The Best Growth Stocks? Research Says Buy Innovators Like Apple (AAPL)

growth stocks profit lab Aug 12, 2019
  • In a 2012 research paper, authors from Harvard and Tuck business schools showed how successful past investment in R&D could predict future sales growth and future stock performance.
  • The authors lay out exactly what makes a company a "good" vs. "bad" innovator and how to find "good" innovators. 
  • The authors found that the shares of "good" innovators outperformed “bad” innovators by nearly 11% per year over the last 29 years.

 

This is Apple's (AAPL) secret wireless "black lab."

Apple, one of the most innovative companies in the world, spent $13.5B on this lab and other research and development (R&D) efforts over just the last 12 months.

And that investment in innovation may be a key to the company's success (and their stock price).

In a 2012 research paper, authors from Harvard and Tuck business schools showed how successful past investment in R&D could predict future sales growth and future stock performance.

How?

First, let's look at the basics: What is R&D?

Growth Stocks Need Good R&D

Investopedia defines research and development as, “the work a business conducts toward the innovation, introduction and improvement of its products and procedures.” You can think of R&D as the in-house science lab where companies experiment on ways to improve.

Take for example Apple's AAPL wireless testing lab above (there's another incredible picture far below). Engadget reported that Apple had “40 engineers working in those labs who were experts and held PhDs in physics, telemetry, and all matter of dark arts that allow the company to continually develop and test wireless technologies.”

So investing big in R&D is good, right?

Well, not quite.

The theory goes like this: A good growth company should translate the money they spend on R&D into meaningful innovations, which in turn translate into new products, which in turn translate into faster sales growth, which in turn translates into a higher stock price.

(...which in turn translates into more money in your pocket.)

Visually, the theory looks like this:

Good R&D investment > valuable innovation > new products > sales growth > higher stock price

Apple AAPL is an interesting example because it's both a blue chip stock and a growth stock. So the company's ability to successfully invest in R&D, expand their product line, and grow sales is especially important. 

(Side note: this paper focused on R&D that led to sales growth, but a company could also innovate in ways that increase their efficiency, reduce their costs, or otherwise grow their bottom line profit. Along those lines, the authors found that the power of good innovators could be measured by the impact not just on sales, but also on other more profit-oriented metrics.)

So part of the key takeaway here is that not all R&D investment is money well spent.

The authors suggest that companies can engage in either “good” R&D or “bad” R&D:

  • “Good” R&D is an investment that directly translates into new products and sales growth.
  • “Bad” R&D doesn't translate into new products or sales growth, and is probably a waste of company time and money.

For example, the authors found that the companies they classified as “good” at R&D had a proven history of research that resulted in an increased numbers of patents, patent citations, and new product innovations - all meaningful drivers of sales growth.

How Good R&D Can Help You Buy the Best Growth Stocks

So here's the most important part for you as a stock market investor. The best high growth stocks to buy are the ones that meet this two-part test:

The authors found that the "good" innovators that have shown a successful ability in the past to translate R&D investment into sales growth AND are investing high amounts of R&D right now consistently outperformed the “bad” innovators by nearly 11% per year over the last 29 years.

Put simply, if you buy companies that have a history of good innovation AND are spending big on innovation today, you're more likely to buy the best growth stocks and beat the market.

Interestingly, as a way of checking their analysis out of sample, the authors ran the same analysis on U.K., German, and Japanese stocks and found the pattern held true across all three stock markets. So the effect isn’t isolated to the U.S. stock market.

So how can you find and buy these innovative growth stocks in your own portfolio? If you're brave, you can try to recreate the formula they use in the paper (which is pretty complicated):

“We compute firm “Ability” by running rolling firm-by-firm regressions of firm-level sales growth (defined as log(Salest/Salest-1)) on lagged R&D (R&Dt-j/Salest-j; where j=1,2,3,4,5). We run separate regressions for 5 different lags of R&D (i.e., R&D from years t-1, t-2, t-3, t-4, and t-5); we then take the average of these five R&D regression coefficients as our measure of ability.”

Yikes.

A simpler approach might be to look for innovative growth companies that have a strong recent history of:

  • Spending a lot on R&D (relative to their sales)
  • Earning lots of patents and patent citations
  • Launching new products
  • Positive sales growth

Then, based on this list of "good" innovators, check to see which are spending a lot on R&D (relative to their sales) now. According to the study, these companies may deliver strong sales growth and be tomorrow's best growth stocks.

Blue Chip Growth Stocks and R&D

Let's look at data for 10 well-know tech companies to see how they measure up: 

Growth Stock Company R&D (M) Sales (M) R&D / Sales Sales Growth
AAPL Apple $13,483 $255,038 5.3% 14.11%
AMZN Amazon $26,263 $208,125 12.6% 38.64%
FB Facebook $8,762 $48,497 18.1% 46.19%
GOOGL Google $18,664 $123,898 15.1% 24.80%
MSFT Microsoft $14,726 $110,360 13.3% 14.28%
NFLX Netflix $1,147 $13,879 8.3% 36.20%
PYPL PayPal $1,020 $14,486 7.0% 23.19%
SNAP Snap $878 $987 88.9% 57.80%
TSLA Tesla $1,453 $13,684 10.6% 35.90%
TWTR Twitter $532 $2,697 19.7% 9.83%

Remember, high R&D spend is only good if the company has a proven history of translating their R&D investment into products and sales growth (I'm looking at you Snapchat SNAP).

In our stock recommendation services, we regularly analyze R&D investment from several different angles before we buy a growth stock.

We research a wide range of proven criteria (just like R&D) to create a model portfolio of the 15 best growth stocks to buy now. They're all stable, successful, high performing blue chip stocks with strong top and bottom line growth.

So when you're researching growth stocks, look for companies like Apple AAPL who have a proven ability to turn this...

...into this:

Apple AAPL Revenue Worldwide (2004 - 2017) ($B)

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