The research and development activity is like a twofer to a business. On the one hand, it may unlock additional customer value so as to widen the competitive gap against peers. On the other side, it could extend product lines or enhance operational efficiency, which would fuel organic growth.
Growth investment guru Phil Fisher considered the effectiveness of a company's research and development efforts in relation to its size as one of the 15 primary factors that he used to evaluate a common stock. Admittedly, to gauge the return on the company's R&D spending is neither easy nor simple. The analysis is by no means straightforward, as competitively advantageous businesses generally require less R&D to maintain market leadership, while rapidly-moving industries usually involve a significant number of R&D activities to rebuild the moat.
However, Fisher did stress the necessity here by stating the following:
"If the cost of poorly organized research is both high and hard to detect, the cost of too little research may be even higher."
- Common Stocks and Uncommon Profits, Phil Fisher
This is why we care about a company's annual R&D spending as a percentage of sales, its trend and comparison with competitors and the track record of pipeline outcome.
Take Graco (NYSE:GGG) as an example. The Minnesota-based diversified fluid handling equipment manufacturer spent over 4% of its revenue on R&D for the past few years (see below), compared with a 1.6% industry average. The highly cyclical business even increased its R&D budget throughout the last two recessions. It aimed to take advantage of an economic contraction to strengthen its market-leading position, with technologically advanced features, pioneering design, high performance and unparalleled reliability (all achieved through innovation). Meanwhile, the management typically expects a double-digit return out of new products, which represent one of the critical long-term growth drivers.
As another example, we recommend checking out Intuitive Surgical (NASDAQ:ISRG), the pioneer of minimally invasive surgery with its renowned da Vinci surgical system. The California-based company had been dominating the lucrative robotic med-tech space for a long time until competitors finally started to unveil their counterparts in recent years (including the much-awaited Hugo RAS system from Medtronic (NYSE:MDT)).
Whether the world's largest medical device company can catch up in this space remains to be seen. Nonetheless, on the top of reputation- and switching-cost-based moats, the focus on innovation at Intuitive Surgical should excite the company's shareholders by providing some visibility of the long-term dominance. According to the chart below, the company now spends the most (in terms of the percentage of annual revenue) on research and development among its peers, including Medtronic, Boston Scientific (NYSE:BSX) and Stryker (NYSE:SYK).
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Intuitive Surgical.
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This article first appeared on GuruFocus.