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School of Business | Department of Finance | Finance | 2013
Thesis number: 13384
What explains the association between R&D increases and excess stock returns?
Author: Ilvonen, Joonas
Title: What explains the association between R&D increases and excess stock returns?
Year: 2013  Language: eng
Department: Department of Finance
Academic subject: Finance
Index terms: rahoitus; financing; menot; expenditure; monialayritykset; conglomerate companies; asenteet; attitudes
Pages: 62
Key terms: research and development; excess stock returns; diversification discount

It seems sensible to assume that technological innovation has a positive association with stock market returns. Indeed, Hsu (2009) finds R&D shocks to hold positive and distinct predictive power for U.S. market returns, a pattern also found in international data. However, the association between R&D and excess stock returns is more nuanced in a firm-specific framework. The same consensus view still holds - increased R&D is associated with excess returns - but there is an unsolved debate regarding the cause of this observation. Some authors suggest the excess returns are due to the mispricing of R&D by investors, while others argue for risk-based compensation. My study's novelty is to include a control group of matched firms that have not significantly increased R&D, allowing me to examine the potential differences in performance between firms that have significantly increased R&D and those that have not. I also test if increased R&D is more valuable for diversified than for single-segment firms, as inadequate R&D is a potent cause for diversification discount.

Borrowing the methodology from Eberhart et al. (2004), my sample includes 348 public U.S. companies, each matched with a benchmark firm. I use the period 1974-2006 for identifying significant R&D increases in NYSE listed companies, as 1974 is the year when accounting treatment of R&D expense reporting is standardized. Consequently I have chosen a sample containing 5 years of operating and stock performance data for each sample firm. I retrieve the fundamental data from COMPUSTAT and data on stock returns from CRSP.

I find R&D increases to be positively associated with excess stock returns, while my results also suggest increased R&D not to be the actual source of excess returns, as a control group of firms that have not increased their R&D experience similar excess returns than those firms that have. Moreover, following their R&D increases, single-segment firms experience higher excess returns than diversified firms. The diversified firms' benchmark firms that have not increased R&D earn higher excess returns, while the single-segment firms' matched firms slightly underperform. These findings propose that there is an industry-specific factor driving the excess stock returns during the time periods when a firm operating in a certain industry significantly increases R&D. This notion is consistent with earlier literature suggesting an extra risk factor associated with R&D not captured by the traditional factor models. Furthermore, the outperformance of single-segment firms over diversified firms could be due to financial constraints that drive the risk and return relation. My findings on the financing behavior of single-segment firms support this explanation, as single-segment firms are more likely to substitute debt for equity than diversified firms.
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