Is R&D Really That Special? A Fixed-Cost Explanation for the Empirical Patterns of R&D Firms

I propose an explanation for the positive relation between R&D, future earnings, and future stock returns based on the fixed-cost qualities of R&D. If R&D is relatively fixed over short horizons, demand shocks realized by some R&D firms will push these firms into R&D intensity levels that are suboptimal as common scale proxies-market equity, assets, and sales-respond more quickly to demand shocks than R&D. In response, R&D firms realizing negative demand shocks reduce future expenses and capital expenditures, producing higher future profitability on lower sales growth. Consistent with the fixed-cost hypothesis, I find the higher future profits of high R&D firms are explained by cost cutting, not revenue growth. Collectively, the restructuring of cost and capital structures of the subset of high R&D firms realizing demand shocks explains the future profit and investment patterns of R&D firms, while the fixed-cost qualities of R&D seem to explain patterns in future stock returns. My results have implications for literatures that examine how decisions on R&D investment levels affect future firm performance, growth, and stock returns.