Does the stock market put pressure on companies to reduce R&D?

The field of finance used to be very dogmatic regarding the efficiency of financial markets. Kuhn (The Structure of Scientific Revolutions) said that new paradigms only surface when the older generation of researchers die. The generation of arrogant, efficient-market fundamentalists in finance is now largely gone. Younger researchers document many interesting phenomena. There is not yet a new paradigm, though. This post looks at how companies' R&D effort change when they are subject to stock market pressure.




Study 1. Quality of patents after IPO. Shai Bernstein compared patenting activity of firms that made an IPO with firms intending to make an IPO, but aborted the effort in the last minute due to the NASDAQ index falling substantially. It is often difficult to have a control group that is fully comparable; there might always be some underlying characteristic making the control group different. I think such worries are put to rest by the clever research design.

If we take patent citations as a proxy for the quality of innovative effort, it went down 44% after the IPO. The effect started two years after the IPO. Furthermore, more inventors left the firms that went through with the IPO. However, the situation is not all bad. The firms that went through with an IPO also acquired more innovations (patents) from outside firms, and these patents generally had higher quality (patent citations). Presumably, the IPO provided funding for such patent purchases. The study did not look at any broader financial or product market implications of the findings.

Study 2. Quality of patents and number of equity analysts. Jie He and Xuan Tian (here) looked at patent quality (same measurement) of companies listed in the stock market. The independent variable was how many equity analysts followed the companies. The authors found that when more analysts followed a particular company, the average patent quality (as well as number of patents) went down. To control for unobserved heterogeneity, the authors used broker mergers as an exogenous shock that is uncorrelated the dependent variable.

Unfortunately, the paper makes it impossible to calculate the effect size of their findings. Since the authors do not mention the effect size, it either is very small or the authors are disconnected from reality.

What does this mean? This two studies have used cutting edge econometrics to try to rule out alternative explanations. However, we need to be careful when trying to understand the implications. We cannot take for granted that better quality patents are more useful, when taking opportunity costs into account. Everything has a cost and it might be that the companies without market pressure over-invest in patenting activities. When the companies are subject to more market pressure, they are forced to invest in manufacturing, sales, and marketing and this is not necessarily bad. Unfortunately the two studies do not address this issue.

Speculations. The world would be boring without speculations. So here are mine.

• Anyone who has looked at equity analyst reports knows that the reports are focused on financial forecasts; often on a quarterly basis. Very rarely is there some genuine insights in the reports. Genuine insights concern the product market, the product pipeline, the quality of the strategic choices, or the unique skills of the top management teams. Such information is generally totally absent from the reports, except for a few individual analysts' reports. This is consistent with the findings in the two papers. 
• It seems that the stock market likes some companies that innovate, as long as the confidence in top management is rock solid. Amazon is a good example that reinvests most of its profit, without any adverse reaction from the stock market. Another example is Apple under Steve Jobs. My impression is that the stock market gives firms the benefit of a doubt initially. However, if the companies fail two-three times, the stock market no longer trusts the company. When this happens, eager management just want to please the analysts in the hope that they will regain their trust. So they cut R&D to make the quarterly results look better. It will fool some of the analysts, but after a one or two years most analysts have understood what is going on. 
• I think a lot of companies go through an IPO without having a viable business strategy. Companies like Zynga, Groupon, and Facebook do have some valuable patents, but probably not enough to sustain a business. It would be better for these companies to learn how to make money before an IPO. Once the company falls out of favour with the equity analysts, the stock market reaction can be ruthless. Management becomes clueless and the people in the R&D department starts looking for another job. This is what has happened with Zynga and Groupon. The same rot can happen to established companies, e.g. Blackberry.