Corporate R&D spending increased significantly during the pandemic, setting the stage for a future boom in innovation and value creation. Is this a sign of the winners just pulling ahead of the rest?

By Joel Paula

Faced with the need to shore up near-term preparedness and resilience during last year’s disruptions, companies demonstrated a strong commitment to long-term strategy to get through the pandemic. New data from the upcoming FCLTCompass 2021 shows that corporate investment in R&D jumped to levels not seen in the past two decades – 10.9 percent of total spending. And that spending was broad-based across industries, not just driven by the healthcare and pharmaceutical industries racing to treat patients and develop COVID-19 vaccines.  

Similarly, investment in fixed assets (capital expenditures) climbed to 29 percent of total spending as companies brought their supply chains in-house and enhanced mission-critical infrastructure. This fixed investment too was widespread and not concentrated in any one particular industry or geography. Potentially due to monetary and fiscal stimulus, data also show that companies had more cash on hand, and that they spent less of it on share buybacks. The broad picture is that corporate cash was put to productive use, setting the stage for a future boom in innovation and value creation. 

Percentage of Total Spend, 2009-2020

This is good news born of a year full of bad. It means that, for firms investing in long-term strategies for the recovery, they will be better positioned going forward to benefit from accelerating trends like online shopping, improving sustainability, or decarbonizing business activities. 

Studies by professor Hendrik Bessembinder, from Arizona State University, show that investing in R&D, while still achieving superior growth in returns, scale, and profitability is a key characteristic of winning companies. The best-performing 4 percent of listed companies account for the entire outperformance and gain of the stock market since 1926. By analyzing the returns of 26,285 companies, Bessembinder finds that there are four stand-out characteristics that drive success (as summarized in the article published by Baillie Gifford) – all of which are corroborated by FCLTCompass data:  

  1. One is that they exhibit strong cash accumulation – profits that drive future investment.  
  2. They exhibit rapid asset growth, from increased output and product development, rather than through mergers and acquisitions.  
  3. They are characterized by sometimes delaying near-term profitability in favor of higher R&D spending that fuels future innovation and value creation.  
  4. The ride can be bumpy, however, as such firms may experience J-curve effects and periods of drawdowns before investments pay off. 

Even though the data in the upcoming edition of FCLTCompass finds long-term investment happening in all sectors (Bessembinder also finds winners in all sectors, not just in technology stocks), market participants are probably wondering how long big tech will continue to dominate. FAANG stocks have powered returns for investors, ballooning from 4.5 percent of the capitalization of the S&P 500 at the end of 2010 to 18.0 percent by the end of 2020. Tesla has been pouring money into research and ramping up production, itself recently topping US$1T in market capitalization. Business activities of the largest tech firms are attracting increased scrutiny from regulators in North America and Europe, particularly on antitrust issues or how digital services should be taxed. China’s clampdown on big tech firms like Alibaba and Tencent has wiped away billions in stock market values. Despite these hiccups, a broad-based shift in long-term investment across markets by many firms is good news for investors who are nervous about big tech and willing to commit to long-term investment horizons. 

But what is also clear is that not all businesses have emerged from the pandemic as winners, and some parts of the economy were hard hit and are struggling to recover, particularly small- and medium-sized enterprises (SMEs). Listed firms boast superior access to capital compared to unlisted firms and SMEs, and were arguably better positioned to adapt to challenges posed during the pandemic. The gap between winners and losers has widened as a result. 

While a challenging prospect, the data tells us that companies that allocated their capital behind long-term strategies during the pandemic-induced downturn will find themselves poised to capitalize on growing trends in the years ahead, especially as firms set targets and ramp up climate and sustainability investments.  

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