1 Konan Chan, Yueh-hsiang Lin and Yanzhi Wang 2010 NTU International Conference on Finance How Do Investors React to R&D Reductions Konan Chan, Yueh-hsiang Lin and Yanzhi Wang 2010 NTU International Conference on Finance Presenter: Yanzhi Wang Discipline of Finance College of Management Yuan Ze University Very preliminary, please do not quote!

2 Background A rich literature shows that research and development (R&D) investments enhance shareholder value and R&D increases predict favorable future performance (Chan et al. (1990), Szewczyket al. (1996), Eberhart at al. (2004), and Hsu (2009). Yet, very few extant papers examine the valuation of R&D reductions. More than 30% of firms covered in both CRSP and Compustat with available R&D information decreased their R&D spending during the three decades between 1975 and The average reduction in R&D expenditures for these R&D- decrease firms is $2.97 million, which represents 2.64% of lagged assets and a 24% decrease in their R&D growth rate.

3 Issue These statistics suggest that R&D decreases are nontrivial events and likely to generate a remarkable impact on firm growth and performance. Therefore, we examine the long-run performance following and economic motives behind significant decreases in R&D expenditures. Then a raising question is what the market valuation to the R&D reduction.

4 Issue Unlike R&D increases, which are commonly considered good news due to more investment opportunities, R&D decrease signals are not nearly as clear. –Managers may reduce R&D to reflect their expectations on future deteriorating fundamentals, an indication of poor subsequent stock returns. –Firms may also suffer overinvestment problems and thus reduce their R&D spending to return to the optimal level of R&D investments. –Previous research raises the concern that managers are myopic and may sacrifice long-term profits from R&D outlays in exchange for increases in short-term earnings (Stein (1989)) Thus, the valuation of R&D decreases is not straightforward.

5 Purpose We study the information content of R&D decreases by asking two questions: How does the market respond to the R&D decrease? –We answer this question by examining the long-run stock returns after significant R&D reductions. –We use the long-horizon approach because R&D investments are generally long-term in perspective and an extended period of time may pass before firms realize the total benefits generated from R&D. What factors explain firm performance following R&D decreases? –To address the second question, we examine various aspects associated with R&D decreases, such as annual stock returns, operating performance, analysts’ forecast revisions, and changes in cost of capital. These investigations can shed light on managerial motives behind large R&D reductions.

6 Main results We extract 3,594 U.S. firm-year observations between 1975 and 2005 that have significant and unexpected reductions in R&D expenditures. We find that, contrary to traditional wisdom, firms experience significantly positive abnormal returns over five years following large R&D decreases. The magnitude of abnormal returns is about 0.89% per month after controlling for size and book-to-market effects.

7 Main results We propose spillover, managerial myopia, and overinvestment hypotheses to account for the positive abnormal return following R&D reductions. Our results are most consistent with the overinvestment hypothesis. –The operating performance deteriorates immediately preceding R&D decreases and firms with low or decreasing investment opportunities outperform. –These findings strongly support the overinvestment hypothesis. While the cost of capital declines after R&D decreases, the market seems to underestimate the improvement in cost of capital.

8 How does the market respond to the R&D decrease?

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10 How does the market respond to the R&D decrease?

11 What factors explain abnormal return following R&D decreases? We propose three hypotheses –Spillover –Managerial myopia –Overinvestment

12 What factors explain abnormal return following R&D decreases? Spillover hypothesis R&D spillover effect suggests that one firm’s R&D can benefit the productivity of other firms. Managers may cut R&D spending in anticipation of potential R&D spillovers. Reducing R&D investments lowers expenses and thus increases current and future earnings. Therefore, the spillover hypothesis predicts that the R&D spillover will create an improvement in firms’ performance following R&D decreases.

13 What factors explain abnormal return following R&D decreases? Managerial myopia hypothesis Myopic R&D investment hypothesis argues that managers temporarily reduce R&D outlays to boost current earnings at the expense of long-term profits. Therefore, the myopic R&D hypothesis predicts a reversal in firms’ performance following R&D decreases..

14 What factors explain abnormal return following R&D decreases? Overinvestment hypothesis overinvestment explanation is that managers trim down R&D investments to resolve the overinvestment problem. It is expected that firms with low investment opportunities and firms with decreasing growth potentials generate higher long-run returns compared with other R&D-decrease firms. Firms shall reduce their cost of capital substantially following decreases in R&D expenditures.

15 Operating performance

16 Abnormal stock return

17 Forecast revision

18 Changes in cost of capital

19 Conclusion This paper examines the long-term performance following significant R&D decreases. We find that, contrary to conventional wisdom, large R&D decreases generate significantly positive future stock returns. We explore three potential economic motives behind R&D decreases—R&D spillover, managerial myopia, and overinvestment. Our results suggest that operating performance deteriorates immediately preceding R&D decreases and firms with low or decreasing investment opportunities outperform; these findings strongly support the overinvestment hypothesis. While the cost of capital declines after R&D decreases, the market seems to underestimate the improvement in cost of capital.