These are strange and unique times. We are nearing the end of a long-term, central bank-driven debt cycle. Much of the stock market’s success over the past handful of decades has been due to the Greenspan / Bernanke / Yellen / Powell put, accommodative monetary policies which fueled earnings growth through progressively cheaper cost of capital. Having exhausted almost all room at the lower bound of interest rates, we are entering into a new age in which quantitative easing will be central banks’ primary lever of further accommodation.
But monetary policy isn’t the only way that the financial world is changing. The rapid rise of the Chinese economy heralds a new age of international trade and geopolitics. The crumbling foundations upon which European prosperity has been based since the end of the second World War bodes poorly for the Continent. And though the United States remains the shiniest tool in the toolshed, we, too, have our problems: slowing growth, political polarity, and many signs of a peaking market.
Faced with an uncertain future that will undoubtedly look much different than the past, investors are looking for proven ways of generating alpha over long periods of time. After all, a great many companies enjoy high stock prices for a time – maybe 5-10 years – but most investors have a longer time horizon than that, and the aging of the current bull run is worrisome. The economic tide may soon go out, at which point we will see which investors have been “swimming naked,” to borrow the words of Warren Buffett.
The Long-Term Hold Strategy for Alpha
One thing investors can do to remain exposed to risk assets while hedging against short-term downside risk is to devote a sizable portion of investable capital to strategies that have been shown to outperform the market over long periods of time.
One strategy I particularly like was famously and forcefully made by Jeremy Siegel in his book, Stocks for the Long Run, later refined in The Future For Investors. Siegel demonstrates that, in some ways, it’s better for old dogs not to learn new tricks; that is, older, time-tested companies with stable business models tend to outperform the bold, new, hotshot companies that attract the youngsters. Even in dying industries, many of the oldest companies still perform phenomenally well. Siegel uses the example of the best performing stock of all time (at least as of the writing of his Future for Investors book) – cigarette maker Philip Morris (i.e. Altria [MO]).
As Siegel also demonstrates, dividends make up 40% of stock returns over long periods, and dividend payers and growers tend to do better than non-dividend payers.
The Importance of Innovation
Research and development (R&D) is undertaken in order to produce the cool new consumer technologies and goods of tomorrow. Everything from the newest iPhone to the next Tesla car model to the latest flavor of SunChips all sprouted from the fertile soil of R&D. But other R&D spending is done for the purpose of enhancing productivity.
This form of investment inevitably leads to higher productivity growth within the company (or in other companies that benefit from the product of that R&D). And, in a broader sense, research and development is the foundation for new wealth creation and economic progress. It boosts labor productivity, which brings wages along with it, and this leads to increased consumer spending. More consumption means more GDP growth and business profits. And some of those profits are plowed back into more R&D.
Over time, this virtuous cycle raises the standard of living for everyone.
In short, R&D is the heartbeat of economic ingenuity and advancement. And the United States is currently responsible for about a quarter of global R&D expenditures, though East Asia as a bloc is quickly catching up.
But, however important R&D is to the underlying economy, the pertinent question here is its effectiveness in stock returns. Does R&D translate into higher returns? Indeed it does.
Innovation for Alpha
Another proven strategy for achieving alpha over a long period of time that perhaps fewer investors know about pertains to innovation.
Joseph Mezrich, head of quantitative investment at Instinet, has put together what he calls the “Innovation Index,” made up of publicly traded companies that invest heavily in R&D and whose efforts are paying off in the form of free cash flow.
Mezrich takes those companies that spend the highest amount of their total value on R&D and then screens for companies with strong free cash flow to create the Innovation Index. (The full methodology of the index is not disclosed, to my knowledge, but we know these two important steps.)
The purpose of the secondary emphasis on free cash flow is twofold, as I see it. First, not all companies that spend heavily on R&D can afford to spend that much money and as such are forced to finance it with debt issuance or equity dilution. This is a red flag and something to be avoided. Second, for those companies that have been investing heavily in R&D for multiple years, free cash flow is one way to gauge the success of those investments.
Mezrich attests that this strategy has borne ample fruits over the past three decades. “From 1990 to 2017,” Mezrich told Barron’s in May of this year, “the high-spending [on R&D] basket within the Russell 1000 achieved an annual return of 21%, while the broader index accrued 9.4% a year including dividends and reinvestments.” Compare that to 15.6% annual return for the Nasdaq over the same time frame.
That is phenomenal outperformance!
The Innovation Index is populated largely (and unsurprisingly) by tech firms, with five of the top ten holdings being Qualcomm (QCOM), Juniper Networks (JNPR), FireEye (FEYE), Western Digital (WDC), and Symantec (SYMC).
But outside the tech sector, Mezrich also compares innovators with cost-cutters and buybackers. For instance, food companies Kraft-Heinz (KHC) and Beyond Meat (BYND) have gone very different directions, the former focused on generating earnings through cost-cutting measures and the latter foregoing profitability in the short-term to focus on inventive new products.
And Kellogg (K), which is among the Innovation Index’s top 20 holdings, has bought into innovation and R&D through its recent purchases of the RXBar brand and other health food snacks. Moreover, it also owns Morningstar Farms, an already profitable and popular vegetarian faux-meat maker.
Interestingly, Mezrich points out that many “old industry” names remain some of the most innovative and, as a result, successful. Farm equipment company AGCO (AGCO) has focused on new technologies to make farm labor more efficient and has outperformed rivals Deere (DE) and Caterpillar (CAT) this year. Petroleum additives company NeuMarket (NEU) has a similar story, along with engine maker Cummins (CMI).
Overlapping Strategies for Alpha
This little-discussed secret of long-term success enjoyed by many tried and true companies opens the possibility for overlap between the two strategies discussed above. Siegel’s strategy (dividend growth stocks with established track records) combined with Mezrich’s strategy (stocks with high R&D budgets and strong free cash flow) may just yield even better results than either one individually.
In order to qualify for this combined alpha strategy, it would seem necessary for a company to have five qualifications:
1. Relatively high R&D spending as a percentage of revenue (higher than competitors).
2. A history and culture of innovation.
3. Strong free cash flow.
4. ROIC consistently higher than WACC.
5. An uninterrupted and uncut dividend that has been paid for at least 15 years.
Typically, companies that exhibit Point 5 also, by necessity, exhibit Points 2, 3, and 4. But the combination of all five, in my estimation, could be a very powerful set of screens to find outperformers.
Let’s take the case of Cummins, which has continually upped its R&D budget as its sales have grown over the last few decades.
While not a dividend aristocrat, the company has been paying an uninterrupted (uncut) dividend since the early 1990s, which qualifies it for Siegel’s strategy. How has the stock performed against the S&P 500? Even in a cyclical industry of diesel engines, CMI has dramatically outperformed:
Or take the case of Disney (DIS) (#4 on Fast Company’s 2019 “World’s Most Innovative Companies” list), which has also been paying uninterrupted dividends since the late 1980s and has also demonstrated its ability to continuously innovate. Though the stock has undergone periods of underperformance, it has eked out a victory over the S&P 500 since 1989.
Or, lastly, consider an “old world” tech company that has paid an uncut dividend since the early 1990s – Intel Corporation (INTC). A long-term hold of this name has resulted in outperformance as well:
The same could be said of big R&D spenders and longtime dividend payers, Pfizer (PFE) and International Business Machines (IBM), although the latter’s performance has become more sluggish in the 2010s:
For tech giant Microsoft (MSFT), which has been paying a dividend since the early 2000s, R&D spending as a percentage of revenue has been falling only because revenue growth has been faster than the growth of the R&D budget. But, as you can see below, the growth of the R&D budget has not slowed:
This combination has resulted in strong total return outperformance, especially in recent years.
Of the 215 companies in the S&P 500 that report R&D spending, the rate of annualized growth from the first half of 2017 to the first half of 2018 was 33%. This may be a one-time bump due to the recent tax cuts, as R&D spending will require amortization starting in 2022.
Perusing the Forbes “World’s Most Innovative Companies” list, one quickly notices that exceedingly few pay more than a paltry dividend, if at all. This is fine for investors whose strategies revolve around or include a tilt toward growth. But for dividend growth investors, finding the right companies to pursue this strategy is a tougher.
After all, a company only has so much free cash flow, and that FCF cannot be simultaneously used on R&D and dividend payouts. Finding the right balance, however, seems like a promising way to achieve long-term alpha.
Here are six companies spending huge amounts on R&D, according to Nasdaq, along with their total R&D expenditures and spending as a percentage of revenue:
- Amazon (AMZN) ($22.62 billion in 2017; 12.7% of revenue)
- Alphabet (GOOG, GOOGL) ($16.62 billion in 2017; 15% of revenue)
- Volkswagen (VLKAY) ($15.22 billion in 2017; 6.7% of revenue)
- Samsung (OTC:SSNLF) ($14 billion in 2018; 7% of revenue)
- Microsoft (MSFT) ($14.7 billion in 2018; 13% of revenue)
- Intel (INTC) ($13.1 billion in 2017; 20.9% of revenue)
Of these, Intel looks to be the most promising candidate for the above strategy. Its 12.15x forward P/E ratio and 2.5% yield make it stand out, at least superficially. But there are probably better buys out there right now that would fit with this strategy.
Personally, since the majority of innovators are technology companies and tech is not my sphere of competence, I would prefer to own an index of dividend-paying tech companies. The First Trust NASDAQ Technology Dividend ETF (TDIV) is a great option to accomplish this. Its 93 holdings span software and hardware, telecommunications and semiconductors, products and services. The top ten holdings make up 58.5% of the fund:
Source: First Trust
I don’t consider the ETF a good buy right now but will be looking to pick up shares on a pullback.
What do you think? Does the above combination of strategies make sense?
Disclosure: I am/we are long ITW, MMM, K. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.