These Companies' Bets On R&D May Pay Off Big For Your Portfolio


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With each passingyear , the United States has lost its edge, a new report suggests.

Whether it's national education scores, health care efficiency, environmental stewardship or a host of other measures, the country has slipped down from the top of the leaderboard.

But by one key measure, Americans can still take a great deal of pride: innovation.

U.S. firms continue to garner the most newpatents every year, and U.S.-designed products -- from Apple's (Nasdaq: AAPL) iPhone and General Electric's ( GE ) locomotives to promising new cancer drugs -- continue to rack up robust globalsales .

The notion that the United States has stoppedinvesting in the future is simply a myth. Sixty years ago, spending on research and development (R&D) by U.S. companies equated to roughly 2% of gross domestic product. Today, that figure is closer to 3%, according to the U.S. National Science Foundation (NSF). According to the NSF, R&D spending has tripled since 1989.

(I recently wrote about the best patent-owning U.S. companies, which alsoprofit from R&D, and you can read about it here.)

Not only does innovation help beef up U.S. exports, but it has also proved to be quite fruitful for investors.

In a broad multidecade study,analysts at Merrill Lynch found that companies that pursue high levels of R&D outperform their peers by roughly 10 percentage points each year. They add that companies spending up to 30% of sales on R&D are typically wiseinvestments , but companies that spend more than 60% of sales on R&D have been generally poor investments.

High levels of R&D might be necessary just to survive. Pfizer ( PFE ) , Merck ( MRK ) and Johnson & Johnson ( JNJ ) spent $25 billion in R&D in 2012, according to Booz & Co. Yet their sales are barely growing as existing drugs losepatent protection.

Still, there are companies seeing huge payoffs from high levels of R&D. Google (Nasdaq: GOOG) , for example, used to spend $3 billion a year on R&D but shelled out $6.6 billion in 2012. Google's current $257 billionmarket value would never have happened if it chose to skimp on basic new product research.

Of course, today's globally interconnectedeconomy can bring a threat to innovation. A wide variety of U.S. companies operating in China have expressed frustration that key pieces of their intellectual property are being stolen by domestic rivals. Several of these U.S. companies have decided to pull up stakes in China, deciding that the loss of their intellectual property isn't worth the benefits of exposure to the Chinese economy.

Indeed, the fears about China's huge R&D spending increasingly appear unfounded, as Chinese engineers appear to be developing "me too" designs rather than producing true innovation. After a 100% jump in five years, China now generates more patent applications than the United States, "but despite this rapid growth, the U.S. has maintained its lead in the number of actual patents granted, suggesting that the quality of the Chinese patent applications may not be as high," said Merrill Lynch's analysts.

Automakers take a different approach with their business in China. They roll out new models in their home markets and then eventually transfer all their tooling equipment to China when the next-generation designs are ready. Many new Volkswagen sedans plying the streets of Beijing are actually based on 5-year-old designs.

Still, the Volkswagen example is instructive. That company is investing huge sums into R&D, and as a result, Volkswagen brands -- including Audi, Porsche, Lamborghini and Bentley -- are delivering a broad set of new technologies in mainstream cars. The 2014 Volkswagen Golf, for example,will have a number of safety, weight-saving and performance technologies that didn't even exist five years ago.

Here in the U.S., there is a clear pack of leading innovators, especially in technology and biotechnology.

Let's look at biotech as an example. I went looking for biotech and medical technology firms that spend at least 25% of their current sales on R&D, have at least $200 million in annual sales and are expected to boost sales at least 20% in 2014.

Clearly, the high levels of research are paying off, and many of these companies now face considerable export opportunities in addition to their domestic sales opportunities.

Even in other sectors, companies are making huge bets on R&D. Using the same criteria noted above (high R&D spending as a percentage of sales, rising sales growth, etc.), I came across 10 companies that are stepping on the gas.

Risks to Consider: Heavy R&D spending doesn't ensure a solid payoff. Facebook (Nasdaq: FB) , for example, has hiked R&D spending from about $300 million in 2010 to roughly $1.4 billion in 2012, and that figure will likely exceed $2 billion this year. Investors are still waiting to see how that will pay off, asshares have been stuck in the mid-$20s throughout much of 2013, even as the broadermarket has zoomed ahead.

Action to Take --> The analysis of a company's R&D efforts can be especially helpful when comparing companies within a particular industry. If two companies have similar financial profiles but one company is making a much larger commitment to R&D, then it is likely to be the better long-terminvestment .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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