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R&D Spending Holds Potential As A Game-Changer For Stocks

Many great stocks represent companies that spend heavily on research and development.

A company with a consistent commitment to R&D will often outperform rivals that lack commitment — especially over the long haul.

The right innovation can lead to market domination and creative destruction of rivals in the stock market today.

Yet before we go further, let's recognize the exceptions. R&D isn't critical for every great stock. For some industry groups, R&D is not a factor at all. A screen of IBD's 197 industry groups found that 40% of the groups involve companies that spend either nothing or less than 1% of sales on R&D.

For example, restaurants and apparel retailers don't face the same pressures to reinvent themselves that technology companies do.

Restaurants and retailers do have to keep up with changes in style and taste, but they don't need a small army of techies with high IQs to stay ahead of the curve.

And if you've seen how techies dress and what they eat, then you know their advice on taste and fashion trends wouldn't put companies such as Michael Kors (KORS), Urban Outfitters (URBN) or even upscale restaurateur Ruth's Hospitality Group (RUTH) ahead of the curve.

The R&D types, however, are indispensable to semiconductor designers, biomedical companies, software, aerospace and other high-tech companies.

R&D is all about the new factor. It gives a company a chance to invent new products and improve established products.

Even some of the blue chips in the Dow Jones industrial average continue to spend aggressively on research and development.

Six of the 30 stocks in the Dow had R&D budgets in 2012 that involved spending a double-digit percentage of sales.

Intel (INTC) spent 19% of sales on research and development; Merck (MRK) 17.3%; Microsoft (MSFT) and Pfizer (PFE), 13.3% each; Johnson & Johnson (JNJ), 13.1%; and Cisco Systems (CSCO) 11.9%.

Here are some interesting facts. So far this year, Microsoft stock is up 31%; Cisco, 22%; Intel and Johnson & Johnson, 19% each; Merck, 15%; and Pfizer, 13%.

The Dow is up 14% this year, and part of that is because of the above stocks. With the exception of Pfizer, the Dow's top spenders in R&D are outperforming the Dow. Granted, that's thin evidence for a grand conclusion. However, if any established company is going to break out of a rut, innovation is the surest path.

IBD ran a screen for stocks trading above $15 a share, a Composite Rating of 90 or better, and R&D spending in 2012 of at least 20% of sales. The table shows many of the 17 stocks making the list.