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What Do Brad Pitt and R&D Spending Have in Common?

Sept. 30, 2013
Investing, Investments
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In Moneyball, Brad Pitt plays Billy Beane, the Oakland A’s General Manager who helped revolutionize baseball statistics. Beane and his team of baseball statisticians believed traditional statistics such as batting average were poor metrics for evaluating players. When investors and CEOs evaluate companies’ innovation, they face a similar problem. The amount that a company spends on R&D and the number of patents a company files are poor indicators for innovation. If that’s the case, how can we determine which companies are truly innovative?

Washington University Olin School of Business Professor Anne Marie Knott, whom some might say is the Billy Beane of innovation metrics, is a good person to help. Knott developed a new metric for R&D productivity called RQ, short for research quotient, that estimates the effect of a company’s R&D investment.

RQ examines how a firm’s inputs affect its outputs. For example it examines how much a 1% increase in R&D spending would increase a firm’s revenue. By using RQ to measure R&D investment, companies and investors are better able to judge R&D spending’s effectiveness.

“For years, companies have been been merely guessing whether and where their R&D is effective,” Knott said. “Knowing RQ helps companies benchmark whether they are getting better or worse over time. It also helps companies understand where they stand relative to rivals (if they have higher RQ you can probably improve your R&D by mimicking some of what they do).”

Using RQ can also help firms optimize their R&D budget.

It can also help investors locate undervalued companies.

“Only about 5% of firms are within 10% of their optimal budget,” Knott explained.   “About 58% are overspending (and accordingly just burning money), and the other 38% are under-spending and could increase their profits and market value by increasing their spending. A lot of firms with great R&D fall below investor radar because they don’t look match the ‘innovative type.’ These firms offer opportunities for above normal returns.  One great example of this is the RQ 50 portfolio.  On average it outperforms all the indexes.”

RQ can help companies figure out how much they should spend, but doesn’t tell them where they should make R&D investments. For companies that underspend on their R&D budget, R&D managers can revive cancelled projects. Bryant University Professor Michael Roberto has some other ideas for maximizing innovation.

“Companies should connect R&D folks directly with customers,” he said. “They need to eliminate the filters in between them. Additionally, they should conduct more anthropological field research with users, rather than focus groups and surveys. They need to see what’s really happening out there. Finally, they need to break down silos within R&D.  Most problems are now interdisciplinary in nature.  No one functional area can solve the problem alone.”

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