R&D investment, product market competition, and stock returns

Abstract

In this article, I consider the interaction between product market competition and investment in research and development (R&D) to tackle two asset pricing puzzles: the positive R&D-return relation and the positive competition-return relation. Using a standard model of R&D return dynamics, I establish that competition and R&D investments have a strong interaction effect on stock returns. It is more likely that firms with high R&D expenditures will end up with very low returns on their ventures because rival firms win the innovation race. Because there are more potential rival firms in competitive industries, R&D intensive firms in competitive industries are riskier. Consistent with the predictions of the model, I find a robust empirical relation between R&D intensity and stock returns, but only in competitive industries. This finding suggests that the risk derived from product market competition has important asset pricing implications and potentially drives a large portion of the positive R&D-return relation. Furthermore, firms in competitive industries earn higher returns than firms in concentrated industries only among R&D-intensive firms. My second finding therefore provides a risk-based explanation for the heretofore puzzling competition premium.