R&D Increases and Long‐Term Performance of Rivals

• Published date: 01 November 2014
• DOI: http://doi.org/10.1111/fire.12056
• Date: 01 November 2014

The Financial Review 49 (2014) 765–792

R&D Increases and Long-Term

Performance of Rivals

Sheng-Syan Chen

National Taiwan University

Weifeng Hung∗

Feng Chia University

Yanzhi Wang

National Taiwan University

Abstract

We examine how a firm’s research and development (R&D) increases affect its intra-

industry competitors in the long run. Consistent with the R&D spillover hypothesis, when a

firm unexpectedly increases its R&D spending, its intra-industry competitors experience im-

provements in operating performance and analyst forecast revisionsand earn positive abnormal

stock returns in the long run. The industry concentration, which is related to the firm’sstrategic

reaction, is crucial in determining the magnitude of the R&D spillover effect.

Keywords: R&D, spillover, intra-industry

JEL Classifications: G30, G31

∗Corresponding author: Department of Finance, Feng Chia University,No. 100 Wenhwa Road, Seatwen,

Taichung, Taiwan 40724, R.O.C.; Phone: 886-4-24517250, ext. 4173; Fax: 886-4-2451-3796; E-mail:

wfhung@fcu.edu.tw.

This research is supported by a grant from the Taiwan National Science Council (NSC 99-2410-H-

035-022).

C2014 The Eastern Finance Association 765

766 S.-S. Chen et al./The Financial Review 49 (2014) 765–792

1. Introduction

Research and development (R&D) spending has attracted increasing attention

in the academic literature, and it is no longer considered an expense but is instead

seen as a value-enhancing investment. For example, many studies show that R&D

investment is a favorable strategy for the investing firm. When a firm increases its

R&D outlay,it earns positive abnormal returns both in the short run (Chan, Martin and

Kensinger, 1990; Szewczyk, Tsetsekos and Zantout, 1996) and in the long run (Lev

and Sougiannis, 1996; Chan, Lakonishok and Sougiannis, 2001; Eberhart, Maxwell

and Siddique, 2004, 2008; Hsu, 2009; Li, 2011; Chen, Yu, Su and Lai, 2012).

We explore the impact of R&D investment on rival firms. On one hand, the

economic literature suggests the existence of an R&D spillover effect (Levin and

Reiss, 1984; Jaffe, 1986; Bernstein and Nadiri, 1989). The R&D spillover effect

indicates that an increase in R&D expenditure at a given firm positivelyaffects other

companies in the same industry.1In this sense the R&D effecton rivals is positive. On

the other hand, Zantout and Tsetsekos (1994) find that the rivals of firms that make

announcements of increases in R&D expenditures suffer statistically and significantly

negative abnormal returns. Sundaram, John and John (1996) also find that the short-

run market reaction to competitors varies depending on their competitive strategy

measure.2

Lev and Sougiannis (1996) and Chan, Lakonishok and Sougiannis (2001) sug-

gest that R&D investment is difficult to realize and to be correctly evaluated over

the short run. Moreover, managers seldom announce R&D increases formally. As a

result, the market might take time to fully reflect managers’ investment decisions.

Thus, a long-term approach is more appropriate in capturing the intangible features

of R&D investment.

If the market underreacts to the direct future benefits of the R&D increases,

which is explored by Eberhart, Maxwell and Siddique (2004), then it might also

underreact to indirect future benefits, or the R&D spillover effect, which a firm’s

rivals may obtain from the firm’s R&D increase. R&D increases provide a natural

experiment in examining the long-run market reaction to the R&D spillover effect, a

form of indirect intangible information. As a result, we expect to see the long-term

abnormal returns of rivals are positive, if rivals do benefit from the knowledge inflow

from the spillover effect.

1Researchers explore the intra-industry effect of many types of corporate events. See Brander and Lewis

(1986) for leverage; Lang and Stulz (1992) and Brewerand Jackson (2000) for bank failures; Firth (1996),

Howe and Shen (1998) and Laux, Starks and Yoon(1998) for dividend changes; Ecbko (1983) and Servaes

and Tamayo (2004) for mergers;and Erwin and Miller (1998) and Massa, Rehman and Vermaelen (2007)

for share repurchase announcements.

2Competitive strategy measure is the impact of a firm’s profitson changes in its competitors’ revenues.

The sign of measure depends on competition style: strategic substitute or complement.