Research and development (R&D) is a major contributor to technological progress and economic well-being. From the standpoint of the individual firm, R&D is a key aspect of doing business and a determinant of long-term growth. In the U.S., R&D intensive firms enjoy higher market valuations and greater stock returns than their peers. HKUST researcher Shiheng Wang and colleagues set out to examine whether this relationship holds internationally.

Using data from 21 countries, the researchers ask whether the connection between R&D and returns observed in the U.S. “is driven by risk premium or behavioral biases,” i.e., mispricing. This, they write, “remains an important issue under debate and calls for further analyses.”

R&D is risky because of the “growth options” it creates, which may expose firms to “unspecified systematic risk factors.” Mispricing may be the result of investor pessimism about the value of R&D, leading to excessive discounting of future cash flows, or of “market frictions,” such as bans on short selling, information lags or other financial constraints that prevent investors from assigning a correct valuation.

The authors examine the effect of intangible assets and technological innovation on returns––the “R&D effect”––from several angles. Different countries have different institutional arrangements, which “enables us to analyze whether the R&D effect can be explained by particular country characteristics,” the researchers write. As well as providing a better understanding of the causation of the R&D effect. As the finance literature lacks asset pricing tests across countries, the “investigation thus fills this gap,” they note.

Using stock return data from July 1981 to June 2018, the researchers ask whether the R&D effect is focused on large companies. “We find that the R&D effect is not concentrated in smaller or larger firms,” they conclude. “Controlling for size does not erode the R&D effect.”

The authors also carry out a series of tests to investigate the role of cross-country variations in returns––which they find are “substantial”––in the R&D effect, and whether these disparities reflect risk premium or mispricing. The tests focus on the extent to which countries value the growth options generated by R&D and whether the R&D effect correlates with market frictions. “Our country-level analyses support that the R&D effect is attributable to risk premium rather than mispricing,” they write.

The researchers also examine the relationship between firms’ R&D intensity and operating performance, return volatility, and probability of default. The results “indicate that R&D-intensive firms are associated with higher future operating performance, return volatility, and default likelihood,” they write. “All these results collectively support that the R&D effect is closely related to the risk premium.”

The study contributes to the literature by extending “studies of asset pricing anomalies to an international setting,” supporting prior findings in the U.S. with evidence from a new sample. “We present both country- and firm-level evidence supporting a risk-based explanation for our findings,” conclude the authors. “R&D investments increase firms’ growth options and thus lead to higher expected stock returns as growth options are risky.”