Research Quotient, Optimal R&D and Stock Returns

Abstract

We find that the stock market appears to mis-value the innovative activity of firms which are currently investing in R&D above its optimal value. A long-short portfolio strategy which exploits information on the firm’s innovative ability and R&D level is profitable only for firms that overspend in R&D, in particular it earns excess returns of 14% annually. However, applying the strategy to the entire sample of firms may reduce portfolio risk. The analysis of the level of volatility of future stock returns of overspending firms suggests that limited attention and the higher risk of these firms contribute to the effect.

Keywords: optimal R&D, innovative ability, limited attention, return predictability, market efficiency

JEL Classification: G12, G14, O32