Do firms invest in long term R&D?
They do, right? There are examples around. Just recently we saw that Intel will invest 50 million dollars in Quantum Computing (Also, this brief note by Intel’s CEO). They don’t expect to have results immediately:
Today Intel Corporation announced a 10-year collaborative relationship with the Delft University of Technology and TNO, the Dutch Organisation for Applied Research, to accelerate advancements in quantum computing. To achieve this goal, Intel will invest US$50 million and will provide significant engineering resources both on-site and at Intel, as well as technical support.
Despite significant progress, quantum computing will take at least a dozen years to fulfill. That’s why practical and theoretical research is needed now, and why we will work with industry partners.
Then, the interesting question would be what kinds of corporations invest in R&D, and at which timescales they do. It could be argued, for example, that Intel’s large slice of the microprocessor’s pie allows them to do this kind of long term investment.
Before continuing, we have to make clear the distinction between R and D: R is research, and it can be applied (Focused on solving a particular problem) or basic (no particular problem in mind), and D is development (To design something that meets some requirements). I think it won’t be surprising to say that there is no problem with applied research and development. Most of the spending on R&D corporations do is in D. Then there is some applied research and relatively little basic research. So in what follows, we will focus on research and not development.
That said, there are people who are doubtful that there exist significant commitment to long term basic research activity because of the incentives faced by corporate executives. This, if true, would not be a massive problem, though: fortunately corporations are not the only players in the innovation game, but it would be a worry, given that they command large amounts of resources, and have the technical means to convert their research into products.
The short-termism hypothesis
The argument against the existence of significant long term investment would be that managers care a lot about their short term results, because in turn investors care about that, even if the company could achieve better results in the long run if the investors were more patient. Only if the rate of return were relatively independent of firm investment (Because of a monopoly), then the firm could (but not necessarily will) invest. Evidence of sorts for the theory would be the fall of the great corporate laboratories like the well-known Bell Labs (The Labs are still around, but as a shadow of its glorious past). We can find something like this in Mazzucato’s book:
A recent MIT multidisciplinary study has looked at the strengths and weaknesses of the US innovation system and the causes of relative decline of manufacturing in America. The study has strived to understand why the development of promising innovations are stalling or simply moving abroad before reaching commercial scale. One of the reasons unveiled by the study is the fact that large R&D centres – like Bell Labs, Xerox PARC and Alcoa Research Lab – have become a thing of the past in big corporations; they have mostly disappeared. Long-term basic and applied research is not part of the strategy of ‘Big Business’ anymore, as corporate R&D now focuses on short-term needs. The study argues that ‘large holes in the [US] industrial ecosystem have appeared’:
In the thirties, a corporation like DuPont not only invested for a decade in the fundamental research that led to nylon, but once the lab had a promising product, DuPont had the capital and the plants to bring it into production. Today, when innovation is more likely to emerge in small spin-offs or out of university or government labs, where do the scale-up resources come from? How available is the funding needed at each of the critical stages of scale-up: prototyping, pilot production, demonstration and test, early-manufacturing, full-scale commercialization? When scale-up is funded mainly through merger and acquisition of the adolescent start-ups and when the acquiring firms are foreign, how does the American economy benefit? (PIE Commission 2013, 26)
This theory has a monopoly proviso, so the Intel quantum computing investment would not count. A reply would be that Intel is not a monopoly, but part of a competitive market, as it doesn’t behave as a typical textbook. Other similar performing products aren’t that much noticeably cheap compared to Intel’s. A counter reply to this would be that market inertia makes sure that Intel has plenty of time to notice if things are going wrong before OEMs stop asking them for more microprocessors. Google’s Google X would receive the same critique. So if we want to play the examples game, we would need a corporation without a big share of its market pie. The example here could then be IBM or Toyota. Some more evidence here.
On its face, the argument seems plausible, and as we will see, there are some pieces of evidence that can be used to support it. But what seems fishy about it it’s that it posits a situation where long term research is being done, and the corporation itself benefits it from it and compares that to the putative present situation, where investors have a suboptimal investment horizon, leading them to lower long term return, and less innovation. Hence, the myopia. This first thesis either presents the investors are irrational, or as rational agents in the context of some sort of prisoner dilemma, where the cooperative solution would be to cooperate (Everyone does research), but the Nash equilibrium would be to defect (No one does research).
The first thesis is the less plausible of the two: If there is a market that works like textbook markets do, that is the stock market. Given that the Efficient Market Hypothesis (with a disputable degree of strength) holds, if you had a piece of information that could be used to make you richer (That you know that future returns will increase if you invest more in R&D than is currently being invested), then some other has probably thought the same, and the price is already corrected.
The second thesis seems just the usual market failure argument (And will be discussed in some post to come).
The market myopia theory
Let’s focus then on the first thesis. For it to hold, it would have to be proven that corporate investment in research has been falling, that corporations have not filled that gap with other thing (say, acquisitions of startups), that said behaviour is motivated by managerial short termism, and that, in turn, this is propelled by investor short termism.
First, are financial markets myopic?
Like Soylent Green, financial markets are people. And people are diverse. We have on one side of the spectrum the day trader (tries to predict short term prices), and on the other the value investor (tries to predict the underlying long term value). The first kind of investors determine the short term prices in the market, and the second ones determine the long run ones. Or as investor Ben Graham used to say “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”. In control theoretical terms, short term investors are a derivative term in a PID controller, and long term investors would be the proportional and integral terms. They both have a role.
So, to sum up, corporations would be myopic if
- Corporate research spending decreases
- And said spending is lower than an optimal amount
- Either market-induced short termism
- Investors want short term rewards
- Managers pursue short term objectives to satisfy investors
- To do so, they slash R&D
- Or market failure
- Corporations know they need certain research
- But research can be appropriated by others
- So they don’t do research, or do less research than an optimal amount
- Either market-induced short termism
- And no other sources of research spending make up for this decrease
Myopia or the rise of non-corporate research, the two explanations
There is evidence for point one in a paper we will now discuss: Killing the Golden Goose? The changing nature of corporate research, 1980-2007 (Arora, Belenzon, and Patacconi 2015)
The article confirms the decrease in corporate research, and speculates on its causes: Perhaps it is short termism (citing Lazonick, one of the pushers of the short-termist hypothesis), or maybe it is a change in the ways corporations do innovations (citing an article in The Economist about the rise of high tech startups that are later acquired by corporations).
They focus first on scientific publications in scientific journals by company scientists, and they find out they have decreased, and from a series of considerations they infer that companies value science less: they publish less, stocks of publications command a smaller market value premium, the acquisition premium paid for publications in M&A is smaller, and when innovative firms are acquired, they invest less. However, patenting has increased, and the implied value of patents has remained stable. They say this finds happen across all industries, save for biotechnology.
This is part of a long term trend, they say: corporations now rely more on external innovations, and value the golden eggs of science, but not the golden goose itself.
Could it be that they are just publishing less to protect their research? Unlikely, they say. If it were true, publication in applied journals would have fallen more than publications in basic science journals, but that is not the case, plus the considerations sketched before are not invalidated by this.
Could it be that they invest less in science because science is less useful? They argue that not, if we measure scientific usefulness by patent citation, recent patents are being cited, and more so by high scientific capability firms.
Could it be market failure? Not in principle: the causes of market failure have not intensified, they say. And their findings happen in both the US and Europe, so legislative changes are unlikely to be the cause.
The cause, they say, is that firms face reduces incentives to develop new products and processes internally. They attribute this to increased competition, and the conjecture that diversified firms can better use basic science than firms with a narrow scope. This is supported by the publication count, and stock market value of publications, of narrow and broad focused firms.
This withdrawal from science has been accompanied by a growing division of innovative labor in which large firms focus on development and commercialization, leaving universities and small firms to generate new ideas. However, our results also suggest that small science-intensive firms cannot simply rely on generating scientific knowledge and hope to be acquired. Because the rewards for pure scientific capability have diminished, these firms also have to invest in finding tangible commercial application of their ideas. To the extent that universities and small firms are ill-equipped to undertake this more applied research, inefficienies may result.
However, we shouldn’t exclude the possibility of strong alliances between universities, venture capitalists, and corporations. Their combination can do what each alone can’t. A review of the many ways of financing innovation can be found in Bakker 2013.
One example of this collaborative approach is illustrated in this this recent article about lithium-ion rechargeable batteries: One of the articles cited include researchers from universities and Toyota, other by universities and Samsung. If interesting innovation is occurring at universities, corporations have strong incentives to keep in touch with the academic world, to take advantage of them.
Back to the article,
Several factors contributed to the growing importance of small firms, particularly in science-intensive sectors. One is the more prominent role played by universities and other research institutions in the commercialization of science. The 1980 Bayh-Dole Act encouraged universities to more aggressively license and commercialize their discoveries, and scientists found increasingly attractive to start their own businesses. The success of Genentech, a biotechnology company founded by biochemist and Nobel Prize winner Herbert Boyer and venture capitalist Robert A. Swanson, showcased the potentially huge rewards associated with such a strategy. Also, start-ups’ high-powered incentives were di¢ cult to replicate in large, established firms, where bureaucracy, politics and the burden of past legacies tend to thwart radical change (Schumpeter, 1942; Leibenstein, 1966; Christensen and Bower, 1996; Sull et al., 1997). Changes in the institutional and legal environment have complemented these trends. Startups can get financing from venture capitalists and SBIR and other government programs (Kortum and Lerner, 2000; Lerner, 1999; Mazzucato, 2013). Intellectual property rights have been significantly strengthened starting from the early 1980s, first in the U.S. and subsequently in other countries (Jaffe and Lerner, 2004; Guellec and van Pottelsberghe de la Potterie, 2007). These developments have promoted a new division of labor, where small start-ups specialize in scientific research and larger, more established firms specialize in product development and commercialization (Arora and Gambardella, 1994)
Note that in another section (6.2) of the paper, they say someting that appears to contradict this: What we already mentioned about this tendency being also European. The best interpretation of this could be that Europe has implemented policy changes similar to those in the US. These changes, such as the American Bayh-Dole Act enabled firms and researchers to claim ownership of research done with federal funds, making it easier to commercially exploit them.
In the same section, the paper rules out the market short-termism hypothesis, saying that the rate of decline of research funding is similar in private (e.g. Koch Industries) and public (e.g. Google) firms.
To sum up the paper: firms are now narrower in scope, and competition may reduce the payoff to innovation (Schumpeterians rejoice, although in other section they say evidence for this is mixed). But, they say, if science were useful, successful firms would invest in it. So there are two explanations for this:
One possibility is that markets, as well as managers, become more short-term oriented when firm profitability declines (as a result of global competition). Alternatively, it could be that investment in internal science is an inefficient relic of a past long gone, when big American and European firms could afford to ‘waste’resources.
In this view, large firms are inefficient performers of research and need to be pushed to outsource research to smaller and more nimble partners.
We find little support for other potential explanations for the decline in publication output by large firms.
So, it seems that the first part of the myopic hypothesis, reduced corporate research, is true. But this paper also casts some doubt on the short-termist market hypothesis, while at the same time leaving this as one explanation for this reduced investment. So if we could rule out the short termist market hypothesis, the other hypothesis they present (the change in the composition of research performance, towards university and startups in partnership with corporations) perhaps is the correct one.
More on market myopia
We now move on to Long-Term Investing: What determines Investment Horizon? (Warren 2014). He reviews the literature on investor’s investment horizon, and comments the different types of investors that exist:
The link between investor short-termism and corporate myopia is not clear cut – While there is some evidence in support of such a link, it is by no mean compelling. Laverty (1996) examines arguments on the existence of short-termism, and points out there is: (1) no clear evidence of flawed short-term oriented management practices; (2) only mixed evidence that stock market myopia encourages corporate short-termism, noting for instance findings of positive stock market reactions to long-term investment by some papers; and, (3) an absence of empirical support for the supposed influence of ‘fluid capital’ on corporate behaviour.
Results of a survey of company management by Marston and Craven (1998) also question the extent to which institutional investors are short-term in focus. While their survey uncovers a perception that sell-side (broking) analysts are focused on the short-term, company management did not consider this the case for buy-side analysts and fund managers. When asked if the buy-side was too concerned with short-term profit opportunities, only 21% agreed while 53% disagreed.
That said, Warren does think there is more short-termism than would be optimal, but that this creates an opportunity for longer term investors.
Another paper, Institutional Investors and Equity Returns: Are Short-term Institutions Better Informed? (Yan and Zhang 2014). They discard the short-termist hypothesis. They analyse short and long term horizon institutional investing, and conclude that short term investing also adds information to the market
An alternative explanation for our results is that short-term institutional investors pressure managers to maximize short-run profits at the expense of long-run firm value [the ‘‘short-term pressure’’ hypothesis; see for example, Porter (1992), Bushee (1998, 2001)]. In particular, Bushee (1998) finds evidence that firms with higher transient institutional ownership are more likely to underinvest in long-term, intangible projects such as R&D to reverse an earnings decline. The short-term pressure hypothesis might help explain the short-run predictive ability of short-term institutional ownership and trading, but it also predicts long-run price reversal for stocks held or traded by short-term institutions. To test this prediction, we examine the relation between institutional ownership and trading and future stock returns up to three years. We find no evidence of long-run price reversal for stocks held or recently traded by short-term institutional investors, suggesting that our results cannot be explained by the short term pressure hypothesis. We also find no evidence that either the holdings or trading by long-term institutional investors predicts long-run stock returns. This result is inconsistent with the hypothesis that long-term institutions are better informed about long-run returns. […]
This article’s results have implications for the issue of identifying and attracting the ‘‘right’’ investors. Recent studies [e.g., Gaspar, Massa, and Matos (2005)] suggest that short-term institutional investors are weak monitors. Moreover, short-term institutions pressure managers into a short-term focus, thereby hurting long-run firm value [e.g., Bushee (1998)]. Collectively, these results suggest that it might be beneficial for firms to target and attract long-term institutional investors [Porter (1992), Brancato (1997), and Bushee (2004)]. We argue that firms should also consider the informational aspect of institutional ownership. Our results indicate that short-term institutions play a significant informational role in the stock market. Since more informative prices facilitate better financing and investment decisions and may reduce cost of capital, our results cast doubt on the benefit of a strategy that attempts to attract only long-term investors.
So even if short-term investors can induce corporate short-termism, this would not be a bad thing, as it would be reflecting underlying information. At a given point in time, there is a tradeoff to be made between funding short vs long term investment, so reducing long term investment at some points would be an efficient strategy. While some studies (Bushee 1998) show that short-termist investors induce cuts in R&D, these views have been challenged in recent studies (see Wahal and McConnell 2000)
A more recent contribution is by Bushee 1998 , who examines reductions in R&D spending to determine whether firms with higher institutional ownership are more likely to cut R&D spending in response to an earnings decline. He is specifically interested in whether managers of firms with high institutional ownership are more or less likely to cut R&D spending to manage short-term earnings. His sample encompasses firms that experienced an earnings decline during a year, which could subsequently be reversed by a cut in R&D expenditures. He estimates a logistic regression in which the dependent variable is one if the firm cut R&D expenditures and zero otherwise and the key independent variable is the fraction of shares owned by institutional investors. Unfortunately, interpretation of his results regarding institutionally induced myopia is also problematic. An implicit assumption of Bushee’s analysis is that a firm’s current level of R&D expenditures is ‘‘optimal’’. Suppose, however, that causation runs from institutional ownership to R&D spending such that firms with high institutional ownership have low R&D expenditures. If so, then firms with high institutional ownership will have ‘‘less room’’ to cut expenditures in response to an earnings decline. In that case, a logistic regression of the type estimated by Bushee will indicate that firms with higher institutional ownership are less likely to cut R&D expenditures, even though institutional investors may generally depress corporate expenditures for R&D. Thus, while Bushee’s tests can speak for the issue of earnings management, they do not address the question of whether institutional ownership leads to lower spending for projects with long-term payoffs, such as PP&E and R&D.
They conclude that
With a sample of approximately 2500 firms from 1988 to 1994, we show that firm-level expenditures for PP&E and R&D are positively related to the level of share ownership and trading activity of institutional investors in those firms. Our results cast doubt on the view that institutions cause corporate managers to behave myopically relative to whatever myopia may be induced by direct share ownership by individual investors. They are consistent with the perspective that institutional investors act as a buffer between firms and less patient individual investors. One of the consequences of this buffer is that it allows managers to have longer investment horizons than they would otherwise have.
At least two caveats are in order when interpreting our results. First, we do not address the question of whether US firms systematically underinvest relative to firms in other parts of the world. That question is, however, examined carefully by Hall and Weinstein 1996 and Lee 1997 . These authors find no evidence that managers of US firms are myopic relative to managers of Japanese and German firms. Second, we can be accused of examining the ‘‘easiest’’ investment categories to analyze, PP&E and R&D, while ignoring those in which the problem of underinvestment is likely to be most severe. Froot et al. 1992 argue that the type of underinvestment that can be engendered by myopic investors is more likely to manifest itself in difficult to observe investments such as development of human resources and the costs incurred in the development of customer loyalty. To the extent that that argument is true, we are missing the target. We can, therefore, only claim that we can find no evidence that institutional investors exacerbate underinvestment in PP&E and R&D, which may very well be different from the conclusion that institutional investors do not exacerbate underinvestment in projects with long-term payoffs. With these caveats in mind, the data do not indicate that institutional investors cause managers to underinvest. Rather, to the contrary, share ownership by institutional investors appears to allow US corporate managers to invest more in projects with long-term payoffs than would direct share ownership by individual investors.
The rise of the startup?
So there seems to be a problem (For the short-termist hypothesis) here: corporate research is in fact decreasing, but apparently this is not driven by induced short-termism. If this is true, the startup-as-innovators view would be plausible. Let’s examine one more paper, The size, concentration and evolution of corporate R&D spending in U.S. firms from 1976 to 2010: Evidence and implications, by Hirschey, Skiba and Wintoki (2012). Some introduction:
Our sample consists of all publicly traded firms over the thirty-five-year period from 1976 to 2010. Our analysis reveals that significant change has occurred in the size, distribution, and economic importance of corporate R&D spending across the economy as a whole. There has been a steady transfer of R&D spending from the government to the business sector. Corporations now account for roughly two thirds of U.S. R&D expenditures. Corporate R&D spending is roughly twice the size of print and broadcast media advertising; it is about one-half the size of corporate spending on property, plant and equipment (capital expenditures). Median R&D spending has grown almost twice as fast as average spending. This means that medium-size firms have contributed more to the growth in R&D spending than the largest firms, although the largest spenders still dominate R&D spending in the United States. With advertising expenditures, the trend has been the opposite. Advertising by large firms has become even more concentrated since 1976. R&D spending is far from uniform across all industries. On an aggregate basis, the distribution of R&D is much more skewed than is the distribution of advertising and capital expenditures; a few high-tech sectors account for the overwhelming share of R&D activity. However, one important fact that emerges from our analysis is that the industry concentration of R&D spending has remained stable over time. For example in 1976, there were 9 industries that reported zero R&D expenditures. In 2010, 4 of these 9 still reported no R&D spending and none of the nine reported aggregate R&D spending greater than one-hundredth of one percent of total sales. R&D spending and R&D intensity (R&D as a percentage of sales revenue) are highest in industry groups such as transportation equipment, tobacco products, chemicals and allied products, petroleum refining, industrial machinery and computer equipment, electronic equipment, business services, and measuring instruments, photography, watches. Little to no R&D takes place among large corporations found in such big sectors as retailing (general merchandise stores, food stores, building materials, hardware and garden), health services, bars and restaurants, construction, and transportation services. Nevertheless, within the industries where there is significant R&D spending, the number of firms that report R&D increased significantly between 1976 and 2010. In 1976, 45% of all firms reported R&D and this increased to 53% in 2010. […]
Our analysis also contributes to the debate on whether or not managerial myopia has had an effect on aggregate R&D spending in the U.S. over the past two decades. In the early 1990s, some academics (e.g. Jacobs, 1991; Porter, 1992), following popular accounts and anecdotes in the business press, suggested that managers in the United States may systematically reduce investments in R&D to meet short-term earnings benchmarks at the expense of value maximization and long-term growth. While the evidence for any cross sectional variation in managerial myopia is mixed at best (e.g. Bange and DeBondt, 1998; Lundstrum, 2002; Wahal and McConnell, 2000), the idea that U.S. firms may systematically under-invest in R&D remains popular in the business press (see, for example, Mandel, 2009).
Maybe the startup hypothesis is true?
While we do not test the managerial myopia hypothesis directly at the firm level, we provide suggestive evidence that is inconsistent with the idea of managerial myopia. For example, the ratio of aggregate R&D spending to corporate earnings increased from 24.6% in 1976 to 34.3% in 2010 across all firms. While the ratio of R&D spending has increased across firms in general, a significant portion of the increase has come from an increase in R&D spending by young, R&D-intensive firms with little or even negative earnings. In addition, as we have already noted, we find that profitability accounts for very little of the cross-sectional variation in R&D spending. Taken together, none of these findings suggests any systematic economy-wide bias towards managerial myopia with respect to R&D. On the contrary, the data suggest a willingness among top managers of large corporations to devote a large share of current profits to risky long-term R&D investment projects with uncertain payoffs. Indeed, we find that even during the 2008–2010 financial and economic crises, the ratio of R&D to sales remains unchanged from the long-term historical average.
Finally, we find strong evidence that managers in industries where fundamental innovation is essential for survival are willing to commit a significant and growing share of earnings to risky long-term R&D. We find little evidence to support the idea popular in the business press of managerial myopia. Managers do not reduce R&D intensity in response to short declines in profitability even during periods of economic recession.
However, they analyse aggregate R&D, and do not specifically talk about basic research, so this has to be taken with care. The finding about young firms could be evidence in favour of the substitution (of corporate by startups research) hypothesis, but this paper is not totally conclusive on the matter. The validity this would hinge on what counts as basic and what counts as applied research. Intel’s Quantum Computing initiative sounds like basic research, and it targets something removed in the future, but the goal is to solve the practical problem of a given piece of tech, so in that sense it counts as applied research. I would have to look up what kind of things are being counted as which, and whether startups are entering the market with relevant pieces of market-ready basic research.
To conclude, given the above, the market induced myopia theory can be rejected. This theory posits widespread irrationality in one of the most textbooklike markets, so we should require strong evidence for the myopic view to be true. If we accept this, then we would need to accept, as per one of the cited papers, that the way research is done has changed. Corporations are not investing in research as they used to, but they have outsourced it. This could have the advantage of enabling the corporations to focus on improving what they are already doing, and leave universities and startups the task of doing radical innovation, since they are free of the financial constraints large firms have. Moreover, they can help solving the R&D market failure problematic. Universities don’t do research to sell it, but as an end in itself, therefore being immune to this market failure. However, furthering the division of knowledge generates coordination problem between the different agents involved. I have not done an in-depth survey of the role of non-corporate source of research funding, but given the above discussion, I expect it to be growing, and their partnerships with corporations, increasing. See this post for some preliminary information.
Given that the myopia argument is brought forward in relation to financialization, and recent changes in capitalism, and not in relation to always present market failures, if we restrict ourselves to this view of myopia, the myopic argument stands rejected. If we expand the thesis to include market failure, then there can be myopia in the sense of the prisoners of a prisoner dilemma being myopic for defecting. How much market failure and where? A study of that will come here, at some point in the future.
EDIT: McKinsey report on share buybacks
EDIT2 (3/10/16): Some evidence to the contrary: http://www.vox.com/the-big-idea/2016/10/3/13141852/short-term-capitalism-clinton-economics
Edit3(1/3/17) Evidence in favour of my thesis here