R&D tells you nothing about a company’s future. Ignore it

Companies spend money on R&D to come up with new products. But there’s more to it than spending money.

It’s easy to pick on Steve Ballmer, the guy who succeeded Bill Gates as CEO of Microsoft.

He was a bad CEO, but that in itself is no big deal. There are lots of bad CEOs. Ballmer’s sin is that he was so weird about it.

He’s the one who charged around the stage at Microsoft’s 25th anniversary conference, drenched in sweat from waist to crown, eyes bugging, fists pumping, screaming “DEVELOPERS! DEVELOPERS! DEVELOPERS! DEVELOPERS!” and “I. LOVE. THIS. COMPANY!”

In 2007 he said “there’s no chance that the iPhone is going to get any significant market share. No chance.” Then, when he realised his mistake, he went all-in on the Windows Phone by buying Nokia in 2014, about five years too late to make any difference (Microsoft ultimately had to write down Nokia’s value by $7.6bn).

And in 2011 here’s how he described Microsoft’s cloud business: “All in, baby! We are winning, winning, winning, winning.” (Amazon Web Services subsequently won.)

Ballmer had a tough job, in fairness. When he took over in 2000 Microsoft dominated the technology business. It owned the desktop PC and office software, which is pretty much all there was back then. Windows and Microsoft Office were spewing out cash.

But there was trouble on the horizon.

The first problem was the internet – the internet belonged to Google and companies like it. Microsoft never figured out how to make money on the internet.

The second problem was mobile. The iPhone was just a glint in Steve Jobs’s eye at the time. But there were signs, such as the iPod, that mobile computing was going to be a big business.

By 2010 it was clear that Microsoft was in trouble. Despite having more resources than anyone, a monopoly on the PC, and the pick of the world’s top talent; it had completely missed the boat on mobile, search, and social networking.

So what happened? How did Microsoft blow the most dominant position in the history of the technology industry?

Whole books have been written on the topic. But today I want to focus on one idea which I think is important, and which matters for any investors in fast growing technology businesses: the importance of research and development, or R&D.

Good money after bad

Companies spend money on R&D to come up with new products. At some point everything was a prototype in a lab somewhere, being fussed over by scientists, technicians and engineers. That’s R&D.

Different industries spend different amounts on R&D. Pharmaceuticals lead the way. They spend billions trying to find new drug compounds. But every industry spends some amount on R&D.

R&D is measured as a percentage of sales. The average across all companies is about 2-5%. Software businesses tend to spend around 13%. The great bulk of R&D spending is engineers’ salaries.

So what about Microsoft? During Ballmer’s tenure as CEO, Microsoft ploughed billions into R&D. Whether you look at the absolute amount spent or the spend as a percentage of sales, the number is huge. In 2011 it was spending $9bn or 13% of sales. Compare that to Apple, which at that time was spending $2.4bn or 2.2% of sales.

So despite spending a fraction of what Microsoft spent on developing new products, Apple was absolutely crushing Microsoft in the marketplace. Around that time it launched the iPhone, the iPad and the iTunes store. Microsoft launched the Zune, the Nokia-Windows phone and the hated Windows 10.

The point is this: new products are very important. In some industries like technology and biotech, new products are the be-all and end-all. And all new products ultimately come from R&D.

But it doesn’t follow that money invested in R&D is money invested in innovation, new products, and new sales. It doesn’t work like that. Having an R&D budget is a necessary but not sufficient condition for coming up with innovative ideas and products. Studies looked into this question. They find no relationship at all between R&D spend and future sales, profits, investor returns.

If it were as simple as throwing money at the R&D department Steve Ballmer would be known as the greatest CEO of his generation and Microsoft would own the smartphone and internet search business.

Other ways of testing innovation have been suggested, like looking at how many patents a company files. But according to studies, patents don’t tell you anything either.

I wish I could tie this piece up with a bow by telling you the real number to watch out for, the secret sign that a company is about to come up with great new products. But it doesn’t really exist. You need to use your own judgment to decide whether the company is working on important problems, and whether it has the right type of culture to solve them.

Or, failing that, just don’t be suckered into thinking a giant R&D department is the solution to all problems. Don’t be like old Steve Ballmer.

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