R&D-Intensity, Mispricing, and Stock Returns in Taiwan Stock Market

Literatures review: properties of high R&D-intensive firms

1. Barron et al (2001) and Barth, Kasznink, and Mcnichols (1999) observe that analysts’ forecast error is negatively associated with a firm level of intangible assets including R&D and others.

2. Aboody and Lev (2000) suggest that R&D expenditures generate information asymmetry and insider gain

3. Kothari et al. (2002) report that the earnings volatility associated with R&D expenditures is three times larger than that associated with tangible investment in property, plant and equipment

4. Barron, Byard, Kile, and Riedl (2001) find that lower levels of analyst consensus are associated with the R&D expenditures of high-technology manufacturing companies.

• The high R&D intensity firms are hard to be correctly evaluated.

• R&D are increasingly importantly under Taiwan’s economic development.

• Given the increasing importance of R&D, are their valuations for R&D different from those in the U.S. stock market recorded in previous literature?

Motivations

The three essential issues

1. Does the stock market correctly value firms’ R&D intensity?

2. Is the valuation meaningfully attributable to the fundamental dimensions of return and associated risks or characteristics of firms? Does mispricing associated with the R&D intensity exist?

3. Is the valuation, if existing, subject to numerous conditions, such as seasonality, market conditions, industrial structures, and even the development process of Taiwan’s Economics?

Recent evidence 1. Chan, Lakonishok and Sougiannis (2001) find evidenc

e that returns on firms involved in R&D are equivalent to the returns on firms without R&D.

2. Many researchers find a positive relationship between R&D expenditures and subsequent stock returns (e.g., Hirschey and Weygandt, 1985; Cockburn and Griliches, 1988; Bublitz and Ettredge, 1989; Lev and Sougiannis, 1996)

3. A recent study by Titman, Wei, and Xei (2001) provide evidence that firms with high capital expenditures yield lower benchmark-adjusted stock returns, a result primarily driven by the over-investing problem.

Samples and Methodology

Data1. All the data are obtained from the Taiwan

Economic Journal (TEJ).2. The sample period covers from July 1988 to

June 2002. There are totally 168 observations for each stock.

3. Following Chan, Lakonishok and Sougiannis (2001), we use R&D expenditures relative to sales (R&D/Sales) and R&D expenditures relative to market value (R&D/ME) as the two measures of R&D intensity.

1. The first measure (R&D/Sales) is used as an indicator of how much money, proportional to their sales, firms spend in R&D activities or how enthusiastically firms devotes their resources to R&D activities.

2. The second measure of R&D intensity (R&D/ME), unlike the first measure, not only depends on firms’ spending in R&D, but also explicitly accommodates the market price or the valuation of investors. The essence of this measure plausibly keeps up with many financial indicators widely used in financial research, such as the ratios of BM, EP, and cash flows to price that embed the stock price information.

The economic interpretations of two R&D intensity measures

Methodology

1. Follow Chan and Chen (1991) to derive the size-adjusted portfolio returns.

2. Follow Carhart (1997) to derive the abnormal returns.

The four-factor model is explicitly defined as:

where ap is the intercept term of the regression or so-called t

he abnormal return of portfolio p after controlling for the risks mimicked by MOM, SMB, and HML.

tptMOMptHMLptSMBptMktpptftp MOMpHMLhSMBsMKTbaRR ,,,,,,,

Preliminary results (Table 1)

1. There is a remarkable upward trend in the aggregate R&D intensity.

2. Compared to those in other countries, R&D intensity in Taiwan was low but grew strongly.

3. Firms in the Electronics industry are enthusiastic in R&D activities.

4. The two measures of R&D intensity, R&D/Sales and R&D/ME, may be very different in essence.

5. Given the high correlation coefficient between R&D/ME and BM as well as size, we expect that R&D/ME is able to predict future returns than R&D/Sales.

Table 1: Descriptive Statistics of R&D intensity

Panel A: Aggregate R&D intensity Year Number of firms

with positive R&D expenditures

R&D/Sales×10 R&D/ME×10 R&D/GDP×10

1987 48 0.044 0.022 0.114 1988 59 0.057 0.019 0.124 1989 63 0.063 0.013 0.139 1990 79 0.074 0.036 0.166 1991 98 0.086 0.037 0.170 1992 121 0.094 0.055 0.178 1993 140 0.097 0.039 0.175 1994 155 0.112 0.042 0.177 1995 187 0.136 0.082 0.178 1996 175 0.181 0.086 0.180 1997 194 0.215 0.076 0.188 1998 230 0.223 0.093 0.197 1999 280 0.224 0.062 0.205 2000 307 0.241 0.137 0.210

Table 1: Descriptive Statistics of R&D intensity (cont.)

Panel B: Industrial R&D intensity in year 2000 Code Industries Number of firms

with positive R&D expenditures

R&D/Sales×10 R&D/ME×10

2200 Automobile 3 0.386 0.602 2300 Electronic 157 0.293 0.142 9900 Other 16 0.232 0.180 1700 Chemical 17 0.231 0.245 2100 Rubber 5 0.211 0.134 1500 Electric Machinery 22 0.208 0.192 1800 Glass Ceramics 5 0.192 0.258 1600 Appliance Cable 12 0.088 0.061 2000 Steel Iron 8 0.075 0.052 1300 Plastics 11 0.060 0.032 2600 Transportation 1 0.057 0.047 1400 Textiles 28 0.056 0.099 1200 Food 11 0.050 0.043 2900 Tourism 2 0.044 0.222 1900 Paper Pulp 4 0.044 0.073 2500 Construction 4 0.021 0.056 1100 Cement 1 0.001 0.007

Panel C: Covariance coefficient

R&D/Sales R&D/ME BM Size R&D/Sales 1.000 0.415 -0.070 0.047 R&D/ME 1.000 -0.281 0.403

BM 1.000 -0.392 Size 1.000

The findings based on R&D/Sales (Table 2)

1. The returns before formation generally increase with respect to the R&D/Sales .

2. The returns after formation monotonically are increasing with R&D/Sales.

3. The zero-cost portfolio returns reported in the last column in years 1, 2, and 3 after formation get enlarged over time and are 0.77%, 0.99%, and 0.73%, with t-value = 1.49, 1.87, and 1.33, respectively.

4. These observations indicate that firms having invested more on R&D are not only the prior winners but also the future winners, and the spread between the portfolio returns with the highest and lowest R&D intensity widens.

5. There is a pronounced difference between the returns on stocks with highest R&D/Sales and stocks without R&D expenditures.

6. The results above are inconsistent with Lakonishok, Shleifer, and Vishny (1994) and Chan, Lakonishok and Sougiannis (2001).

7. The evidence suggests that firms that the return spread between firms with different levels of R&D intensity is not caused by size effect.

8. Investors undervalue the R&D-intensive firms and overvalue the non-R&D-intensive firms.

9. These preliminary results seem to support mispricing hypothesis that the market could not correctly values the future benefits from the R&D spending.

The findings of portfolios based on R&D/Sales (cont.)

Table 2: Monthly returns (%) and characteristics of portfolios based on R&D/Sales

0 (No R&D) 1 (Low) 2 3 4 5 (High) High-Low

Panel A：Returns（%）

2.44 25.42 ** 28.51 *** 26.77 *** 33.53*** 41.33*** 13.80*** Avg. yearly return over the three years before formation 0.32 (2.42) (2.95) (4.09) (4.26) (4.63) (3.50)

1.97* 1.60 1.94** 1.83* 2.19** 3.05*** 1.45*** Avg. monthly return over the one year before formation (1.87) (1.57) (2.03) (1.93) (2.18) (2.89) (3.00)

1.30 1.00 1.01 1.14 1.34 1.77* 0.77 Avg. monthly return over the first year after formation (1.27) (1.01) (1.08) (1.22) (1.42) (1.73) (1.49)

0.51 0.36 0.44 0.38 0.79 1.35 0.99* Avg. monthly return over the second year after formation (0.52) (0.38) (0.47) (0.44) (0.84) (1.40) (1.87) 0.13 0.66 0.77 0.63 1.26 1.39 0.73 Avg. monthly return over the third year after formation (0.13) (0.69) (0.81) (0.71) (1.34) (1.49) (1.33)

Panel B：Size-adjusted returns（%）

-0.12 -0.16 -0.14 0.10 0.21 0.69** 0.85* Avg. monthly return over the first year after formation (-0.92) (-0.66) (-0.73) (0.39) (0.73) (1.97) (1.74)

-0.20 -0.28 -0.00 -0.10 0.32 0.80** 1.09** Avg. monthly return over the second year after formation (-1.40) (-1.15) (-0.02) (-0.37) (1.17) (2.34) (2.21)

-0.24 -0.22 -0.14 -0.06 0.47 0.58* 0.80 Avg. monthly return over the third year after formation (-1.44) (-0.76) (-0.57) (-0.21) (1.68) (1.74) (1.60)

Table 2: Monthly returns (%) and characteristics of portfolios based on R&D/Sales (cont.)

0 (No R&D) 1 (Low) 2 3 4 5 (High) High-Low

Panel C：Characteristics

First year after formation Number of firrms 113 30 30 30 30 31 - R&D/Sales 0.000 0.001 0.005 0.011 0.019 0.053 0.052 BM 0.811 0.825 0.621 0.602 0.554 0.432 -0.393 Log (Size) 8.515 8.868 8.891 8.973 8.931 9.033 0.164 Earnings/Price -0.032 -0.005 0.026 0.002 0.003 0.034 0.038

Second year after formation R&D/Sales 0.000 0.002 0.005 0.010 0.019 0.048 0.046 BM 0.832 0.867 0.727 0.623 0.579 0.454 -0.412 Log (Size) 8.911 8.963 8.895 9.064 9.079 9.170 0.208 Earnings/Price -0.037 -0.002 0.003 -0.001 -0.007 0.029 0.031

Third year after formation R&D/Sales 0.000 0.002 0.005 0.010 0.018 0.044 0.042 BM 0.888 0.938 0.814 0.666 0.598 0.451 -0.487 Log (Size) 8.934 9.017 8.903 9.103 9.178 9.337 0.319 Earnings/Price -0.048 -0.016 -0.047 0.004 0.008 0.003 0.019

1. The relationship between returns and R&D/ME are much stronger than between returns and R&D/SALES.

2. The mispricing of stocks not only exists but also is persistent.

3. Size effect cannot explain the anomaly.

4. It is obvious that mispricing phenomenon is even stronger using R&D/ME as the measure of the R&D intensity than using R&D/Sales.

The findings based on R&D/ME (Table 3)

Table 3: Monthly returns (%) and characteristics of portfolios based on R&D/ME

0 (No R&D) 1 (Low) 2 3 4 5 (High) High－Low

Panel A：Returns（%） 2.44 29.66*** 31.42*** 30.15*** 30.79*** 32.77*** 1.94 Avg. yearly return over the

three years before formation 0.32 (3.15) (3.59) (3.77) (3.89) (3.51) (0.91) 1.97* 1.83* 2.13** 1.79** 2.55*** 2.37** 0.53 Avg. monthly return over the

one year before formation (1.87) (1.82) (2.16) (1.96) (2.59) (2.18) (1.22) 1.30 0.75 0.96 1.15 1.29 2.11** 1.35*** Avg. monthly return over the

first year after formation (1.27) (0.79) (1.00) (1.27) (1.38) (2.04) (3.09)

0.51 0.13 0.14 0.61 0.76 1.61* 1.48*** Avg. monthly return over the

second year after formation (0.52) (0.15) (0.16) (0.70) (0.81) (1.65) (2.96)

0.13 0.64 0.44 0.85 0.89 1.83* 1.18** Avg. monthly return over the

third year after formation (0.13) (0.67) (0.50) (0.95) (0.99) (1.85) (2.06)

Panel B：Size-adjusted returns（%） -0.12 -0.37 -0.08 0.08 0.08 0.98*** 1.36*** Avg. monthly return over the

first year after formation (-0.92) (-1.82) (-0.37) (0.36) (0.28) (2.87) (3.03)

-0.20 -0.38 -0.32 0.15 0.19 1.04*** 1.43*** Avg. monthly return over the

second year after formation (-1.40) (-1.55) (-1.49) (0.65) (0.71) (2.83) (2.73)

-0.24 -0.15 -0.36 0.09 0.01 0.98** 1.13** Avg. monthly return over the

third year after formation (-1.44) (-0.50) (-1.42) (0.40) (0.07) (2.50) (2.03)

Table 3: Monthly returns (%) and characteristics of portfolios based on R&D/ME (cont.)

0 (No R&D) 1 (Low) 2 3 4 5 (High) High－Low

Panel C：Characteristics First year after formation

Number of firrms 113 30 30 30 30 31 - R&D/ME 0.000 0.001 0.003 0.007 0.013 0.031 0.030 BM 0.811 0.620 0.585 0.596 0.549 0.665 0.045 log (Size) 8.515 9.229 9.065 8.941 8.885 8.606 -0.623 Earnings/Price -0.032 0.017 0.030 0.018 0.026 -0.027 -0.044

Second year after formation R&D/ME 0.000 0.001 0.004 0.007 0.014 0.028 0.027 BM 0.832 0.768 0.659 0.576 0.592 0.619 -0.149 log (Size) 8.911 9.245 9.081 9.065 9.014 8.842 -0.403 Earnings/Price -0.037 0.004 0.004 0.019 0.020 -0.021 -0.025

Third year after formation R&D/ME 0.000 0.002 0.006 0.008 0.015 0.025 0.023 BM 0.888 0.843 0.808 0.643 0.611 0.530 -0.313 log (Size) 8.934 9.178 9.041 9.117 9.122 9.150 -0.028 Earnings/Price -0.048 -0.014 -0.054 0.020 0.849 0.014 0.028

Abnormal returns (Table 4)

1. The four-factor model works rather well for R&D/Sales-based portfolio returns, but not for R&D/ME-based portfolio returns.

2. All results provide further evidence that mispricing does exist and persist, especially when applying R&D/ME as the measure of R&D intensity.

3. The relatively low adjusted R2’s of the regressions on the R&D-intensive portfolio returns support that the uncertainty associated with the R&D activities cannot be captured by the four well-known factors.

Table 4: Abnormal returns

Year after formation Year 1 Year 2 Year 3

Portfolio a t(a) Adj. R2 a t(a) Adj. R2 a t(a) Adj. R2 Panel A：Abnormal return based on R&D/Sales 1 (Low) -0.42 -1.59 93.20% -0.37 -1.33 91.35% -0.22 -0.71 89.48% 2 -0.24 -0.86 91.01% -0.26 -1.01 92.16% -0.15 -0.50 89.23% 3 0.02 0.05 87.43% -0.05 -0.18 87.28% -0.02 -0.05 86.17% 4 0.20 0.56 85.34% 0.28 0.81 85.74% 0.53 1.39 83.71% 5 (High) 0.59 1.53 86.30% 0.85** 2.25 85.08% 0.63* 1.69 83.80% High-Low 0.57 1.36 36.60% 0.78** 1.97 44.46% 0.43 1.10 48.31% Panel B：Abnormal return based on R&D/ME 1 (Low) -0.59** -2.46 93.96% -0.55** -2.20 92.85% -0.22 -0.67 88.65% 2 -0.32 -1.04 90.27% -0.47 -1.58 89.43% -0.36 -1.19 88.54% 3 -0.01 -0.06 89.83% 0.05 0.18 89.50% 0.12 0.40 88.34% 4 0.16 0.47 85.84% 0.25 0.72 86.20% 0.09 0.29 86.91% 5 (High) 0.91** 2.20 84.53% 1.13** 2.82 83.82% 1.07** 2.43 80.34% High-Low 1.06** 2.44 5.37% 1.24*** 2.99 32.20% 0.87* 1.91 37.65%

Explanatory power of the R&D intensity in stock returns

• To investigate the relationship between stock returns and competing characteristics such as firm size, BM, R&D/Sales, and R&D/ME, we employ the following empirical model the estimate the stock returns:

,)/&ln(

)/&ln()/ln()ln(

...4

..3..2..1.0..

titit

tittittitttfti

MEDRb

SALESDRbMEBEbMEbbRR

The results (Table 5)

1. Consistent with the results of Chan et al. (1998) and Chui and Wei (1997), no evidence of the BM effect exists in Taiwan stock market.

2. The explanatory power of the R&D intensity measured by R&D/ME is stronger than that measured by R&D/Sales.

3. The result suggests that, in Taiwan stock market, the R&D intensity may be more informative than firm size and BM.

Table 5: Average coefficients of the regression results of stock returns on ln(ME), ln(BM), ln(R&D/SALES), and ln(R&D/ME)

Model Statistics C ln(ME) ln(BM) ln(R&D/Sales) ln(R&D/ME) (1) Mean 5.51 -0.45* t-ratio (1.91) (-1.77) (2) Mean 0.95 0.08 t-ratio (0.86) (0.14) (3) Mean 2.00* 0.15 t-ratio (1.86) (1.39) (4) Mean 2.53** 0.24*** t-ratio (2.38) (2.73) (5) Mean 4.55* -0.39* 0.09 t-ratio (1.73) (-1.71) (0.17) (6) Mean 5.28** -0.34 0.40 0.16 t-ratio (2.03) (-1.47) (0.71) (1.50) (7) Mean 5.26** -0.32 0.10 0.22*** t-ratio (2.05) (-1.38) (0.21) (2.58)

Figure 1: Cumulative returns on the market index, Electronic index, and zero-cost portfolios from July 1988 to June 2002

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TAIEX

Electronic index

Zero-cost portfolio based on R&D/Sales

Zero-cost portfolio based on R&D/ME

Zero-cost portfolio based on Size

Table 8: Returns and characteristics of portfolios based on R&D/ME in the Electronic industry and non-Electronic industries

Electronic Industry Non-Electronic industries 1 (Low) 2 3 (High) High-Low 1 (Low) 2 3 4 5 (High) High-Low Monthly return 1.52 1.90 2.65** 1.13** 0.82 0.72 0.91 0.76 1.43 0.61* t-ratio (1.36) (1.60) (2.14) (2.36) (0.86) (0.74) (1.02) (0.87) (1.54) (1.82)

R&D/ME 0.005 0.015 0.038 0.033 0.000 0.002 0.004 0.008 0.022 0.022 BM 0.423 0.420 0.652 0.229 0.628 0.670 0.634 0.671 0.684 0.056 ln (ME) 9.421 9.161 8.628 -0.793 9.233 8.876 8.863 8.832 8.644 -0.589

Table 9: Average coefficients of regressions of stock returns on ln(ME), ln(BM), and ln(R&D/ME) for all firms, firms in the Electronic industry, and firms in non-Electronic industries before and after 07/1996

Model Statistic. C ln(ME) ln(BM) ln(R&D/ME) C ln(ME) ln(BM) ln(R&D/ME) C ln(ME) ln(BM) ln(R&D/ME) Panel A: All firms Panel B: Firms in the electronics industry Panel C: Firms in non-electronics industries From 07/1988 to 06/1996 From 07/1992 to 06/1996 From 07/1988 to 06/1996 [1] Mean 5.77 -0.44 0.60 -3.77 0.86 2.20** 4.92 -0.36 0.52 t-ratio (1.38) (-1.20) (0.73) (-0.65) (1.16) (2.05) (1.16) (0.97) (0.63) [2] Mean 5.45 -0.38 0.69 -0.00 -3.32 0.88 1.99* 0.12 4.81 -0.34 0.60 -0.02 t-ratio (1.33) (-1.05) (0.84) (-0.04) (-0.59) (1.19) (1.89) (0.44) (1.17) (-0.92) (0.73) (-0.34) From 07/1996 to 06/2002 From 07/1996 to 06/2002 From 07/1996 to 06/2002 [1] Mean 2.92 -0.33 -0.57 3.76 -0.13 0.42 4.25 -0.48** 0.61 t-ratio (1.16) (-1.46) (-0.72) (1.10) (-0.42) (0.49) (1.80) (-2.32) (0.92) [2] Mean 5.02 -0.23 -0.33 0.52*** 5.23 -0.10 0.04 0.45** 4.91 -0.42** 0.62 0.23** t-ratio (2.00) (-0.99) (0.42) (3.04) (1.47) (-0.34) (0.05) (2.19) (2.09) (-2.03) (0.90) (1.98)