When Activist Investors Should Slash R&D — and When They Shouldn’t
In order to reduce the debt levels imposed by Covid-19, governments will need their country’s economies to grow. Corporate innovation is the major source of economic growth. Unfortunately, companies are generally wasteful in R&D spending, according to a measure called RQ, which allows you to assess the profits generated for the last dollar of R&D. The evidence suggests that activist investors are good at figuring out when companies are wasteful with their R&D budgets but their fixes are oriented to cutting expenses and speeding up project completion in order to deliver immediate stock price performance and do not deliver more innovation in the long run. By studying RQ at the unit level and over time, companies can identify internal benchmarks to improve their overall R&D efficiency and even identify external practices to adopt.
The combined cost of government programs for Covid-19 has pushed U.S. federal debt to 102% of GDP, the highest level since World War II. In order to afford the new debt without dramatically decreasing spending or increasing taxes, we need substantial economic growth. The primary path to this is innovation, which from 1990-1995 accounted for an estimated 60% of growth — and 70% of that innovation was funded by companies. As such, company-driven innovation is likely going to play a huge role in the recovery.
A possible obstacle in their path is activist hedge funds. The hedge fund industry began 2021 with a record $3.6 trillion assets under management. Its size, coupled with corporate weakness from Covid-19 shutdowns, portends an increase in activist investment. To be sure, some of this investment will be beneficial. However, the 10-year average life of hedge funds dictates that activists must pursue relatively short-term gains, which typically come at the expense of long-term investments. According to this logic, companies with substantial R&D investment would seem to provide low-hanging fruit: cut R&D, immediately increase profits.
But, that’s not necessarily the case. As we’ll see, some companies do spend too much on R&D, but that’s because they’re not doing R&D very well, not because the investment isn’t needed. There are also companies that could benefit from investing more in R&D because what they’re doing is productive. And while smart investors can often figure out which category a given firm falls into, they’re not best placed to take a direct hand in deciding how to actually spend the money, which is where the real action has to be.
R&D: Overspending or Not Good Enough?
There is evidence that activist investors do in fact distinguish between valuable R&D investment and wasteful investment. Take for example Trian Fund’s 2013 campaign to get DuPont to cut costs, including in R&D operations. Nelson Peltz was castigated for seeking to dismantle one of the preeminent industrial research labs. I, too, worried he would be destroying a valuable national asset, so did some digging to assess that.
What I found was that DuPont’s innovation engine had deteriorated fairly dramatically. While its R&D productivity, according to a measure I developed called RQ (which stands for Research Quotient), ranked it as one of the most innovative firms in the early 1990s, now it was below average. DuPont was not alone in that: R&D productivity in companies has declined 65% on average over the past four decades. Not only had DuPont’s deterioration gone undetected, worse, as a consequence, in 2013 they were over-investing in R&D by about $1 billion dollars per year (over-investment refers to dollars of R&D that generate less than a dollar of profits). It was this waste that likely provided the low-hanging fruit for Trian.
How do we know this? Because Trian didn’t go after Dow. The two firms were in the same industry, specialty chemicals, and were investing similar amounts in R&D: $1.75 billion for Dow, versus $2.1 billion for DuPont. Moreover, to a naïve outsider, Dow’s R&D budget looked more wasteful: it amounted to 6% of revenues — twice the R&D intensity of DuPont, which was investing only 3% of its revenues in R&D.
What did Trian know about Dow and DuPont that naïve outsiders didn’t? They knew that Dow had the better innovation engine. My numbers confirmed this: Dow’s RQ had been among the top 50 firms for 15 of the prior 25 years. In fact, its innovation capabilities were so much stronger than DuPont’s that even at 6% of revenues they were under-investing in R&D.
This comparison illustrates a few important points. First, activists aren’t necessarily the villains they’re made out to be — DuPont needed to reshape its R&D, and without Peltz’ intervention that was unlikely to happen. Second, the best defense against an activist campaign is taking opportunity off the table — keeping your company’s innovation engine tuned, and not flooding it with excess investment. How do you go about doing that?
What’s Your RQ?
RQ can help managers fix their innovation engines before the activists do it for them. Knowing your RQ lets you compute the expected growth in revenues, profits, and market value from a given change in your R&D budget. It also allows you to compute the optimal investment in R&D — i.e., the level where your last dollar spent on R&D generates a dollar of profits.
As the Dupont and Dow examples illustrate, the likelihood of an activist campaign increases when companies spend beyond their optimal levels, and a statistical analysis of firm’s RQs and their financial reports makes it possible to create a vulnerability score for each firm. My analysis shows that companies are primarily at risk because they are over-investing in R&D. Two thirds of the 1,416 companies I looked at over-invested by more than 10%, and on average each is leaving $445 million of profits on the table every year. Like DuPont, many are over-investing because their RQ has declined, rather than because they have dramatically increased R&D. In most cases, if they could restore their prior RQ, they would be spending at appropriate levels. (Under-investment also leaves profits on the table. But this tends to attract less attention from activist investors because figuring out how to invest more in R&D is harder than simply cutting wasteful expenditure.)
Note that companies normally appearing on “most innovative companies” rankings, often have below average RQ, as was the case with DuPont. These rankings are typically based on either R&D spending or surveyed opinion. As we’ve just established, basing your assessment of how innovative a company is on the size of its R&D budget is simply going to favor the companies that spend the most, regardless of how effective that spending is. Similarly, innovation surveys generally ask executives and consultants to rank all companies. Accordingly, the results favor companies producing innovations visible enough that that executives outside the industry notice them, which may be equally misleading.
In principle, companies can reach the optimal budget for their RQ simply by cutting the overall budget. That’s certainly what activist shareholders push for. Research by Alon Brav, Wei Jiang, Song Ma and Xuan Tian indicates that activists usually get companies to reduce R&D spending by 20%. But the problem with this is deciding what goes into the 20%. If companies cut fat, they may at the same time change the RQ for the better and find that they’re now underinvesting. And if they cut productive activities, they will end up more vulnerable than before. The devil, as ever, is in the details — in this case of what you cut and what you don’t.
That’s why activists usually insist on adding a technologist to the company’s board and increase the equity stakes of chief technology officers (CTOs) at their targets by about 50%, which motivates these executives to increase the target companies’ market value. That sounds good and does appear to increase innovation when using some measures (stock-optioned CTOs do seem to get more patents processed, for example). However, the evidence suggests that target company RQs generally tend to decrease following activist investment, suggesting that the choices of the CTOs may be aligned to the shorter time horizon of the activists who bring them on. Since RQ is the only measure theoretically and empirically linked to long-run growth, it seems that activists are probably detrimental to our goal of paying off the federal debt from Covid.
What will make that goal more achievable is for companies to work on boosting their RQ themselves. And they have every incentive to do this. Not only will higher RQ increase company growth, thereby contributing to economic growth, it will also make them safer from activists. Research indicates that on average, a 5-point RQ increase leads to 11.1% higher 5-year growth, and 2.7% higher market value.
The question, then, is how to go about increasing RQ.
Moving the needle
The first step is taking care of the low-hanging fruit identified in my book How Innovation Really Works. The book serves as the final report for practitioners from two NSF funded studies linking companies’ R&D practices to their RQs and documents the RQ impact of all practices for which there is publicly available data linked to firms.
But the book only documents practices that hold across the entire economy. High RQ requires going beyond that to implementing practices whose value may be confined to your technologies or your industry. Begin by benchmarking against your past history. On average, companies’ RQs have declined 1.5% per year, so their RQs were generally higher in the past. Pick a year that is particularly high, then determine what were you doing differently at that time. Identify which of those differences likely made you more productive and implement the ones still relevant to your current technologies.
Next, start benchmarking across divisions. Divisional RQs can differ dramatically within a company and, while some of these differences are undoubtedly market or technology related, often the high RQ divisions employ distinct R&D practices. So once you’ve identified the RQs of each of your divisions, determine how R&D is conducted differently in the high RQ divisions, assess which of those practices are relevant to remaining divisions, and diffuse those throughout the company.
These kinds of internal benchmarking should be easy — aside from effort, there is nothing precluding you from obtaining the necessary information about where higher RQ resides (or has resided) and what practices underpin it. External benchmarking, however, is harder because companies typically keep information about their R&D very close to their chests. But if you can work out a competitor’s RQ and discover that it’s higher than yours, you should be able to figure out what your rival does differently from analyzing public sources such as annual reports, conferences, and media accounts, not to mention from employees you have who have moved from your competitors.
Although efforts by companies to decrease vulnerability to activists, and efforts by activists to restructure innovation both increase shareholder value in the short-run, only the vulnerability-reducing mechanisms increase long-run growth. Accordingly, companies should continually assess the vulnerability of their innovation engines to activist investment. If they find themselves vulnerable, they should take measures to remove those vulnerabilities. Doing so will not only increase their own long-term growth and market value, it will contribute to the growth of their economies — a win-win path to getting out from under the mountains of Covid-related debt.