As you’re pondering resolutions for 2022, here’s one that benefits you while also benefitting society—investing in companies that drive economic growth. Growth sounds like an abstract goal, so let’s make it concrete by comparing U.S. life in 1900 to life today. If you were born in 1900 you lived to the ripe old age of 47; you worked 58 hours per week (yes, I know many of you still do, but the average workweek is 34.6 hours); and for that 58 hours you made $490 per year in today’s dollars. The most visceral difference between then and now however, is that only 1% of households had indoor plumbing. So in order to bathe, the remaining 99% had to go outside, fill buckets from a well, bring them back inside, heat the water over a stove, fill the tub, bathe, then reverse the process on the way out. This was so onerous, people only bathed once per week, on Saturday night, from a single tub of water: first the father, then the mother, then the children.
There was tremendous growth and and accordingly, tremendous progress between 1900 and 1980. However, nominal GDP growth has been declining since then. The natural consequence of declining growth and expanding services is that federal debt must increase. It is currently at the highest level in U.S. history. The only way to repay this debt, and continue improving standards of living for those left behind is through growth. You can help stimulate that growth, and earn higher returns in the process. Here’s how.
Where Growth Comes From
The primary driver of economic growth is technological change. In Solow’s Nobel Prize winning work, he found it accounted for 63% of growth. So, not surprisingly, the reason GDP growth is declining is that the US innovation engine is broken. Companies’ R&D productivity, measured as RQ, has declined 70% over the same period that GDP growth has declined, as shown in the figure below.
The Role of Investors
For a number of years, I’ve been appealing to companies to improve their RQs. The argument is simple: raising your RQ increases your growth, profits and market value. The appeals have been ineffective, however. Just as companies ignored their ESG ratings in 1990, they’re ignoring their RQs now. It’s understandable they’re being ignored, because the payoffs to higher ESG scores and RQs are longer-run than executive tenures. So executives bear the investment costs, without enjoying the benefits. Accordingly, companies only care ESG and RQ when their longer-horizon investors do.
Honestly, I was caught off-guard by the power investors wield over company decision making. On one end of the spectrum, a Chief Technology Officer (CTO) told me there was no way he could increase R&D “because our investors would kill us”. On the other, and more disheartening end of the spectrum, a CTO told me, “I just spoke with our investor relations group, and they said no one was asking about our RQ, so I don’t need to worry about it”
Once I realized how important investors were, I first did some academic work showing a) how profit growth and market value are derived from RQ, b) that those growth and market value “predictions” hold over 47 years for all US traded companies, and c) that RQ is the only innovation measure that reliably predicts market returns.
While the academic work provided an important foundation, it typically doesn’t diffuse to practice, so I did something more tangible. I created a synthetic portfolio, the RQ50, that was first showcased by CNBC, then featured the following year in a master class on “Valuing Innovation” at the CFA Institute.
The RQ50 is the set of 50 U.S. firms, each spending more than $100 million in R&D, who have the highest RQ in a given year. We back-tested an equal-weighted, annually rebalanced portfolio of these RQ50 firms from 1973 to 2020, and found it outperformed the S&P500 by a factor of 10! While $1000 invested in the S&P 500 in July 1973 grew to $129,538, the same $1000 invested in the RQ50, would have grown to $1,371,820. This was true, even though the RQ50 and the S&P500 have the same volatility.
Since then, I’ve been working to create an RQ50 ETF. Progress has been slower than expected, but while waiting, I invested in the RQ50 the hard way—doing the annual rebalancing manually. From November 2018, when I first invested, through the end of 2021, the S&P500 has done really well: returning 75%, but the RQ50 has done even better: 167.5%, and that’s after hefty transaction costs, since I’m a “retail investor.”
How You Can Do Well By Doing Good
So the first way you can contribute to economic growth while earning higher returns is to invest in the RQ50. You can invest on your own, using an M1 Finance pie, or wait until there’s an ETF by providing your information here.* Hopefully companies will aspire to the RQ50 as they do to the S&P500. If so, they will improve their RQs, their own growth, and accordingly economic growth.
However, 50 companies don’t an economy make. So to have even broader impact, begin asking your financial advisor for the RQs of R&D companies in your holdings. Once companies’ investor relations hear people ask for their RQs, CTOs will begin to pay attention to them…and work to improve them. With your help, we may be able to restore company RQs, and revive growth to mid-20th century levels. That should make for many Happy New Years!
*Note: I am not a registered investment, legal or tax advisor or a broker/dealer. All investment and financial opinions are from personal research and experience, and are intended as educational material. Although best efforts are made to ensure that all information is accurate and up to date, occasionally unintended errors may occur.