Firms that devote a substantial proportion of their sales to research and development (R&D) can secure a vital and enduring edge over their rivals, says Dr Mike Tubbs
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Investment in research and development (R&D) generates the new products, processes and services that can give a company an edge over its competitors. New products and processes that are patentable also provide a “moat” – an enduring competitive advantage – preventing the innovations resulting from R&D from being copied by rivals.
The amount a company invests in R&D is therefore a useful guide for investors seeking the most innovative companies likely to draw ahead of their competitors over the next few years. The extent of R&D at a company is known as R&D intensity, which is the ratio of investment in R&D to sales.
However, one cannot just compare the R&D intensities of different companies because the average intensity of different sectors varies markedly. R&D is a crucial factor in some sectors, such as pharmaceuticals, but of minor importance for others, such as mining or insurance.
The right approach is therefore to compare the R&D intensities of companies within the same sector and to do this only for industries where R&D is key. These R&D-intensive sectors are biotechnology; pharmaceuticals; software; technology hardware; health; electrical and electronic engineering; and aerospace and defence.
The average R&D intensity for biotech and pharmaceuticals is roughly 15%, between 9%-11% for software and hardware, and 5%-6% for health and electronics. Companies in the aerospace and defence and automotive sectors, meanwhile, have average intensities of 4%-5%.
More bang for their buck
However, defence companies’ customers tend to pay for additional R&D over and above that funded by the companies from their own resources, so the overall intensity is substantially higher. But company accounts do not always enable investors to understand the size of that additional R&D.
As investors, we target companies within each sector offering a significantly higher R&D intensity than the industry average, while still delivering growth with respectable profit margins and having a strong position in their subsector or market niche.
There are three caveats. The first is that the R&D should be well directed to provide new products and services that customers need and will therefor
