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Posted 5/19/2000
Kenner & Niederhoffer
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Wall Street
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Extra!
Adapt or die in this Darwinian market
Volatility is testing investors' patience, but the fittest will survive. We introduce a new formula to help you find companies that profit from research and innovation.
By Laurel Kenner and Victor Niederhoffer
As usual, the market did the unusual.
Last week, after going down terribly three days in a row, stocks closed with two strong days on Thursday and Friday. This week, after going up for two beautiful strong days, it closed with three horrible down days.
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To instill the maximum of fear and trepidation in its votaries, the market hit limit down -- the maximum price drop allowed in a single trading day -- in the major futures contracts on Friday before rallying 0.5% from its low to the close. The net result for the week: unchanged in the Dow, down 1% in the S&P 500 and down 4% in the Nasdaq.
It’s horrible, but realize that it’s all part of the game the muse of markets plays to make us lose hope. We take consolation at times like these with Darwin’s noble thought from “The Origin of Species”:
As buds give rise by growth to fresh buds and these, if vigorous, branch out and overtop many a feebler branch, so with the great tree of life, which fills with its dead and broken branches the crust of the earth, and covers the surface with its ever-branching and beautiful ramifications
We would hope that our readers maintain a similarly positive philosophic mien during these trying times. Perhaps your comfort will be increased by noting that the declines in many Asian and South American markets this year are much more severe than in the United States. Year to date, only 11 of the world’s 62 major stock indexes are in the black.
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True, the Nasdaq is down 16%, and this hurts. But it’s still up 367% since Feb. 1, 1995, when the Fed ended its last major sequence of interest-rate increases. The Dow and the S&P 500 have both tripled since then, and their declines this year are relatively minor compared to the sustained move upward they have shown for all long-term holding periods.
For what it’s worth, we note that after the market throws a terrible end of week at its participants, it’s usually ready for a very nice rise the next week. The average move is a gain of about 0.5%, with a 3-to-1 chance of an up-week.
Brains, not brawn
Our economy, as well as the market, is in a state of turmoil. The way to take advantage of this is to use brains, not brawn. Companies need to research and innovate or die.
Our favorite book on the subject is “Funky Business,” by Jonas Ridderstrale and Kjell Nordstrom. A couple of quotes give the flavor:
- “Infostructure will become more important than infrastucture.”
If research leads to products, and if these products can be sold profitably, sales and earnings follow -- and the stocks of the companies will rise. In designing the Taurus, the America’s most popular automobile for most of the ‘90s, Ford identified 400 features and functions of cars that were important to consumers, and researched the automobiles that were “best in class” in each category. The Taurus was designed to match or exceed those standards in 320 of the 400 features.
Kenner & Niederhoffer
Victor Niederhoffer has traded stocks, currencies and futures worldwide for the past 40 years; he is the author of "The Education of a Speculator." Laurel Kenner is a trader and former Bloomberg markets editor. In a special series of weekend columns for MoneyCentral, they'll assess the past week's Wall Street performance and next week's prospects. Let us know what you think in the Start Investing Community.
Research has tax advantages that add to the bottom line. And there is always a chance that a company’s research will attract an acquirer that sees an opportunity to exploit it over a wider product or customer base.
Many stock-valuation models evaluate the rate of return from use of existing assets --the most common being the return on equity (ROE) or return on invested capital (ROIC). A better model for today, we think, would be one that looks at returns from research.
Murphy has invented the concept of growth flow -- the ratio of price-to-earnings-plus-research expenditures. We propose a variation on this: the percentage of sales spent on research divided by the price/sales ratio.
As a test, we computed the percentage of research expenditures to sales for companies listed on the New York Stock Exchange through the end of 1997. We found 19 with a ratio of 14% or more. We then looked at the return for these companies since 1997, and compared it with the average return for companies in the NYSE Composite Index.
The results were spectacular. The companies with high R&D ratios rose an average of 124% in the period, versus 27% for the average NYSE company.
| Company | % of sales spent on research | Price/research ratio | % Return (1997-present) in stocks |
| Midway Games (MWY, news, msgs) | 22 | 31.3 | 403 |
| Northrop Grumman (NOC, news, msgs) | 15 | 24.5 | 372 |
| Network Equipment Technologies (NWK, news, msgs) | 17 | 21.4 | 54 |
| General DataComm Industries (GDC, news, msgs) | 16 | 17.9 | -41 |
| Input / Output (IO, news, msgs) | 22 | 6.3 | 53 |
| Advanced Micro Devices (AMD, news, msgs) | 22 | 5.7 | 560 |
| Cadence Design Systems (CDN, news, msgs) | 20 | 5.4 | 39 |
| Union Pacific Resources (UPR, news, msgs) | 16 | 5.1 | -76 |
| Cabletron Systems (CS, news, msgs) | 15 | 5 | 8.6 |
| National Semiconductor (NSM, news, msgs) | 24 | 4.8 | 366 |
| Pharmacia (PHA, news, msgs) | 14 | 3.8 | -64 |
| LSI Logic (LSI, news, msgs) | 14 | 3.5 | -33 |
| Cypress Semiconductor (CY, news, msgs) | 18 | 2.8 | 112 |
| Vastar Resources (VRI, news, msgs) | 17 | 2.6 | -44 |
| Alza (AZA, news, msgs) | 15 | 2.5 | 78 |
| Eli Lilly (LLY, news, msgs) | 18 | 2.3 | 31 |
| Texas Instruments (TXN, news, msgs) | 14 | 1.8 | 513 |
| Pfizer (PFE, news, msgs) | 17 | 1.7 | -5.6 |
| Analog Devices (ADI, news, msgs) | 18 | 1.3 | 124 |
Other things being equal, higher values for the price-research ratio are bullish. But we caution that studies like these have many gaps. Not the least is that the stock market is fickle in its valuation of research companies. During the last two and a half years, it has smiled on such efforts. But cycles of appreciation and depreciation have a way of changing in markets and life.
Also, not all research leads to profitable products. As reader Frank Linet points out, the roster of billion-dollar duds is long. RJR Nabisco’s smokeless cigarette, McDonald’s McRib, Coca-Cola’s New Coke and Pepsico’s Pepsi Free are some notable examples.
“Competition breeds greatness, but lack of focus and inconsistent vigor breeds mediocrity,” Linet writes. “People focused and willing to think and do without constraint will usually beat the esteemed and well-established fat cats.” Hence YooHoo beat Nestle, Double Bubble beat Bazooka and Microsoft slayed Big Blue.
It would be good to have a measure of the quality of research as well as its quantity, but no systematic procedures are available. Perhaps steps in this direction could be made by measuring patent applications or awards for new products given by various independent entities.
At the time of publication, Vic Niederhoffer was short S&P futures and options. Laurel Kenner holds no issues mentioned in this column. Mail Laurel and Victor at lkvn@hotmail.com.
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