Companies that spend a lot on research are promising candidates for super-charged growth. But how can you tell which ones are wasting their money? Dr Mike Tubbs explains.
Successful growth investing relies on identifying companies that can increase their sales and profits year by year. One of the best drivers of such growth is investment in R&D (research and development) which, if well directed, enables a company to gain an edge over its rivals by producing an ongoing stream of new and improved products and services, such as new models of car or smartphone, for example. This organic growth can be supplemented by bolt-on acquisitions and, in most cases, is superior to growth mainly by acquisition (Carillion being a clear example of what can go wrong with the latter strategy).
The biggest gains often come when R&D leads to the development of a successful and entirely new product, such as the Sony Walkman, the iPad or Dyson’s bagless vacuums. In short, R&D is one of the most important invisible assets for many companies – but its value is rarely immediately reflected in the share price. That is why many quality companies with high levels of R&D investment enjoy share-price gains well above those of the general market.
Thousands of companies spend on R&D each year, but the top 2,500 in the world – which each invest over €24m a year – account for roughly 90% of the total. The R&D investment and financial performance of all of these companies is collected and analysed in the annual EU Industrial R&D Scoreboard, which I help to prepare each year. This article draws on the latest scoreboard, which was published in early December 2017. It is publicly available online, and it’s an invaluable reference for investors. So I want to show you how to make the best use of it – and to highlight some of the more interesting companies currently on the list.
The biggest spenders on research
The top ten R&D companies in the world are shown in the first table (below), ordered by their 2016/17 R&D investment. Note that this table differs from the one in the official EU Industrial R&D Scoreboard, with the inclusion of Amazon. The online retail giant discloses its ‘‘technology & content’’ (T&C) investment, but does not separate out the technology (R&D) spend separately. The scoreboard’s rules on disclosure mean that, as a result, Amazon’s T&C investment cannot be included. The figure shown in this table (with Amazon in sixth position) is our best estimate of the technology component. The total R&D spend for the 2,500 firms in the scoreboard was up 5.8% over the previous year. By geographic region, spending in the US was up 7.2%; in the EU by 7%; but in Japan it fell by 3%.
|Top ten companies by R&D in 2016/17|
|Johnson & Johnson||€8.6bn|
R&D spending is concentrated – the ten firms listed in the table alone account for more than 15% of the total €742bn spent by the top 2,500, while the top 100 companies account for more than half of the total. However, absolute levels of spending on R&D are only part of the story. It is also important to look at how large R&D spending is in relation to sales. This ratio – R&D intensity (R&D/sales) – enables us to compare companies based on how significant a role R&D plays as a driver of corporate growth. An extreme example is oil and gas giant Shell. The company has the 148th largest R&D spend in the world, but an R&D intensity of only 0.4%, because of its vast turnover. In other words, R&D is not the main driver of growth for Shell.
Companies whose R&D intensity is above average for their sector are most likely to produce products that have an edge over rivals, and are therefore likely to enjoy better share-price growth. The table below looks at the top ten large companies (those spending more than €1bn a year on R&D) with the highest R&D intensity. They are all drawn from the software, hardware and biopharmaceuticals sectors. Note that only one of the companies in this table (Intel) also appears in the first table. Seven of the ten are from the US.
|Top ten companies by R&D intensity|
Which countries and sectors invest the most?
The US accounts for 39.1% of the R&D spending of the top 2,500 companies. Europe is next at 29.8%, just ahead of the main Asian economies (Japan, China, South Korea and Taiwan) on 27.9%, of which half is accounted for by Japan. But the sectoral split of R&D is very different according to geographic region. Automotive is the largest sector in both the EU and Japan, accounting for about 30% of total R&D, but it’s only the third-largest in the US, on just 8.1%. The US, on the other hand, invests 49.2% of its R&D spend in ICT (information and communications technology) and 26.5% in health, compared to the EU with 19.5% in ICT and 24.3% in health, and Japan with 24.3% in ICT and 12% in health. There is an even more obvious gap in software, where the US accounts for about 75% of global R&D (up from around 65% ten years ago).
Interestingly, China’s sectoral split is more similar to the US than to other regions, in that it has 44.1% in ICT and 12.5% in automotive. However, it differs in investing only 3% in health. The US focus on ICT – and software in particular – is the main reason that US R&D companies as a group have consistently higher profitability than those in other major regions.
US average profitability is 12.7% compared with the EU and Japan on 7.6% and China on 6.9%. For investors, the straightforward lesson is that large, profitable software companies are most likely to be found in the US; hardware companies in the US and Asia; and healthcare stocks in the US and Europe.
As for the UK – the country has a substantial number of medium-sized software companies with strong positions in their market niches, but many such companies have gone on to be acquired by overseas companies who have been impressed by their quality and performance.
The broad ICT sector is by far the world’s largest, followed by health, then automotive. From an investment point of view, the four sectors with the highest R&D intensity (ie, where R&D is the main driver of growth) are biotech, pharmaceuticals, software and technology hardware, although R&D can also be a key driver for some companies in the electronics and electrical sector, as we shall see. These four sectors account for all 50 of the world’s top large companies by R&D intensity. The US is the dominant player in both biotech and software.
How R&D investment can deliver big returns
The scoreboard shows how some companies have soared up the R&D rankings over the last 13 years with an accompanying rise in share price (measured over the last six years from end-December 2011 to end-December 2017). This is illustrated in the table below, using five examples of larger companies and five medium-sized ones.
To put the share-price rises quoted in the right hand column of the table in perspective, compare them with the 37% rise in the FTSE 100 over the same period. A number of these companies also pay reasonable dividends. Biotech giant Gilead, for example, yields 2.9% (as of end-December) and engineering group Halma has the enviable record of having increased its dividend by 5% or more every year for 38 years.
How to find the next big winners
The successful companies in the table below are great examples with which to illustrate some of the key criteria that can help investors to identify R&D-intensive companies with the potential for large share-price gains. The four main criteria for investors to consider are as follows:
• A substantial and well-directed R&D investment, with R&D intensity above the sector average.
• A strong position in the company’s global market niche.
• A strong balance sheet, preferably with plenty of cash.
• A record of profitable growth with strong cash generation.
The investment risk of a company increases if one or two of these criteria are not met, but such companies may still provide decent investment opportunities, albeit at a higher risk. One example is Amazon, which was making a loss as recently as 2014, but has still seen 500%-plus share price appreciation from 2011 to 2017 because of its investment in growth. The following four companies on the other hand (also drawn from the table below) meet all four criteria, and offer good examples of what investors should be looking for.
|Share-price gains for companies that have moved up the R&D rankings|
|Company||Sector||World R&D rank and amount in 2017||No. of places up from 2004 to 2017||Share price rise 12/2011 to 12/2017|
|Software/internet||20 (€5.6bn)||>200||+563% (5 yrs)|
|Gilead Sciences||Biotech||33 (€4.4bn)||>200||+250%|
|ASML||Tech. hardware||138 (€1.03bn)||43||+245%|
|Illumina||Pharma/biotech||260 (€484m)||>200 (from 2012)||+617%|
|Hexagon||IT for engineering||321 (€366m)||>200||+299%|
Alphabet (the parent company to Google), is the world leader in online advertising; it invests 15% of sales in R&D, compared with a software sector average of 10.6%; it has a record of profitability; and a cash pile that amounts to $100bn.
ASML is a world leader in precision lithography, the key step in making complex semiconductor chips. There are only two companies in this market – ASML is by far the largest (Nikon is the other). ASML’s R&D intensity is 15.1% compared with the hardware sector average of 8.4%, and it has both net cash and a record of profitability. Gilead Sciences is number one in HIV and hepatitis C treatments. It invests 15.4% of sales in R&D (the biopharma average is 15%), has a record of profitable growth, excellent management and a cash pile of over $28bn. Its recent acquisition of Kite Pharma shows that it is serious about becoming a major player in oncology.
Finally, Renishaw is a world leader in precision metrology. It invests 12.8% of sales in R&D (versus the electronics sector average of 4.7%), has a record of profitability, and a cash pile of £52m.
A further consideration for investors who are searching for smaller R&D companies that might be capable of rapid growth is the degree of risk involved. This ranges from very high for a small biotech company with a couple of promising drugs in clinical trials but little revenue, through to medium or even relatively low for a well-established software company with a wide product range, a strong position in its market niche, and which may already pay a respectable dividend (engineering software provider Aveva, healthcare software specialist Craneware and financial-services software group Fidessa are all good UK examples).
Remember though that even the largest and apparently stable FTSE 100 companies can have serious and often unexpected problems – so portfolio diversification remains vital.
I’d suggest that you use the criteria above to help sift the top 2,500 R&D companies in the scoreboard (http://iri.jrc.ec.europa.eu/scoreboard17.html) to find promising companies consistent with your appetite for risk. In the box below, I’ve offered suggestions on how to use the scoreboard to identify investments at different levels of risk.
Using the scoreboard to identify solid growth investments
The scoreboard has a useful set of data for each of the top 2,500 companies in the report. It also covers a further 433 EU companies with R&D spending in the range of €7m to €24m. As a result, the report covers 1,000 EU companies in total, when combined with the 567 already in the top 2,500. This group of 1,000 contains 290 UK companies. The scoreboard enables investors to pick companies in any size range – from very large to small or medium-sized – using the data tabulated for their R&D investment, sales, profits, number of employees, capital expenditure, the growth of these quantities over the previous year, profitability, R&D intensity and market capitalisation. I’ll take some of the companies mentioned above and use them to illustrate how the scoreboard can be used to select potential investments.
The highest-risk companies in the scoreboard are biotechs with substantial R&D intensity, but small sales and either only modest profits, or no profits at all. Large biotech companies with substantial sales and interesting pipelines such as Gilead (Nasdaq: GILD) are a lower risk option. Amongst medium-sized biotechs, Vertex (Nasdaq: VRTX) – which has risen by 351% over the past six years – has a strong position in cystic fibrosis and good growth potential (I recommended the stock in the 12 January issue of MoneyWeek). Investors interested in biotech, but with only modest resources available to invest in the sector, could instead consider the Biotech Growth Trust (LSE: BIOG), an investment trust mainly invested in US biotechs. Its top ten investments account for 62% of its holdings and include Biogen, Celgene, Gilead, Illumina and Vertex. The trust has performed well over the past five years (it’s up 169%) and was up 12.1% in the year to end-December 2017. It currently trades on a small discount to net asset value of around 4%.
Turning to lower-risk examples in other sectors, Alphabet (Nasdaq: GOOGL) has a commanding market position in online advertising and has a range of non-core projects including “smart” thermostat unit NEST and the self-driving technology of its Waymo subsidiary. The forward p/e for Alphabet, if we exclude cash, came in at around 22 at end-December, which is reasonable for a company growing sales at around 20% a year. However, Alphabet’s sheer size may limit its future growth potential.
Mining the scoreboard for medium-sized companies which satisfy the four key criteria is a medium-risk approach. Precision measuring technology specialists Hexagon (Stockholm: HEXA-B) and Renishaw (LSE: RSW) from the table above; safety and environmental technology group Halma (LSE: HLMA); and healthcare software company Craneware (LSE: CRW) (which has returned 200% over the last six years) are all good examples that have proven to be successful investments. The growth of companies such as this can be followed in the scoreboard’s history database – the scoreboard website contains full datasets for all scoreboards from first publication in 2004 to 2017.