by the level and intensity of R&D expenditures) tend to, over the long term, outperform their less R&D-intensive peers and the broader markets. In his 1996 study, NYU professor Baruch Lev tested whether "capitalized R&D" (as adjusted by Lev) is related to subsequent stock returns. He found that the level of capitalized R&D is positively related to subsequent (higher) stock returns, and that capitalizing R&D results in statistically significant and relevant data to the financial statement user. He further hypothesized that the outperformance of such companies was related to a systematic mispricing by the market owing to the lack of quantifiable accounting information about R&D costs.

In a 2002 study, Dennis Chambers from the University of Illinois also found a positive association between R&D levels and excess returns. While reaching the same conclusion as Lev, Chambers wrote that the outperformance "was [more] likely due to a compensation for hidden risks than from systematic mispricing." Chambers was saying because R&D projects are by their nature risky, the excess returns were simply additional return earned by investors for an additional undisclosed and non-quantified risk.4

And in the same year, Allen Eberhart of Georgetown University tested whether R&D increases result in higher than expected returns and whether investors misprice or ignore this benefit. He wrote, "For the five-year period following R&D increases, we find consistently strong evidence that companies experience significantly positive abnormal operating performance" and that "shareholders experience significantly positive abnormal stock returns" during the same five-year period. He concluded, "Our results provide strong evidence...


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