Research and development is alive and well. Source: Bloomberg/Getty Images.
(Editor's Note: Fisher Investments’ MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)
Here is a common bit of grousing about the state of corporate America: Firms are returning too much cash to shareholders and not investing enough in the future—particularly in research and development (R&D). Without more R&D, we lose innovation and risk lapsing into “secular stagnation,” if we aren’t there already.[i] This sounds bad, but we are here to tell you it is a myth. Stock buybacks don’t detract from investment, which is higher than most suggest.
Stock buybacks and R&D are often, wrongly, portrayed as an either/or. Either companies can take the longer view, investing in a new project that might take years to pay off (and might not work out), or they can placate shareholders with a more immediate pop by buying back stock (which reduces share supply, boosting prices). This false choice is then twisted into a portrayal of an epic battle between short- and long-term interests. Rent-seeking executives—paid partly based on earnings and partly in company stock—are content to bleed the company’s future in order to keep their jobs and bump up their own pay, so they favor buybacks. This allegedly hurts long-term shareholders and US economy, which might benefit more if companies plowed all their spare cash into new initiatives that might lose money now but bring big earnings growth years down the line.
This is all pretty much false. For one, buybacks and R&D spending have risen in tandem during this expansion, and both are near all-time highs. The myth persists partly because everyone loves a good-vs-evil, tortoise-vs-hare, greed-vs-moderation narrative, and partly because of how buyback and R&D spending are measured. Both are scaled, which in theory gives more context than absolute numbers, but the scaling is myopic. Both are usually reported as percentages of cash flow, EBITDA[ii] or earnings, which implies a small, finite pie to divvy up. For example, the Harvard Business Review reported that the 449 firms in the S&P 500 from 2003 through 2012 spent 54% of net income on buybacks and 37% on dividends—a combined 91% of earnings returned to shareholders. Many took that to mean only 9% of earnings went to capex and wages—with an even smaller portion spent on R&D.
This ignores one of corporations’ biggest funding sources—borrowing! Corporations finance buybacks, mergers and R&D with bonds. It’s simple arbitrage: Borrow cheap, plow the proceeds into something with return potential they believe exceeds the interest payments, and enjoy big profits in the long run if it works out. Corporations issued $6.3 trillion in new bonds in US markets from 2010 through 2014. They’re on a tear this year, too. They’re also raising money abroad, tapping even lower rates in Europe and Japan. Hence how buybacks, dividends and investment have soared without depleting corporations cash balances (which have also soared during this expansion, ending 2014 at $2 trillion).
Meanwhile, last year, R&D spending grew the fastest since 1996. This slice of investment has grown faster than the broader economy during this expansion. No, the 6.9% growth rate doesn’t touch the frequent double-digit growth rates during the 1950s, the so-called military-industrial complex’s heyday. But the Cold War spending boom is perhaps not the best benchmark for today. We think it’s far more telling that present growth rates are nicely in line with the extremely innovative, high-tech 1980s and 1990s—even though buybacks, which rose from $277 billion in 2009 to $570 billion in 2014, are growing much faster than they did back then. The combined surge, happening while firms are flush with cash and operating comfortably in the black, speaks to how healthy Corporate America is.
We could leave it there, but there is another misperception to address: the widespread belief a massive surge in R&D spending is necessary for companies and the economy to grow, flourish and innovate in the long term. Some folks might be surprised to hear how little R&D spending it takes to generate big ideas, big new products and big long-term profits. For example, Apple has spent just $33 billion on R&D in total over the last 23 years—that $33 billion has yielded gadgets and gizmos galore and a $750 billion market cap. It has also fostered dynamite growth up and down its supply chain—in turn inspiring suppliers to innovate, and their suppliers, all the way down.[iii] Also, spending on R&D for the sheer sake of it isn’t always wise. Pie-in-the-sky research sounds great, with utopian visions of pure scientists hunkered down in labs, experimenting for the thrill of it. But companies have a duty to shareholders to invest in productive endeavors. History is littered with big R&D ideas that didn’t pan out great. Remember the DeLorean? The Chevy Vega? Betamax? Laserdisc? New Coke? Crystal Pepsi? WebTV? We like reading about Elon Musk’s, Richard Branson’s and James Dyson’s big ideas and wacky tests as much as the next guy and gal, but for every Tesla there is an Edsel. If companies are being judicious and not overextending themselves by chasing every flight of fancy, that seems like a good thing, not bad.
Needless to say, sentiment is all twisted around this, which is bullish. Companies are investing for the long term, we aren’t secularly stagnating, and shareholders are getting an unloved boost from buybacks, too! This is the sort of false fear bull markets thrive on.
[ii] Earnings before interest, taxes, depreciation and amortization. Usually we’d spell these things out in the text, but we didn’t want to bore your brain to death with accounting lingo.
[iii] It also had the Newton, but in a way that eventually paid off in spirit by paving the way for the Palm Pilot, kicking off the smartphone wave that eventually came full-circle with the iPhone.