Bad News or Good News? The Impact of R&D Reductions

Abstract

There is an extensive literature showing that R&D intensities and increases are positively related to firm performance, but there is little research on the valuation of R&D reductions. This paper contributes to the literature by examining the long-term performance following significant R&D reductions. We find that, contrary to conventional wisdom, large R&D cuts are associated with significantly positive future stock returns. This return drift cannot be explained by a battery of important factors in asset pricing nor properly accounted for by R&D intensity or prior R&D increases. We explore two potential economic motives behind R&D reductions—R&D spillover and firm life cycle. We show that operating performance deteriorates immediately before R&D reductions but exhibits no abnormal pattern afterward, evidence inconsistent with the spillover hypothesis. While firm growth falls substantially and variability in profitability reduces, firms with low or declining investment opportunities outperform. These findings lend support to a firm life cycle story that firms attempt to resolve the overinvestment problem that arises as they move to a lower growth stage. We further show a significant decline in the cost of capital after R&D reductions, but the market appears to underestimate the improvement in the cost of capital.