World Report
Bill Sterling and Stephen Waite, of C.I. Global Advisors LLP, are fund managers for C.I. Mutual Funds. Their reports are interesting and timely, especially for anyone interested in the larger global picture and how it may affect their investments. See our links page for links to C.I. Mutual Funds and other featured mutual funds. Their recent book, "Boomernomics", is highly recommended.

"The profits that accrue to an investment professional need not be a market inefficiency, but may simply be the fair reward for unusual skill, extraordinary effort, or for breakthroughs in financial technology." 
J. Doyne Farmer and Andrew Lo, Frontier of Finance: Evolution and Efficient Markets

Not too long ago, a financial journalist phoned us to discuss equity market valuations. After a few questions about the general level of the U.S. stock market, the discussion turned to individual stocks.

"How can you justify owning a company like Chiron today?" she asked. "The stock is selling at a price equivalent to around 60 times earnings!" The stock in question is a promising U.S. biotechnology stock whose P/E multiple was indeed well above the market average.

Our answer was that the stock is much cheaper than it looks on a conventional P/E basis. We noted that Chiron's annual earnings are significantly understated due to the fact that the company spends a relatively large amount of money on research and development (R&D). We think it is worth sharing our explanation with you in some detail, because of the growing importance of R&D spending among the world's most innovative companies.

R&D as an Investment
For many companies, particularly in the manufacturing sector, R&D spending is not a big issue. R&D is often an insignificant share of corporate sales. This is not the case in the information or biotechnology sectors. In these sectors, R&D is a major expenditure - sometimes the largest single item on the cost side of the income statement. Chiron, for example, spends almost $300 million, or 40 percent of sales, on research and development. Accountants treat R&D as an ordinary business expense. Therefore, companies with high R&D budgets are forced to write off large sums of money. This, in turn, depresses reported earnings.

"Fair enough," the journalist replied. "So how do we go about valuing R&D-intensive companies?" To be sure, there are no hard and fast rules. But for starters, it makes very little sense in the information and biotechnology sectors to fully write off annual R&D outlays. Such outlays are in truth more like capital expenditures. Capital expenditures are treated as investments, which are properly written off as expenses over a number of years. 

When DaimlerChrysler invests in machinery, it does so with the expectation that the machinery will be used to produce cars not only this year, but for years in the future. This is a unique characteristic of such expenditures, and the accountants tell us that amortizing outlays on machinery is the correct thing to do. Imagine if auto companies had to expense annually their investment in machinery and equipment. Reported earnings would be significantly lower than they are today. Few analysts question the wisdom of allowing auto companies to amortize expenditures on machinery and equipment because it makes perfect economic sense.

When Chiron invests to pioneer a new medical therapy, such expenditures are correctly categorized as research and development. However, from an economic perspective, these expenditures are actually more like investments than traditional accounting expenses. After all, if Chiron didn't spend money to research and develop new drugs, the company wouldn't have much of a future. We certainly would have trouble owning a biotechnology company that didn't spend money researching and developing new therapies.

Accountants apparently don't see it the same way. Chiron's spending on R&D is treated as an ordinary business expense, the same way selling and general administrative expenses are treated. This seems odd. Suppose that Chiron's spending on R&D leads to an innovative treatment for the prevention of cardiovascular disease. This would be a major medical breakthrough. Such spending would obviously have a future payoff that extends far beyond the year such outlays were expensed. Why treat such spending as an expense when in truth it is an investment?

Curiously, few people question the conventional wisdom of expensing R&D in the information and biotechnology sectors. We would argue that R&D is as vital to companies in the information and biotech sectors as investment in plant and equipment is to many manufacturers. Why not treat R&D the same way as capital expenditures?

Earnings Distortions
Chiron's income statement reveals how earnings are distorted by R&D spending (see Table 1). Last year, the company made $0.48 per share. The company spent $294 million on R&D in 1998, which comes to $1.62 a share (the company had 181 million shares outstanding). But suppose we consider Chiron's R&D expense as a capital expense and write it off over seven years using straight-line depreciation. Then its R&D expense for 1998 would be only $0.23 per share ($1.62 divided by seven) and its R&D-adjusted EPS would soar to $1.87. That's nearly four times its reported EPS. What a difference an accounting definition makes!

As Table 1 shows, treating R&D spending as an expense can dramatically reduce a company's reported per share earnings and raise its P/E ratio. Chiron is selling on 60 times last years' earnings per share of $0.48. However, the company's R&D-adjusted P/E ratio is only 15.5 - well below the P/E multiple of the S&P 500. Treating R&D as investment rather than an expense can have a significant impact on conventional valuation measures, such as a P/E ratio.

In light of our analysis, it's no surprise that R&D-intensive information and biotechnology companies have relatively high P/E ratios. To be sure, many companies in these sectors have relatively high earnings growth, which can justify higher P/E ratios (see last month's Sterling Perspective, Growth Man vs. Value Man. However, many investors don't look at P/E ratios in relation to the company's prospective earnings growth. Rather, like our friendly financial journalist, they infer that a stock is expensive simply from looking at a firm's P/E ratio.

Investing in the 21st Century
Some investors may view this discussion as an abstract technical issue that doesn't deserve attention. However, we note that R&D-intensive industries are garnering a larger share of global stock markets as we head into the 21st century. R&D-intensive sectors (i.e., information technology and health care) today account for over one-third of the S&P 500 index market capitalization (see Table 2). 

R&D-to-sales ratios for the technology and health care companies are significantly higher than companies in the automobile, energy and basic materials sectors (see Table 3).

Twenty years ago, the top 10 largest companies in the S&P 500 were AT&T, IBM, Exxon, General Motors, General Electric, Kodak, Royal Dutch, Standard Oil Cal., Standard Oil Ind., and Schlumberger. There was only one information technology company in the top 10. Today, there are five: Microsoft, Intel, Cisco, Lucent, and IBM. 

We believe the share of R&D-intensive sectors in the S&P 500 index could rise in the years ahead as the biotechnology revolution shifts into high gear. Currently, there is only one biotechnology company (Amgen) in the S&P 500 index. A decade from now, we expect to see a number of biotech companies in the index. It is not unreasonable to think that sometime in the next two decades, over half of the market capitalization of the S&P 500 index could be comprised of R&D-intensive sectors.

As we head into the 21st century, it will become increasingly important for analysts to look beyond conventional accounting measures to better capture the growing importance of R&D spending. There is some evidence that the market does attempt to place a more realistic value on R&D spending. A number of studies have shown that companies' stock prices tend to increase when they announce increases in their overall R&D spending. There is also some evidence that the stock market views R&D expenditure not as an immediate expense (as accountants treat it), but rather as a long-lived asset that should instead be capitalized and amortized. 

Nevertheless, there may still be large inefficiencies in the way R&D is valued in the markets today. The rewards from exploiting these inefficiencies should lead analysts to develop new tools and metrics to uncover value in information and biotechnology stocks, rather than dismiss the stocks out of hand based on obsolete accounting.

The Case for Classic Value
The case for new metrics to analyze R&D-intensive companies is compelling. As we have shown, all P/E ratios are not created equally. Firms that spend large sums of money on research and development have earnings streams that are understated in the short run. Unless accounting rules change to recognize R&D spending as an investment, making adjustments for R&D seems appropriate to determine valuation. 

There is, we believe, an equally promising approach. This involves calculating the present value of all future cash flows. We prefer the classic value approach, primarily because it allows investors to determine the long-term value of an asset, irrespective of certain accounting issues that can distort earnings in the short run. 

As the long-time proponent of classic value investing, Warren Buffett, has noted: 

"Whether appropriate or not, the term `value investing' is widely used. It connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a `value' purchase."

The classic value technique rewarded investors during the last century. We believe it will continue rewarding investors in the next century.