A Portfolio Framework For R&D Investments

After our recent call, we received an insightful question about how we view research and development (R&D) because surely not all R&D is productive and profitable? While there is always the chance that an individual R&D project may fail, we believe, based on the leading academic research on innovative accounting, that R&D should be viewed from a portfolio perspective and not on the basis of individual projects. Let us explain below but first let’s briefly look at the historical accounting treatment of R&D to add context to the framework we use.

R&D activities are first mentioned in accounting literature in 1917 by the Federal Reserve Board in a Federal Reserve Bulletin. At this time, the Federal Reserve Board declared that R&D should be categorized as a deferred charged in published financial statements. This is another way of saying R&D expenses should be capitalized and recorded on the balance sheet. We follow this treatment of R&D in our intangible-adjusted financial statements. This capitalization view held for four decades and was supported by a wide variety of financial institutions such as the National Association of Cost Accountants, the Internal Revenue Service and again by the Federal Reserve Board. In the mid-1950s, the IRS modified its stance and allowed companies to, in effect, keep two sets of books. One book for internal purposes, wherein most companies capitalized R&D, and another for tax purposes, wherein most companies expensed R&D in order to lower their taxable income.  It is believed that the IRS took this approach in order to spur investment after WW2. This “dual book” system lasted for two decades and it wasn’t until 1974 that the Financial Accounting Standards Board (FASB) enacted Statement of Financial Accounting Standards (SFAS) No. 2 which stated that a direct write-off of R&D expenses was mandated. At this point, companies could no longer choose how they wanted to treat R&D and had to expense all R&D expenses as they were incurred. The great irony here is this rule was put into effect just a few years after the start of the greatest technologically innovative period in the history of humankind. Corporations for the past four decades have undertaken more R&D than in any other period in human history, however, SFAS No. 2 completely obfuscated those corporate innovative activities from investors. This is one of the primary reasons why the Knowledge Effect exists. 
Before changing the rule in the 1974, FASB actually considered four different methods of accounting for R&D. They considered: 1) charging all costs when incurred 2) capitalizing all costs when incurred 3) capitalizing some costs when incurred if those costs met certain specified conditions, and 4) accumuling all costs in a special category until the future benefits could be determined. In the end, FASB took the most conservative approach and declared all R&D expenditures must be immediately expensed. This is where our view, as well as leading academic views, of R&D considerably differs from FASB. FASB took a very myopic view in determining whether or not the future benefits of R&D could be determined, and consequently, be capitalized as an asset on a company’s balance sheet. They were concerned with the riskiness of individual R&D projects and worried individual projects had a high rate of failure. However, they overlooked that a portfolio of R&D projects can have a much lower aggregate level of risk than an individual project has. On a collective basis, an individual R&D project can offset a portion of another R&D project’s risk because of the benefits of diversification and because knowledge creation creates many beneficial spillover effects. As professionals in the investment community, our readers are well versed on this interaction between risky endeavors as this is one of the bedrock principles of modern portfolio theory. Diversification produces a lower level of overall risk for a portfolio than individual assets can produce. This holds as much for a portfolio of stocks as it does for a portfolio of R&D projects.  Also large, modern corporations indeed view R&D from a portfolio perspective, not on an ad-hoc, individual basis. R&D for companies that follow an innovation strategy, such as those that we define as Knowledge Leaders, is part of an organizational strategy. As such, companies do not put all of their innovative eggs in one basket or one project. A portfolio perspective on R&D, accompanied with the capitalization of innovative investments, gives investors the clearest picture available of the unique capital stock that drives future profits for a corporation.