Profitability, R&D Investments and the Cross-Section of Stock Returns

Abstract

In this paper, after controlling for the level of R&D expenditures, I find that profitability of R&D intensive firms is more important for subsequent returns than the R&D intensity (measured with R&D-to-market value or R&D-to-assets) and past performance. In a sample of firms where I am able to compute abnormal returns around quarterly earnings announcements R&D-to-market value variable becomes insignificant even when not controlling for the firm’s profitability. Since quarterly profits are reported by big firms this suggests that R&D anomaly is driven by small stocks. Big firms with high R&D-to-market value earn lower not higher subsequent returns, once I control for the level of R&D expenditures and firm’s profitability. The previously recorded anomaly, namely that R&D intensive firms earn positive abnormal returns, seems to be driven by the level of R&D investment, its profitability and small stocks.

Keywords: cross-section of stock returns, R&D expenditures, profitability, small stocks, five-factor asset pricing model, earnings momentum, Fama MacBeth regression

JEL Classification: G12