The Trillion Dollar Sure Thing, Or Business Consultants Say the Darnedest Things
Over at the Harvard Business Review, Washington University in St. Louis professor of strategy Anne Marie Knott has published, The Trillion Dollar R&D Fix, in which she claims that by short-sightedly under-investing in R&D American business executives are leaving trillions of dollars on the table. She comes to her conclusions by running a regression analysis aiming to uncover the effectiveness of R&D spending using data from 610 publicly traded companies from 1981 to 2006. Professor Knott finds:
A new metric for R&D productivity—which I call RQ, short for research quotient—can change all that. RQ allows you to estimate the effectiveness of your R&D investment relative to the competition and to see how changes in your R&D expenditure affect the bottom line and, most important, your company's market value. My research—which includes a comprehensive analysis of all publicly traded companies in the U.S.—suggests that if the top 20 firms traded on U.S. exchanges had optimized their 2010 R&D spending using the RQ method, the collective increase in market cap would have been an astonishing $1 trillion.
Amazing if true. However, over at The Atlantic Monthly blog, Jim Manzi, founder and Chairman of Applied Predictive Technologies, argues that Professor Knott's analysis is largely bunk. Manzi is the author of the insightful new book, Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics and Society (which I review in an upcoming issue of The American Conservative.) Manzi explains:
For example, Knott claims that she knows that Apple would have maximized its market value by spending $9.5 billion on R&D in 2010 They actually spent $1.8 billion. That's a fairly incredible claim. She thinks that what is generally conceded to be a management team that is pretty savvy about innovation underspent on R&D by more than 400 percent—Apple ought to have quintupled its R&D spending in 2010. As another example, Knott claims that Dow Chemical could have roughly doubled its total market capitalization by increasing its R&D spending by 10 percent. That's a lot of money for them to leave on the table. And a very easy fix.
Knott claims that if just the top 20 American corporations had followed her recommendations, they would have collectively increased their market capitalization by more than $1 trillion. Consider this assertion for a moment The current total market capitalization of the top 20 U.S. public companies is a little over $4 trillion. Knott claims that she has outsmarted the entire system of management teams, investors, equity analysts, hedge funds, large-scale private equity firms and everyone else who is trying to change management practices to increase share price, and knows how to increase the total value of the most-closely followed companies in the world by almost 25 percent….by building a regression model using publicly-available data.
If you could rely on Knott's predictions, you could raise capital, buy these companies, change R&D spending in line with her model, and then sell them again at an enormous profit. You could start with Dow, because you know how to double its share price.
Maybe Knott has discovered an incredible, remediable market inefficiency, and somebody is about to get very, very rich. Or maybe there's a problem with her model.
Manzi shows that there is a problem with her model. It is no doubt the case that some companies do under-invest in R&D and that some over-invest, but can a one-size-fits-all formula really capture the information needed by a business executive to navigate his company through the competitive marketplace? In his new book, Manzi persuasively shows why everyone should be highly skeptical of results emanating from regression analyses of truly complicated social phenomena. The whole Atlantic Monthly Manzi post, There is no Easy Button for R&D, is well worth reading.