European top innovators: R&D intensity drives returns

R&D is an important factor to consider for the long-term investor

In a recent research note Increasing Returns – Identifying Returns and What Drives Them by Michael Mauboussin and Dan Callahan the authors talk about what drives equity returns. The table from their note (see below) shows the five main drivers of increasing returns for companies and their shareholders. It worth reflecting on as an investor as it can help you identify whether a company that you are considering investing in has one of more of these drivers of long-term increasing returns. For Tesla Wright’s Law is at play which is the Learning by Doing factor as cost per unit (EVs) drops by about 20% for every doubling of cumulative output. The force often goes hand in hand with the Economies of Scale factor as increasing cumulative output also increase volume of production up to a certain point.

The hallmark of competitiveness and these increasing returns are a high return on invested capital (ROIC) which reflects that a company has a structure and offers a product that yield a return on capital surpassing the cost of capital. High ROIC figures for an industry are often a sign of significant industry or technology changes. Historical data suggests that abnormal ROIC does tend to revert to the long-term average but that the time period is different across industries and technologies.

One of the findings around companies with increasing returns is that superstar firms substantially outspend their competitors on intangible assets. Increasingly those investments are going into proprietary software and those investments are now growing faster than traditional R&D, acquisitions, advertising, and lobbying. In other words, software is key driver of future moats for many companies. In the old economy advertising was important but today software is more important. High R&D spending is generally associated with companies innovating faster than competitors and winning long-term.

We are used to talk about US exceptionalism because the US won the digitalization with Europe’s technology sector sleeping at the steering wheel. But what about Europe, does the continent offer any superstars when it comes to R&D and innovation? The list below highlights 20 European publicly listed companies. We have filtered on those with a market cap above €10bn, ROIC above 12%, and then selected those companies with the highest R&D spending to revenue. We have also chosen companies across a wide range of industries as the list would otherwise be concentrated too much around pharmaceuticals and semiconductors.