Warning: This Announcement May Signal A Sea Change For Investors

There was some interesting news from one of America’s corporate giants that came out last month.

This announcement might signal a sea change in the business world — specifically, firms selling their competitive advantage.

I know this sounds hard to believe. But this high-profile example I’m going to tell you about suggests that companies are moving away from long-term planning. Instead they are focusing on shorter-term pandering to near-sighted investors in search of a quick buck.

Recognizing this change — and how it will affect the business landscape — could be key to picking winning stocks going forward — and avoiding big losers.

The reason has to do with one of my Top 10 Stocks advisory’s core themes: economic moats. Moats are entrenched advantages that keep a firm on top of its industry — and ensure profits for years, or even decades into the future.

Most of the companies in my portfolio have distinct moats. Intel (Nasdaq: INTC) creates cutting-edge chip technology that’s difficult to replicate or replace, which is why it dominates more than 80% of the PC chip market. Philip Morris (NYSE: PM) owns many of the world’s most popular cigarette brands and has one of the most relentlessly rising dividend payouts in corporate America.

You would have more than doubled your money investing in these companies just five years ago…

Looking for such durable business strategies should be a big part of the analysis for any serious investor.

But the dangerous trend I mentioned earlier suggests that many investors today are ignoring this advice and doing the exact opposite — rewarding companies that are selling off their economic moats. 

These firms are monetizing their most important strategic advantages, and — in effect — auctioning off the guts of their business.

It seems improbable. But it’s happening.

Just look at the recent news from major pharmaceuticals player Forest Labs (NYSE: FRX). On December 2, the company announced a major corporate restructuring, including $500 million in spending cuts across its operations.

The biggest part of the reduction comes through cuts to the company’s research and development (R&D) budget. The firm plans to reduce R&D spending by $270 million, a reduction of over 25%.

What did investors think of this move away from R&D innovation? They loved it. The stock jumped almost 10% on the announcement, adding $1.3 billion to the company’s market cap.

On the surface, the reaction is understandable. In the short term, the restructuring puts more cash in Forest’s corporate pocket. This is cash that can be used for dividends and share buybacks, providing immediate and visible benefits for shareholders.

By contrast, the benefits of R&D spending are neither immediate nor obvious. Millions spent in the lab by a firm such as Forest could take years to yield fruitful results. There’s even a chance that R&D could produce no results at all — after all, not all research succeeds.

But despite the risk, R&D spending is critical for business success. That’s why many of today’s most successful firms run large research budgets. 

Several of my Top 10 Stocks portfolio’s biggest gainers have been doing this for a while. In 2012, Abbott Labs (NYSE: ABT) spent $4 billion on R&D — enough money to buy a third of Hertz’ (NYSE: HTZ) auto rental outfit. Cisco (Nasdaq: CSCO) spent $6 billion. Intel spent over $10 billion on R&D in 2012, amounting to nearly 70% of its operating income for this period.

Would these firms be better served instead returning this money to investors? Should we expect Intel — and other big research spenders — to go the way of Forest Labs and cut budgets for new product development?

Investors should hope for the opposite. R&D spending is actually a major economic moat for many of the best companies on the market. It’s exactly how Intel, Abbott Labs and Cisco stay miles ahead of their competitors.

And it pays off to invest in companies that spend big money on R&D. As the chart below shows, over the last 20 years companies that spent the most money on R&D (as measured by a ratio of R&D budget to sales) more than doubled the return of the S&P.

The chart speaks for itself — higher R&D spending creates higher corporate value.

There are several reasons for this, but the most obvious one is for long-term competitiveness. Great companies aren’t just looking at the next twelve months of business performance. They’re eying the next twelve years — or more. They’re figuring out how to maintain market share and grow into new markets that will increase sales and profits.

R&D is a major part of this push for the future. Research leads to innovation. And that’s key to attracting new customers and keeping existing ones.

Look at a company like Samsung (OTC: SSNLF). Management’s drive to add innovative display features to its phones has created big sales and grabbed market share from competitors such as Apple (Nasdaq: AAPL).

Done right, R&D spending is one of the highest-return activities a corporation can spend its money on.

Let’s look at Intel once more. The company spent $7.8 billion on R&D through the first nine months of 2013. Most of that spending was geared toward smartphone and tablet products.

It’s easy to see why the company is focusing on this space. The smartphone market alone is estimated to be worth over $150 billion globally in 2014. Even grabbing a small percentage of this space easily pays back Intel’s R&D investment, potentially many times over if the company establishes ongoing market share in this exploding industry segment.

There simply aren’t a lot of other ways that a company can make that kind of return on its invested capital.

If history is any indicator, I expect companies like Intel, Cisco, Abbott Labs and others — which maintain significant R&D budgets and wide moats — to outperform the market in long-run. I continue to hold these firms and others like them in my Top 10 Stocks portfolio because I believe they make the best investments for long-term growth and income.

P.S. — My latest report details several more market-dominating companies with wide moats, but with a special twist. We call this particular group of investments “Legacy Assets,” because they have the potential to deliver market-beating gains and dividends not just for years, but for generations. One has been a leader in freight rail for nearly two centuries and has increased its dividend by 729% in the past decade. Another dominates two-thirds of the North American market and has gained 20% in the past three months while yielding over 4% — Warren Buffett has even invested $332 million in it. If you want to learn more about “Legacy Assets,” I invite you to watch this presentation.

This article was originally published by Dividend Opportunities under the title: Warning: Avoid This Dangerous New Investing Trend At All Costs

This article originally appeared on InvestingAnswers
Author: Dave Forest
Dividend Opportunities

Warning: This Announcement May Signal A Sea Change For Investors