I Love R&D

I love R&D,
So put another dime into research, baby!

-- Paraphrasing Joan Jett

It's not unusual to see an earnings report with lower than expected net income simply because research and development turned out to be more expensive than expected. The analyst herd tends to give such reports the cold shoulder, with downgrades, lowered target prices, and other such silliness close at hand. But they warm my heart tremendously.

You see, R&D expenses are an important part of any serious company's investment in the future, at least in the industries I like to follow. I'd raise an eyebrow if a major bank blamed research for the latest shortfall, or if a pure-play retailer did the same.

But most companies actually make something, and they need to figure out how to make better widgets, and provide better services than the competition. Slacking off in that arms race can be a recipe for disaster, and lower year-over-year R&D expenses raise all kinds of colorful flags for me.

It's not just a platonic love, either. This stuff makes money for investors like you and me. Data I pulled from Capital IQ showed that over the past 12 months, the average R&D spending for publicly traded companies was about 12% of their gross margin. In other words, they spent one-eighth of the money left over after paying for their goods and services on coming up with better goods and services.

Companies with higher than average R&D spending also created above-average market returns for their investors. Their market price's 8% compound annual growth rate over the past five years -- a difficult market period by any measure -- puts the S&P 500's 5.6% CAGR over the same time to shame.

Electronic Arts (NASDAQ:ERTS) spent 26% of its gross income on research, or making new games, five years ago. Its stock has appreciated by 13% annually since then. Intuitive Surgical (NASDAQ:ISRG) turned a 27% investment in its future into a stunning 77% CAGR. Red Hat (NYSE:RHT) invested 32%, and its price has more than tripled in five years.

It's easy to love Volvo (NASDAQ:VOLV) or Cisco (NASDAQ:CSCO) for ignoring the analysts' cries for moderation when the results of their decadent indulgence in sweet, sweet R&D creates such great results.

For further Foolishness:

• IBM Develops Its Future
• Texas Instruments Is Misunderstood
• Cisco on Demand

What's sending Fools' hearts aflutter? Go back to our intro page to see what else we have a crush on.

Electronic Arts is a Motley Fool Stock Advisor recommendation, and Intuitive Surgical is a Rule Breaker, in a good way.

Fool contributor Anders Bylund holds shares of Volvo and Intuitive Surgical, but has no other position in any of the companies discussed here -- though he does love a couple of the others, too. You can check out Anders' holdings if you like, and it's easy to love Foolish disclosure.