Upgrading the capital markets operating System: Introducing R&D efficiency

Bringing the current market OS into focus

The short term nature of the capital markets has had a long-term effect on the economy. According to a comprehensive McKinsey study, if all U.S. publicly listed firms operated like their long-term counterparts, the economy would have created more than five million additional jobs and generated an additional $1 trillion in gross domestic product in the 14 years that ended in 2015.¹

If this is the case, it would seem rational for all market participants to do everything possible to unlock such a substantial amount of potential value. However, like virtually all operating systems, whatever is positioned at the center of a system defines the incentives and logic which determine what is, and isn’t, compatible with the system.

Last year, we identified six events primarily responsible for gradually supplanting long-term companies from the center of our capital markets operating system. Long-term companies were replaced by market participants with business practices driven by short-term incentives. For example, most hedge funds compensate themselves monthly or quarterly. Given this structure, these funds are incentivized to maximize their compensation through short-term trading gains. The rise of shareholder activism and the historical shift toward providing quarterly guidance — now the norm — provides further evidence of the shift to a short-term focus in our capital market system.

We are at a crossroads

The public markets were designed to support long-term companies to innovate and produce goods and services in a sustainable manner. The public markets were meant to encourage healthy competition so that the best ideas, and execution of those ideas, could thrive and enhance shareholder value. A long-term sustainable operating system represents a simple core value that requires alignment between long-term minded companies and long-term investors.

Today, the public markets are inverted. Most companies are pressured to shape their business practices to serve a short-term based incentive system.

There is, “hard evidence that short-termism genuinely detracts from company performance and economic growth has remained scarce.”²

The public market OS needs an upgrade

Over the past few years, there has been increased momentum for companies to evolve toward the concept of stakeholder capitalism. This movement represents a challenge to our current capital markets system for the following reasons:

• A market operating system, whose rational norms are driven by short-termism, will logically resist real or perceived threats to those norms. It will cast judgments and criticisms on ESG initiatives based on those “norms.”
• ESG was created to function as a framework to organize broadly disparate terms under one unified umbrella. Moreover, ESG was intended to reflect sustainability practices, however in its current form, the commercialization of ESG has meaningfully deviated from its intended application.
• The current version of ESG has been commercialized and mis-used by some major market participants — often becoming opportunistic and short-term in nature.
• The next step in the journey toward a more sustainable form of capitalism is for ESG to be more constructively framed through a lens of impact and long-term sustainability — which integrates traditional measures of financial performance.

Sustainable Capitalism: The new capital market OS

If we are going to make the next, and urgently needed, version of sustainable capitalism a reality, we must develop a common Sustainability Taxonomy. LTSE’s most recent comment letter to the SEC emphasized the need for a Sustainability Taxonomy that establishes definitions and activities that can be categorized as sustainable business practices.

Capitalism is and will continue to be an ongoing experiment. We now know that the quarterly version of our capitalist experiment is not optimal to maximize long-term value creation. Where do we go from here?

We think it’s best to start with a focus on traditional measures of financial analysis that are indicators of long-term sustainable performance, such as Research & Development (R&D).

Back to Basics: Introducing R&D efficiency

A company’s investment in R&D is, by its very nature, long-term. However, companies readily admit to short-changing investments in R&D in order to meet quarterly Wall Street expectations.

According to a comprehensive academic survey, eighty percent of CFO’s say they would cancel or postpone long-term investments in order to meet quarterly estimates.³

LTSE analyzed R&D spend⁴ across a cohort of public software companies. We chose to use the software sector in this analysis for two reasons. First, this sector has a very tight cycle time between its R&D initiatives and the impact such initiatives have on driving revenue growth. Second, since the cycle time from investment to revenue growth is tight, it is a good barometer for a market with a short-term attention span. Additionally, we developed a new metric called R&D Efficiency to analyze R&D spend over time.

R&D Efficiency is simply the return on R&D investments based on revenue growth:

An R&D Efficiency ratio above 1.0 means the company’s R&D spend had a positive return and a ratio below 1.0 means a negative return. We applied this metric to a cohort study of public companies.

R&D efficiency analysis

We analyzed 54 software companies⁵ that went public between 2009 and 2014 to understand the relationship between long-term performance and R&D Efficiency. Our findings are particularly relevant to the current market environment since these IPOs overlapped with the Great Recession.⁶ We measured long-term performance using long-term investor value appropriation (LIVA). LIVA⁷ quantifies the value created or destroyed for investors over a specified period of time. In our analysis, we defined long-term to be the five calendar years after the year the company went public.

We used LIVA as it allows for an over time analysis versus traditional performance metrics, like Total Shareholder Return, that only focus on one-year performance.

Our analysis showed a striking divergence between the companies that created and destroyed the most value. The top quartile⁸ of companies — those that created the most value — created over $76B of value over the course of five years, while the bottom quartile⁹ destroyed $34B of value.

We found that long-term performance is driven by strategic R&D spend, as evidenced by an R&D Efficiency above 1.0x. Strategic R&D spend resulted in greater than 20% revenue growth, gross margin expansion, and reduced trading volatility for the top quartile of companies from a LIVA perspective.

Oftentimes, traditional financial analysis emphasizes R&D as a percent of revenue, assuming higher spend will result in higher revenue growth. We found that the amount that a company spends on R&D is less important than the return on that spend.

This is a critical insight because R&D Efficiency informs management and investors as to the judgment associated with the selection and execution of R&D initiatives. Poor selection and execution would result in poor R&D Efficiency. As a result, R&D Efficiency may also be a leading indicator for a company’s long-term sustainability practices — with an emphasis on employee satisfaction and process (i.e., the Social and Governance components of ESG). We hypothesize that companies with strong R&D Efficiency have strong long-term sustainability practices — focused on excellence — supporting that efficiency. This is a metric that investors, senior management, existing employees, and potential employees should monitor as it is one that reflects the integration between traditional financial analysis and long-term sustainability practices.

The charts below show how, over time, consistent and smart spending on R&D in the top quartile resulted in a high R&D Efficiency Ratio, while the bottom quartile chose to cut R&D spend once revenue growth slowed.

The divergence between the top and bottom quartile of companies can be seen in other financial metrics as well. Gross, EBITDA, and Net Income Margins showed the top quartile focused on a high revenue growth strategy, while the bottom quartile pivoted to profitability when R&D was inefficient.

As a result of these divergent strategies, the markets reacted predictably for the top and bottom quartile of companies. The top quartile of companies were categorized as high growth stocks, while the bottom quartile became value stocks. Over the course of the five years, the median share price appreciated 363% for the top quartile, while the bottom quartile depreciated 53%. Additionally, the bottom quartile had 30% higher 250D volatility at the end of the analysis period.

The relationship between R&D efficiency and ESG capital

For software companies, R&D spend is primarily a human capital investment and process (i.e., the S & G in ESG). The ability to attract and retain top engineering, product and design talent is paramount to the success of these companies. Given the voluntary nature and lack of standardization with respect to ESG disclosures, we could not analyze human capital disclosures and processes to understand their interplay with R&D. However, R&D Efficiency may be the most objective measurement available of a company’s commitment to human capital.

To gain some initial validation for our hypothesis that strong R&D Efficiency companies have strong sustainability practices, we calculated the amount of ESG Capital (ESG Integrated Funds, ESG-Focused Funds and Impact Funds) invested across those companies in our analysis who still remain public today. We believe the amount of ESG Capital may be a good near-term proxy until we have more data to isolate the correlation or causation between R&D Efficiency and Human Capital Practices.

We found the top quartile — comprising eleven companies — has, on average, 27x more ESG Capital than the bottom quartile — comprising six companies.¹⁰ In other words, companies that are long-term oriented, as measured by strong R&D Efficiency, are likely sustainable in nature.

Integrating sustainability with traditional financial analysis

At the Long-Term Stock Exchange, we've created a new playbook for Sustainable Capitalism that integrates sustainability practices with traditional financial analysis. We've created an environment where companies that perform over the long-term and investors that are aligned with these companies are the rule — not the exception.

Our R&D Efficiency Analysis is a prototype for how one aspect of traditional financial analysis is a reflection of sustainability — in this case, human capital development — in long-term companies. For different industries and sectors, there will be a number of tailored factors that reflect sustainability.

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Sources

1. Barton, Dominic, Malyuik, James, Koller, Tim, Patter, Robert, Godsall, Jonathan and Zotter, Josh,“Where companies with a long-term view outperform their peers.”, McKinsey Global Institute (February 8, 2017) at page 3 ,https://www.mckinsey.com/featured-insights/long-term-capitalism/where-companies-with-a-long-term-view-outperform-their-peers

2. Barton, Dominic, Malyuik, James, Koller, Tim, Patter, Robert, Godsall, Jonathan and Zotter, Josh,“Measuring the Economic Impact of Short-termism”, Discussion Paper, McKinsey Global Institute (February 8, 2017) at page 1, https://www.mckinsey.com/featured-insights/long-term-capitalism/where-companies-with-a-long-term-view-outperform-their-peers

3. Graham, John R., Campbell, R. Harvey, and Rajgopal, Shiva, “ Value Destruction and Financial Reporting Decisions” (September 6,2006), augmenting “The Economic Implications of Corporate Financial Reporting” Journal of Accounting and Economics (2005), https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/12924/Rajgopal_value.pdf

4. R&D spend includes Capital Expenditures. For software companies, Capital Expenditures typically include internal software development costs or costs related to developing new products that arise from R&D; these costs usually create benefits for companies that last longer than a year. As a result, we’ve included Capital Expenditures to capture the full extent of R&D efforts.

5. Companies include: LogMeIn, Medidata Solutions, Broadsoft, RealPage, Envestnet, Intralinks, Qlik Technologies, SciQuest, Telenav, Angi, Carbonite, CornerStone OnDemand, Imperva, Jive, Pandora, ServiceSource, Zynga, BrightCove, EPAM, Guidewire Software, Proofpoint, Qualys, ServiceNow, Shutterstock, Splunk, Synacor, Workday, Yelp, BenefitFocus, ChannelAdvisor, Endurance International Group, Mandiant, Marin Software, Model N, Professional Diversity Network, RingCentral, Tableau, Veeva, 2U, Castlight Health, Five9, Hubspot, CareCloud, MobileIron, New Relic, Paycom, Paylocity, Q2, Sabre, Truecar, Upland Software, Varonis Systems, Workiva, Zendesk

Note: Facebook and Twitter have been excluded in this analysis as they were outliers from a LIVA perspective. Facebook created ~$293B in value, while Twitter destroyed ~$36B.

6. The Great Recession was an 18 month period spanning December 2007 through June 2009 which resulted from the collapse of the housing market and devastated global financial markets. It was marked by a loss of more than $2.0 trillion in economic growth globally.

7. Wibbens, PD, Siggelkow, N. Introducing LIVA to measure long-term firm performance. Strat. Mgmt. J. 2020; 41: 867– 890. https://doi.org/10.1002/smj.3114

8. Companies include: Medidata Solutions, EPAM, Proofpoint, ServiceNow, Shutterstock, Splunk, RingCentral, Veeva, Five9, Hubspot, Paycom, Paylocity, and Zendesk

9. Companies include: RealPage, Qlik, Angi, Jive, ServiceSource, Zynga, Yelp, BenefitFocus, ChannelAdvisor, Endurance International Group, Mandiant, Sabre, Truecar

10. LTSE uses a proprietary data-set and methodology to estimate the amount of long-term ESG capital allocated to the 17 companies making up the top and bottom quartiles of our analysis

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