Needham Growth Factor 8/2: "Putting Active Share To Work"VW Staff
CFO Jim Giangrasso looks at how High Active Share can differentiate funds from their benchmarks, and low turnover allows portfolio companies to execute on their business plans with less regard for short-term events or quarter-to-quarter blips. He also focuses on the importance of a company’s attention to R&D and how R&D leaders tend to outperform as stocks in the years after their spending on R&D.
To read the piece in its entirety, please click here: The Growth Factor
Putting Active Share to Work: Excessive Return Tendencies of Innovative Companies
In The Growth Factor Vol. 19, “Patient Capital Outperformance: High Active Share Managers Who Trade Infrequently,” we described two factors that explain The Needham Funds’ long-term outperformance vs. its benchmarks: High Active Share of over 100% combined with low turnover (but past performance does not guarantee future results). High Active Share differentiates our Funds from their benchmarks, and low turnover demonstrates the patience we allow our portfolio companies to execute on their business plans with less regard for short-term events or quarter-to-quarter blips.
Another factor that contributes to potential outperformance is investing in companies spending on research and development (R&D). Professors Baruch Lev, Suresh Radhakrishnan and Mustafa Ciftci published “The Stock Market Valuation of R&D Leaders” in 2005. It is one of a number of studies which show that investing in R&D leaders contributes to outperformance.
As growth investors, we believe that understanding R&D spending and a company’s new product pipeline is vital to achieving outperformance over a period of time.
Accounting Treatment of R&D Leads to Mispricing (It’s an Information Problem)
Ever since the FASB (Financial Accounting Standards Board, the accounting industry’s standard setting body) released Statement of Financial Accounting Standards No. 2 in 1975, companies have charged all costs related to their R&D activities against current period earnings, despite the fact that R&D endeavors may benefit future periods and therefore might be deducted against the revenue they generate. In contrast, other expenditures that provide future benefits, such as buildings and capital equipment, are capitalized (treated as an asset on the balance sheet) and depreciated or amortized against earnings over time in future periods using some rational method. The treatment of R&D costs as an expense rather than an asset is inconsistent with the FASB’s own definition:
“Assets are probable future economic benefits obtained or controlled by aparticular entity as a result of past transactions or events… The common characteristic possessed by all assets is “service potential” or “future economic benefit.”1
The accounting profession justifies this inconsistency with an override:
“To be recognized [in financial reports], information about the existence andamount of an asset, liability, or change therein must be reliable. Reliabilitymay affect the timing of recognition [of assets]. The first available information about an event that may have resulted in an asset… is sometimes too uncertain to be recognized.“2
Not all R&D endeavors bear fruit and therefore cannot always be clearly tied to future revenue. So the accounting profession has sacrificed the matching of expenses with future benefits for the sake of reliability and certainty.
Innovation & Excess Returns
Several academic studies over the past two decades have concluded that the most innovative companies who are R&D leaders (as measured by the level and intensity of R&D expenditures) tend to, over the long term, outperform their less R&D-intensive peers and the broader markets. In his 1996 study, NYU professor Baruch Lev tested whether “capitalized R&D” (as adjusted by Lev) is related to subsequent stock returns. He found that the level of capitalized R&D is positively related to subsequent (higher) stock returns, and that capitalizing R&D results in statistically significant and relevant data to the financial statement user. He further hypothesized that the outperformance of such companies was related to a systematic mispricing by the market owing to the lack of quantifiable accounting information about R&D costs.
In a 2002 study, Dennis Chambers from the University of Illinois also found a positive association between R&D levels and excess returns. While reaching the same conclusion as Lev, Chambers wrote that the outperformance “was [more] likely due to a compensation for hidden risks than from systematic mispricing.” Chambers was saying because R&D projects are by their nature risky, the excess returns were simply additional return earned by investors for an additional undisclosed and non-quantified risk.4
And in the same year, Allen Eberhart of Georgetown University tested whether R&D increases result in higher than expected returns and whether investors misprice or ignore this benefit. He wrote, “For the five-year period following R&D increases, we find consistently strong evidence that companies experience significantly positive abnormal operating performance” and that “shareholders experience significantly positive abnormal stock returns” during the same five-year period. He concluded, “Our results provide strong evidence investors underreact to the benefits of an R&D increase.” 5
But perhaps the most compelling study was Lev’s 2005 “The Stock Market Valuation of R&D Leaders.” 6 In what may be the definitive work on the subject, Lev and his colleagues divided companies into R&D “Leaders” and “Followers” and found strong evidence that:
- R&D Leaders have higher future profitability and sales growth.
- R&D Leaders have lower future risk (lower stock price variability and lower earnings variability) than Followers, which is counter-intuitive. One might assume greater spending on R&D (which may fail) would create more risk.
- Future risk-adjusted abnormal returns on average are higher for R&D Leaders, suggesting that stock prices do not reflect R&D relevant data in a timely fashion.
- R&D Leaders’ long-term earnings estimates are revised downward by analysts twice as often, “Perhaps due to analysts’ reaction to lower current earnings.”
A Sampling of R&D Innovation in the Needham Funds’ Portfolios: KVH Industries, Inc.
KVH Industries, Inc. (KVHI) is a leader in the design, development, and manufacturing of mobile communications products and services for the marine and land mobile markets, as well as navigation, guidance, and stabilization products for the defense and commercial markets.
KVH strives to be the first company to bring new products to the markets it serves. New product research is focused on products and services for their existing marine and land mobile communications markets, and navigation, guidance, and stabilization application markets. KVH spent approximately 8% of sales on R&D in 2013 and 2014, although that figure is understated because customer-funded R&D is accounted for as revenue and cost of sales. When customer-funded R&D is included, the figures are closer to 10% of sales.
In June 2014, KVH introduced its new TACNAV 3D product, which is FOG (fiber optic gyro)-based and provides full 3-D navigation to a wide range of military vehicles. KVH announced a $1.5 million order for their TACNAV system on May 1, 2015. The FOG system is also being used in driverless cars.
In October 2014, KVH launched IP-MobileCast, a content delivery service. Content and data files are transmitted using a sophisticated “multicast” technology across their global satellite network to every vessel or mobile vehicle that has an active, compatible TracPhone V series or V-IP series terminal. The content is stored on the terminal itself or on a KVH-supplied media server. This delivery mechanism reduces the amount of bandwidth required to transmit large files to a large population of customers. Before multicasting was possible, large data files were generally transmitted across satellite networks “on demand,” which consumes significant bandwidth.
We believe that IP-MobileCast and the FOG system could lead to accelerated revenue and earnings growth in 2016 and beyond.
A Sampling of R&D Innovation in the Needham Funds’ Portfolios: PDF Solutions, Inc.
PDF Solutions, Inc. (PDFS) is a leading provider of process-design integration technologies and services to lower the cost of integrated circuit (IC) design and manufacturing, enhance time to market, and improve profitability by addressing design and manufacturing interactions from technology development and product design to initial process ramps and mature manufacturing operations.
PDF develops and introduces new proprietary technologies, software products, and enhancements to their existing solutions. The company believes its team of engineers will continue to advance their market and technological leadership. To achieve this, PDF can have up to one-quarter of its 60 R&D engineers operating in the field, partnered with solution implementation engineers in a deliberate strategy to provide direct feedback between technology development and customer needs. PDF spent between 13-15% of sales revenue on R&D during the last three fiscal years.
PDF Solutions is well known for its software and services used to improve yields in new semiconductor manufacturing plants. PDF has been investing in process equipment control with its Exensio Platform, comprising the Exensio™-Yield and Exensio™-Control modules for yield improvement as well as fault detection and classification. In April 2015, PDF announced the release of Exensio™-Test software. This new module provides test floor operation, adaptive test and analysis technology that produces diagnostic and predictive information during test, assembly and packaging operations. This data is critical to optimizing customers’ test operations, productivity and yields. PDF recently acquired Syntricity, which provides a cloud-based software-as-a-service (SaaS) system for hosting and analyzing this data.
We believe PDF’s most significant R&D investment is in its design for inspection initiative. The next generation of semiconductor wafers will be very difficult to inspect with light. PDF’s approach involves electrical testing of the connections deep within an integrated circuit that can no longer be seen with light. We believe these initiatives may double the size of PDF’s market opportunity and lead to accelerated revenue and earnings growth.
A Sampling of R&D Innovation in the Needham Funds’ Portfolios: Entegris, Inc.
Entegris, Inc. (ENTG) is a worldwide developer, manufacturer and supplier of yield-enhancing materials and solutions for advanced manufacturing processes in the semiconductor and other high-technology industries. Its products and materials are used to manufacture semiconductors, micro-electromechanical systems (MEMS), flat panel displays, light emitting diodes (LEDs), high-purity chemicals, such as photoresists, solar cells, gas lasers, optical and magnetic storage devices, and critical components for aerospace, glass manufacturing and biomedical applications.
Key elements of Entegris’ R&D expenditures over the past three years have included the development of new product platforms to meet the manufacturing needs for 28 and 20 nanometer and smaller semiconductor devices. Driven by the proliferation of new materials and chemicals in the manufacturing processes and more demanding platforms for contamination control for 300mm wafers, investments were made for new contamination control products in the areas of copper interconnects, deep ultra-violet (DUV) and EUV photolithography, and chemical and gas management technologies for advanced wafer cleans, deposition and etch equipment. The company’s employees work closely with customers’ development personnel. These relationships help them identify and define future technical needs on which to focus its engineering, research and development efforts. The company also supports research at academic and other institutions targeted at advances in materials science and semiconductor process development.
Entegris has steadily increased R&D as a percentage of sales every year since 2010. R&D went from 6.4% of sales in 2010 to 9.1% in 2014.
In June 2015, Entegris announced the first shipments of production quantities of UPE (ultra-high molecular weight polyethylene) membrane from its i2M Center for Advanced Materials Science in Bedford, Massachusetts. UPE membrane is a core material used in high-purity filtration solutions for semiconductor and life sciences applications.
“In the first half of 2015, we reached multiple milestones in our expansion plan to provide new membrane technologies to solve the yield challenges our customers face to manufacture semiconductor devices,” said Entegris Vice President of the Liquid Microcontamination Control business unit, Clint Haris. “Several key customers have completed their qualification process and are now receiving i2M-based products for use in current applications, as well as for their developmental programs. We’re excited to take this step forward as we continue to commercialize other UPE-based technologies in 2015.”
The 80,000 sq. ft. facility, opened in June 2014, was a $60 million investment intended to create one of the most advanced facilities of its kind. The investment included an expansion of membrane manufacturing capacity, implementation of advanced process controls, and upgraded quality monitoring systems. In addition, the i2M Center is used to develop and manufacture gas filtration and specialty coatings products.
A Sampling of R&D Innovation in the Needham Funds’ Portfolios: Vicor Corporation
Vicor Corporation (VICR) designs, manufactures and markets innovative, high-performance modular power components, from encapsulated power modules (known as “bricks”) to semiconductor-centric solutions, to enable customers to efficiently convert and manage power from the wall plug to the point-of-load. Complementing an extensive portfolio of patented innovations in power conversion and power distribution with significant application development expertise, Vicor offers comprehensive product lines addressing a broad range of power conversion and management requirements across all power distribution architectures. Vicor focuses on solutions for performance-critical applications in the following markets: enterprise and high-performance computing, telecommunications and network infrastructure, industrial equipment and automation, vehicles and transportation, and aerospace and defense electronics.
Throughout its history, Vicor has modified its strategy to adapt to evolving market challenges and opportunities, leveraging its strength in R&D. In response to current trends and changes in customer requirements, Vicor is implementing a strategy addressing both the realities of today’s power conversion marketplace and their vision of its long-term direction. Vicor’s balanced strategy involves maintaining a profitable legacy business in bricks and brick-based system solutions, while investing in the next generation of power management components incorporating innovations of their VI Chip ™ and Picor ® subsidiaries.
Vicor invested 18.4%, 20.0%, and 17.7% of revenues in R&D in 2014, 2013, and 2012, respectively.
Vicor has invested over $250 million in R&D and capital expenditures to develop and launch a comprehensive array of game changing products in 2015. While reviewing the company’s performance for the fourth quarter and year ended December 31, 2014, Patrizio Vinciarelli, Chairman, President and CEO of Vicor, commented, “Throughout 2015, the pace of introduction of highly differentiated Vicor products will accelerate, enabling end-to-end implementation of Factorized Power solutions across a broad range of applications. For chassis-mount front-end applications, upstream of the point of load, we will unveil next-generation system solutions, which we are calling ‘VIA’ (short for Vicor Integrated Adapter) products. VIAs incorporate ChiPs within mechanically and thermally adept packages. Architected with ease of use in mind, VIA front ends will provide attractive power system solutions across a multiplicity of markets.”
We believe these new products position Vicor for revenue growth in 2016 and beyond.
Professors Lev, Radhakrishnan and Ciftci have shown that R&D leaders tend to outperform as stocks in the years after their spending on R&D. They hypothesize that the financial markets misunderstand the value of R&D spending. Many of the companies in our universe of stocks have strong R&D programs. As growth investors, it is important for us to understand the new product pipelines resulting from R&D. We’ve described a few of these companies, where we believe recent R&D investments have the potential to lead to accelerated revenue and earnings growth-and outperformance for the stocks. However, R&D is a cost to a company that may not bear fruit and could potentially lower a company’s performance.
About Needham Funds: http://www.needhamfunds.com/