Presenter: Yanzhi Wang Discipline of Finance College of Management Yuan Ze University

1. How Do Investors React to R&D Reductions Konan Chan, Yueh-hsiang Lin and Yanzhi Wang 2010 NTU International Conference on Finance Presenter: Yanzhi Wang Discipline of Finance College of Management Yuan Ze University Very preliminary, please do not quote!

2. Background • A rich literature shows that research and development (R&D) investments enhance shareholder value and R&D increases predict favorable future performance (Chan et al. (1990), Szewczyket al. (1996), Eberhart at al. (2004), and Hsu (2009). • Yet, very few extant papers examine the valuation of R&D reductions. • More than 30% of firms covered in both CRSP and Compustat with available R&D information decreased their R&D spending during the three decades between 1975 and 2005. • The average reduction in R&D expenditures for these R&D-decrease firms is $2.97 million, which represents 2.64% of lagged assets and a 24% decrease in their R&D growth rate.

3. Issue • These statistics suggest that R&D decreases are nontrivial events and likely to generate a remarkable impact on firm growth and performance. • Therefore, we examine the long-run performance following and economic motives behind significant decreases in R&D expenditures. • Then a raising question is what the market valuation to the R&D reduction.

4. Issue • Unlike R&D increases, which are commonly considered good news due to more investment opportunities, R&D decrease signals are not nearly as clear. • Managers may reduce R&D to reflect their expectations on future deteriorating fundamentals, an indication of poor subsequent stock returns. • Firms may also suffer overinvestment problems and thus reduce their R&D spending to return to the optimal level of R&D investments. • Previous research raises the concern that managers are myopic and may sacrifice long-term profits from R&D outlays in exchange for increases in short-term earnings (Stein (1989)) • Thus, the valuation of R&D decreases is not straightforward.

5. Purpose • We study the information content of R&D decreases by asking two questions: • How does the market respond to the R&D decrease? • We answer this question by examining the long-run stock returns after significant R&D reductions. • We use the long-horizon approach because R&D investments are generally long-term in perspective and an extended period of time may pass before firms realize the total benefits generated from R&D. • What factors explain firm performance following R&D decreases? • To address the second question, we examine various aspects associated with R&D decreases, such as annual stock returns, operating performance, analysts’ forecast revisions, and changes in cost of capital. These investigations can shed light on managerial motives behind large R&D reductions.

6. Main results • We extract 3,594 U.S. firm-year observations between 1975 and 2005 that have significant and unexpected reductions in R&D expenditures. • We find that, contrary to traditional wisdom, firms experience significantly positive abnormal returns over five years following large R&D decreases. The magnitude of abnormal returns is about 0.89% per month after controlling for size and book-to-market effects.

7. Main results • We propose spillover, managerial myopia, and overinvestment hypotheses to account for the positive abnormal return following R&D reductions. • Our results are most consistent with the overinvestment hypothesis. • The operating performance deteriorates immediately preceding R&D decreases and firms with low or decreasing investment opportunities outperform. • These findings strongly support the overinvestment hypothesis. While the cost of capital declines after R&D decreases, the market seems to underestimate the improvement in cost of capital.

8. How does the market respond to the R&D decrease?

9. How does the market respond to the R&D decrease?

10. How does the market respond to the R&D decrease?

11. What factors explain abnormal return following R&D decreases? • We propose three hypotheses • Spillover • Managerial myopia • Overinvestment

12. What factors explain abnormal return following R&D decreases? • Spillover hypothesis • R&D spillover effect suggests that one firm’s R&D can benefit the productivity of other firms. Managers may cut R&D spending in anticipation of potential R&D spillovers. Reducing R&D investments lowers expenses and thus increases current and future earnings. Therefore, the spillover hypothesis predicts that the R&D spillover will create an improvement in firms’ performance following R&D decreases.

13. What factors explain abnormal return following R&D decreases? • Managerial myopia hypothesis • Myopic R&D investment hypothesis argues that managers temporarily reduce R&D outlays to boost current earnings at the expense of long-term profits. Therefore, the myopic R&D hypothesis predicts a reversal in firms’ performance following R&D decreases. .

14. What factors explain abnormal return following R&D decreases? • Overinvestment hypothesis • overinvestment explanation is that managers trim down R&D investments to resolve the overinvestment problem. It is expected that firms with low investment opportunities and firms with decreasing growth potentials generate higher long-run returns compared with other R&D-decrease firms. Firms shall reduce their cost of capital substantially following decreases in R&D expenditures.

15. Operating performance

16. Abnormal stock return

17. Forecast revision

18. Changes in cost of capital

19. Conclusion • This paper examines the long-term performance following significant R&D decreases. • We find that, contrary to conventional wisdom, large R&D decreases generate significantly positive future stock returns. • We explore three potential economic motives behind R&D decreases—R&D spillover, managerial myopia, and overinvestment. Our results suggest that operating performance deteriorates immediately preceding R&D decreases and firms with low or decreasing investment opportunities outperform; these findings strongly support the overinvestment hypothesis. While the cost of capital declines after R&D decreases, the market seems to underestimate the improvement in cost of capital.