Green clay facial masks> make women look frightening for 15 minutes but lovely after. Research spending has much the same effect on a company s profit statement. Embrace shares of companies whose allure is temporarily masked by development expenses, and the result later on might be glowing returns.
To see why, consider how a company reports spending for its electricity bill versus how it reports the purchase of a new delivery truck. Utility charges are ordinary operating expenses, so they re subtracted from profits right away. A delivery truck costs plenty upfront but will pay for itself over several years. If such costs were deducted from profits all at once, the result would be losses in years companies made big investments and big profits in years they didn t. To smooth results, accountants call trucks and the like capital investments, and deduct their costs from earnings little by little over the projected useful life of the goods, a process called depreciation.
Research spending, like that delivery truck, will produce profits in coming years. One study looked at 8,313 cases between 1951 and 2001 where companies that already spent plenty on research started spending more. Profit margins for these companies increased one to three percentage points faster than those of peers over the next five years, and shares outperformed by five percentage points a year. Yet in the past, when research spending was treated as a capital investment, some companies abused the system by labeling every imaginable cost as research, so accounting standards today require that all research spending be treated as ordinary operating expenses. The result is that the more companies spend today to ensure rich profits tomorrow, the worse their shares look in the meantime and the bigger the opportunity for informed investors.
The companies below spent plenty on research and development over the past year, and spent more in the past two quarters than the same quarters a year earlier. They also have low stock market values relative to their past four quarters worth of research and development spending low P/R&D ratios if you like. One study of stock performance over 20 years ended 1995 found that companies with low P/R&D ratios beat the market by an average of six percentage points a year.
Increased research spending is an especially welcome sign during the current earnings season. Companies are beating profit estimates more often than sales estimates, suggesting many are using short-term cost cuts to boost numbers. Earlier this month I reported on why upside earnings surprises fueled by, among other things, slashed R&D spending foretell lousy long-term returns. Better to favor companies that are investing enthusiastically, even at the near-term expense of Wall Street s applause.
Electronic Arts (ERTS)
Have a look if you like at details on these and other screen survivors below.
|Electronic Arts||ERTS||Video games||$19.97||6,427||23||5|
|Rofin-Sinar Technologies||RSTI||Industriaol lasers||19.29||558||34||14|