Future Excess Returns to High R&D Firms and Firm Size

Abstract

Prior research documented that high R&D intensity firms generate future positive excess returns. We explore the magnitude of future excess returns to small and large capitalization firms within the high R&D intensity group. Our inquiry is motivated by arguments in the innovation literature that technical and commercial uncertainty associated with R&D is larger for small than large R&D firms. Using data over the period 1975 to 2005, we find average excess returns over the three-year post portfolio formation period of 6.40% for the high R&D intensity portfolio. However, the excess returns are 7.15% and 3.15% for the small and large high R&D intensity firms, respectively. Small firms constitute only 8.57% of the total market value of the high R&D intensity portfolio, while large firms constitute 78.20%. Taken together, the results suggest that the large magnitude of future excess returns to small high R&D intensity firms do not imply large gains for investors. We also find that the spread in uncertainty (future profitability) between large and small firms within high R&D intensity firms is larger (smaller) than the spread in low and non-R&D firms, suggesting that uncertainty (future profitability) is disproportionately high (low) for small, high R&D firms. These results suggest that the larger magnitude of future excess returns to small, high R&D intensity firms are likely due to greater risk associated with them.