The R&D Advantage

Jan 09, 2014

An unwavering focus on research and development is keeping the U.S. at the forefront of global innovation. The latest wave of advances is primed to change your life—along with the world’s economy

The steady rise of China as an economic power during the past decade has sometimes made the rest of the world seem earthbound in comparison. Other developing countries, propelled by young, ambitious, inventive populations, have found their own places in the roster of rising global powers. Meanwhile, in the wake of the recession, the U.S. has sometimes appeared to be on its way to a diminished role, along with the rest of the developed world.

But when you take a closer look, the picture is very different. In the matter of innovation, the U.S. is actually outpacing the rest of the world, upending the status quo and driving opportunity on a number of different fronts. New technology for energy production has doubled U.S. reserves of natural gas in the past decade. Creators of "cloud-based" software are revolutionizing the way software and data are distributed and used. Advances in wireless technology and mobile apps are creating new business models and enabling commerce, via smartphones and tablets, where none previously existed. Farmers are now able to plow, cultivate and harvest their fields by remote control while sharing data about their crops with dealers and commodities markets. And 3-D printing, while still used mostly for jaw-dropping demonstrations and the creation of expensive prototypes, has seemingly limitless potential.

All these pockets of innovation translate into greater economic vitality for the U.S.—and potentially significant gains for leading companies in the many industries that continue to pour money into research. "The innovation cycle in the U.S. is alive and well," concludes Savita Subramanian, head of U.S. equity and quantitative strategy for BofA Merrill Lynch Global Research. "And it could continue to serve as an engine of growth for some time to come."

American Ingenuity, by the Numbers

Those who worry about waning U.S. innovation often point to a traditional yardstick of inventiveness: the patent. In 2010, China took over the No. 1 spot in generating patent applications, a place of honor long held by the U.S. But it's worth noting that the Chinese government provides tax breaks and other incentives for filing patent applications, which leads some strategists to suspect that the explosion in Chinese applications may be artificially inflated. Subramanian notes that some companies can be financially motivated to file applications for ideas that have little chance of winning approval. Meanwhile, the U.S. still leads the way in the number of patents actually granted, accounting for more than 20% of all new patents worldwide in 2011.

That achievement seems to be a direct result of a commitment to research and development that has never wavered in this country, even during the economic downturn. The U.S. still spends more on R&D than any other country—more than China, Japan, South Korea and Taiwan combined. In fact, since 1989, companies in the Standard & Poor’s 500 index have tripled their R&D outlays. At the same time, American productivity, as reflected in gross domestic product per worker, has continued to increase, according to Martin Neil Baily, senior fellow at the Brookings Institution.

Investing in Innovation

U.S. companies' commitment to research and development not only brings innovation to our world; it also offers tangible benefits for investors. According to BofA Merrill Lynch Global Research, stocks of corporations investing up to 30% of their sales in R&D bettered the S&P 500 index by 2.7 percentage points during the three months after disclosing their R&D expenditures—and three years later, they were still 0.8 points ahead. On the other hand, the stocks of companies that claimed no R&D spending trailed the S&P 500.

Corporate spending on R&D is bearing fruit across a broad spectrum of industries, and a number of companies could potentially help meet your need for growth in your portfolio. Pay particular attention to companies that have already established a track record of successful innovation, as well as those reporting significant R&D spending. In addition, you can work with your financial advisor to identify exchange-traded funds (ETFs) and mutual funds that follow sectors where R&D is important. Here are some key areas in which innovative U.S. companies can offer opportunities.

Cloud computing Recent advances in cloud computing have been especially dramatic, says Tal Liani, telecom analyst at BofA Merrill Lynch Global Research. And while much of the buzz about the cloud involves consumer applications, it may be even more important to business, he contends. To take advantage of the cloud, corporations build data centers that may be located miles from a company's headquarters. Then, rather than investing in computers and software for every employee, that company can rely on a storehouse of computing power to serve global operations.

It's a shift that transforms the economics, scale and delivery of services to employees, helping them become more innovative and productive. Although it presently accounts for only about 5% of the information technology sector, cloud computing is likely to expand rapidly during the coming decade, Liani says. "Companies are eager to invest in innovations that cut costs," he explains. A natural starting place for potential investors could be with the enterprise software companies that have led the way in designing and disseminating cloud-based services.

Smartphones and tablets The profusion of increasingly powerful mobile devices is transforming the way people around the globe communicate and shop. In the short time since they were introduced in 2010, tablets have become a $50 billion market and are forecast to grow at a 35% annual rate through 2014. Yet while manufacturers of the innovative hardware have gotten most of the early attention, much of the creative ferment—and investment opportunity—in this area involves innovators who develop novel applications. Consumers spent $10 billion on apps in 2011, and that figure could grow to $46 billion by 2016, according to Liani. Apps are leading to entirely new markets for mobile advertising, mobile payments and other related products and services.

Semiconductors Researchers have managed to make a transistor measuring a mere 22 nanometers (22 billionths of a meter) in diameter—so microscopic that you could fit more than 100 million on the head of a pin. That’s just one more innovation in an industry that gets an especially big bang for its research buck, generating the highest ratio of R&D spending to sales. New 3-D transistors are disrupting the 2-D approach that has dominated semiconductors for more than 20 years. Potential investment opportunities could also come from the U.S.-based companies producing the chips that enable wireless connectivity—especially combining Wi-Fi, Bluetooth, GPS and even FM radio.

Robotics Robots have been in factories for years, helping automate difficult or dangerous production tasks while keeping manufacturing flaws to a minimum. They’re one of the reasons that U.S. productivity has continued to rise even during the recent recession. But the future of robotics calls for machines that can do more than fulfill a repetitive task on a production line. Innovators are now working to create robots that are able to handle much more complex industrial chores and to work in the home, even helping elderly people who need assistance with daily activities. As robotics costs decline and skills increase, robots are plowing new ground—in some cases almost literally, by automating some of agriculture’s most sensitive tasks. "We are getting to the point where you can automate jobs like picking fruit or lettuce," says he Brookings Institution's Baily.

Genetic testing and treatment A decade ago, scientists finished mapping the approximately 25,000 genes of the human body, part of a project that took 10 years and cost $3 billion. Now anyone’s genome—the totality of a person’s genetic information—can be sequenced in 24 hours for less than $5,000. And the $1,000 genome is coming soon, says Derik de Bruin, a BofA Merrill Lynch Global Research analyst who covers life sciences and diagnostic tools. Sequencing breakthroughs are giving researchers the tools to examine cancer tumors at their most basic levels, and scientists in medical centers and pharmaceutical company labs aren’t just finding mutations that enable malignant cells to multiply; they're also creating drugs that precisely target those abnormalities and make tumors literally disappear. That approach is far preferable to the traditional surgery, radiation and chemotherapy that debilitate patients, often with little effect.

According to de Bruin, emerging genetic industries are in the earliest stages of an expansion that should produce steadily rising earnings and stock values. He recommends that investors look at genomic sequencing leaders as well as their suppliers. "We like the companies that provide the picks and shovels that are used for doing research," he says.

Health data management Alongside the revolution in genetic techniques, new data management systems are creating efficiencies in the health sector, which has traditionally been a difficult place to boost productivity. In the future, physicians will be able to use mobile devices to determine the effectiveness of treatments and develop customized approaches for individual patients. Christopher J. Wolfe, chief investment officer of the Private Banking and Investment Group at Merrill Lynch, says that mobile systems will also be able to track data on individuals. That will allow doctors and patients to instantly tell, for instance, when a blood pressure reading shows signs of being abnormal. "In the past, data on a patient was stored in many places," says Wolfe. "Now with a wireless system, all the data can come to a doctor's cellphone. That will cut costs and make treatments more effective." Data management is a vast area of the health care marketplace, and one place to look for opportunities is among companies that operate on a large enough scale to be major drivers of efficiency.

These are just a sampling of the kinds of innovative advances generating potential earnings growth for a wide variety of U.S. manufacturers and service providers. Another can be seen in the energy arena, where the ability to extract natural gas and oil from shale rock formations through hydraulic fracturing, or "fracking," continues to gain momentum. The next step may be to export this largely American technology to China, Argentina and other countries with enormous shale gas and oil reserves. Other innovations are changing the shape of everything from banking to real estate, lifting up companies bold enough to break the mold.

While there are still factors that could act as headwinds to innovation and economic growth (see "Still Room for Improvement" sidebar), the overall outlook remains bright, Subramanian says. She notes that for years, eager entrepreneurs have come to the U.S. from other countries because of the advantages they find here for developing their ideas. To judge by the long list of recent breakthroughs and other advances still on the drawing board, it appears that the U.S. will remain fertile ground for innovators for years to come.

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