Tag: Anne Marie Knott

Pharmaceutical and biotechnology companies topped the 2021 RQ Top 50 list of the most innovative U.S. companies. The annual ranking identifies the smartest R&D spenders – those companies that both spend big (at least $100 million in R&D) and provide the greatest returns to shareholders from that investment.

Notably absent from the list were the three most attention-grabbing pharmaceutical and biotechnology companies of the year – Pfizer, Moderna and Johnson & Johnson.

That’s because the RQ50 is not like other innovation rankings. Developed by Anne Marie Knott, the Robert and Barbara Frick Professor in Business at Washington University’s Olin Business School, RQ (research quotient) measures R&D productivity in theoretical models linking R&D investment to revenue growth and market value – precisely the outcomes executives and investors care about, Knott said.

“RQ essentially measures how smart companies are. Just as high IQ individuals solve more problems per minute, high RQ companies solve more technical problems per dollar,” Knott said.

“While most of the market still thinks R&D spending is the best gauge of companies’ innovativeness, it’s not. It’s quality not quantity of R&D spending that matters.”

The proof is in the numbers: The RQ50 portfolio historically outperforms the S&P 500, despite the fact that the two portfolios bear the same level of risk (beta), Knott said.

What does it take to make the RQ50?

The 2021 RQ50 represents a broad swath of the economy. The biggest representation comes from pharmaceutical and biotechnological companies, which comprise nine of the top 50, or 18%. Makers of semiconductors make up 14% of the list followed by computer programming at 10%. By contrast, 28% of the RQ50 are the only firms in their industry to make the cut.  

“So it’s not the case these firms are all riding the same wave of opportunity,” Knott said. “The RQ50 firms are standouts in their respective industries.”

Now in its eighth year, the RQ50 ranking is fairly stable: 66% of firms from the 2020 ranking appear again in 2021. According to Knott, that’s because firm capability changes slowly.

Of the 50 companies who made this year’s ranking, six have made the RQ Top 50 all eight years since CNBC published the initial RQ50 in 2014. These standouts include Hasbro, Lam Research, Netflix, NewMarket, Synaptics and Xilinx. 

New to the list

Seventeen companies are new to the RQ50 list. How did they make it?

• Alarm.com, FMC, Guidewire Software, Match Group, NortonLifeLock and Qualcomm were close last year, but ascended this year.
• Abiomed, Church & Dwight Co. and MaxLinear crossed the $100 million R&D threshold in FY2020.
• Cara Therapeutics – No. 2 on the list – was excluded last year because its R&D exceeded revenues.
• Prior to FY2020, Acacia Communications, Blueprint Medicines, Corcept Therapeutics, Hewlett Packard Enterprise, Lumentum Holdings, Square and Xperi Holdings hadn’t been publicly traded and conducting R&D for enough years to form their RQ.

Who dropped out?

In order for 17 firms to ascend, another 17 had to drop out. What happened to them?

• AMAG Pharmaceuticals and The Meet Group were acquired.
• Retrophin rebranded itself and now trades under a different name.
• Halozyme Therapeutics and Ironwood Pharmaceuticals dropped out because their R&D spending fell below the $100M threshold for inclusion.
• Arena Pharmaceuticals, Enanta Pharmaceuticals, Lexicon Pharmaceuticals and PTC Therapeutics no longer have revenues that exceed their R&D, a criterion for inclusion. 
• Allison Transmission, Dow, Intuitive Surgical, FireEye, Sirius XM, Take-Two Interactive, United Therapeutics and Veeva Systems failed to maintain RQs sufficient to keep them in the top 50.

COVID-19’s effect on innovation

While the COVID-19 pandemic shut down manufacturing lines and disrupted global supply chains, research and development – at least so far – appears to have continued its upward trend. During FY2020, which for some ended in June 2020 and for others not until May 2021, R&D spending in absolute dollars increased by 6%. During this same time period, revenues fell on average 10%, making the R&D investment even more significant.

“In most cases, firms committed to their FY2020 R&D spending before the pandemic. So it’s still too early to measure the pandemic’s full impact on firm R&D investment,” Knott said.

“However, I’m cautiously optimistic that firms will continue to prioritize R&D because if there’s anything the pandemic has taught us, it’s the importance of innovation.”

Anne Marie Knott, the Robert and Barbara Frick Professor of Business at Olin, has won the 2021 Olin Award for “RQ Innovative Efficiency and Firm Value,” forthcoming in the Journal of Financial and Quantitative Analysis.

The Olin Award, which includes business school recognition and a $10,000 prize, is intended to promote scholarly research that has timely, practical applications for complex, real-world management problems.

Dean Mark Taylor surprised Knott with the good news on Tuesday during a Zoom chat, which she initially believed was to discuss her annual performance review.

“I didn’t know it was a party!” Knott said when she joined the chat, which was populated by a small group including Richard J. Mahoney, former CEO of Monsanto and a Distinguished Executive-in-Residence at Olin.

Taylor told her the Olin Award judges had chosen her paper as the winner, and he led a round of applause.

“Thank you! I’m so excited,” Knott said.

“One of the things our judges liked was that it was written in our native tongue,” said Mahoney, who initiated the Olin Award 14 years ago. “Not that it was simple, but it was well written.”

Knott’s winning entry—one of 14 papers submitted—­­explores RQ’s ability to serve as a robust measure of a firm’s innovation for the finance audience. RQ is short for research quotient, which is measured as the output elasticity of Research & Development. First developed by Knott in 2008, RQ can be estimated for any firm reporting R&D.

Knott’s paper is “making an academic impact as well as a business impact,” Taylor noted.

Knott said people already had downloaded it about 5,000 times. “It’s my most-downloaded paper,” she said.

R&D is the primary source of growth for 40% of companies, Knott explained in her submission letter, “yet companies are flying blind with respect to their R&D, because they lack good metrics.”

The front-end implication of flying blind is that companies don’t know how much to invest in R&D, she said.

“Only 4% of companies invest within plus 10% of optimal levels. The remaining 96% of companies are leaving an average of $182 million of foregone profits on the table each year.”

The back-end implication of flying blind is that companies can’t tell if they’re effectively managing their R&D.

“As a consequence, companies’ R&D productivity has declined 65% over the past four decades,” she said. “This not only hurts companies and their stakeholders; it hurts the entire economy, because R&D is the primary driver of economic growth.”

Knott said she and her co-authors wondered if academics suffered similar problems with respect to innovation metrics. So they tested the ability of academic innovation metrics to predict firm value.

“While all metrics performed well in some tests, only RQ consistently predicted current and future firm value,” she said.

Knott will present her paper during a virtual Olin Award event in the spring. A date will be announced soon.

Research and development is the key expertise of Anne Marie Knott, who developed the metric known as the Research Quotient (RQ), the only innovation metric that reliably predicts firm value.

With the new presidential administration announcing its economic-policy intention to invest $300 billion in research and development, there is a key voice offering the caution: Aim for the development end.

That is the counsel of Knott, the Robert and Barbara Frick Professor in the Olin Business School.

“President Biden has his work cut out for him in ensuring ‘a future made in all of America … where the United States wins … the jobs and industries of tomorrow.’

The most important thing he can do in the short-run is dedicate the $300 billion additional R&D to development (D) rather than research (R), she said.

“This level of investment could indeed bear fruit, but not if targeted at research,” Knott said.

(Research is diligent inquiry or examination to seek or revise facts, principles, theories, applications, etc. Development is about growth and directed change. Essentially, one is the creation of new ideas and the other is the application of them.)

“There has indeed been a dramatic decline in federal R&D support, but the decline is not in research. It is entirely in development.

“In fact, the decline in American R&D productivity tracks the decline in federal development almost perfectly. The decline in federal development is therefore the most likely culprit for the decline in R&D productivity. Thus, investing in research is solving the wrong innovation problem.”

A central puzzle of corporate strategy is whether headquarters can add value to their business units beyond the burden of their own overhead. The record is bleak: On average, corporations trade at a 20% discount relative to their breakup value.

“This is the problem that we want to try fix,” said Anne Marie Knott, Olin’s Robert and Barbara Frick Professor of Business.

She proposed and tested a theory of how corporations could overcome that record. On November 10, she presented the findings as part of the Olin Business Research Series. More than 60 people tuned in for the virtual event.

The 20% discount could mean that multibusiness firms fundamentally destroy value or that they are poorly managed. Regardless, a whopping $5 trillion economic gain could be had from a better understanding of how headquarters add value in multibusiness firms, Knott says.

Bank One and its return on assets

Bank One, a bank holding company, motivated the theory. Knott and co-author Scott Turner, of the University of South Carolina, explain how in “An Innovation Theory of Headquarters Value in Multibusiness Firms” in Organization Science.

Bank One increased the return on assets of its target banks by 40-70%.

“This would be really easy if they were purchasing underperforming banks,” Knott said. But they weren’t. They were buying well-managed banks.

The theory relies upon dynamics between business units where laggard units improve their performance by imitating leaders. In turn, this “competition from below” stimulates leaders to innovate more.

Beyond demonstrating that headquarters can add value through innovation and growth, the theory offers prescriptions on how to do that. For instance, they can establish systems that create norms for sharing, which eases innovation. They also can offer high-powered incentives to fuel innovation.

In general, Knott’s research examines the optimal environment and policies for innovation, which she summarizes in her book, “How Innovation Really Works” (March 2017). This interest stems from issues arising during an earlier career in defense electronics at Hughes Aircraft Company.

KEY TAKEAWAYS:

• A $5 trillion economic gain could be had from a better understanding of how headquarters add value in multibusiness firms.
• Bank One increased the return on assets of its target banks by 40-70%.
• The theory relies upon dynamics between business units where laggard units improve their performance by imitating leaders.
• In turn, this “competition from below” stimulates leaders to innovate more.

Paul Sagel seems to have violated all the presumed rules about innovation at big companies. With a swipe of gel and a strip of plastic, the Procter & Gamble research fellow created a $250 million annual line of business for company No. 45 on the 2019 Fortune 500 list.

Among business researchers, however, the conventional wisdom said Crest Whitestrips should never have happened. A nagging thread in the academic literature since the 1940s strongly suggests that the bigger a company gets, the less efficient it becomes with its investments in innovation. As they grow, firms spend more and more, yet they get less and less out of it.

Not so fast, says Olin’s Anne Marie Knott, who has a forthcoming paper in Organizational Science designed to tease apart this riddle: Why would firms engage in this seemingly irrational behavior? How can they hope to outpace the innovation in small, nimble startups that aren’t saddled with overhead and corporate inertia?

The answer to the riddle is that large companies aren’t acting irrationally. The paper, “Reconciling the Firm Size and Innovation Puzzle”—written with former Olin PhD student and current Drake University professor Carl Vieregger—concluded researchers just haven’t had the right tools to measure the productivity of investments in research and development.

Knowing the answer is vital, Knott said, because big companies remain a thriving engine of innovation and shouldn’t let conventional wisdom slow them down.

“Large firms comprise 87% of the innovation engine in this country,” said Knott, Olin’s Robert and Barbara Frick Professor of Business, citing numbers from the National Science Foundation. “They do 5.75 times more R&D than smaller firms with fewer than 500 employees—and they’re more productive with it.”

Breaking the rules

According to the conventional academic wisdom on R&D, large firms tend toward process innovation—how can we produce products more efficiently?—rather than toward new products or services. And they lean more toward incremental updates—“new and improved!”—versus new-to-the-world breakthroughs.

So Paul Sagel “broke the rules” when Procter & Gamble launched Crest Whitestrips in May 2001. The company invested years of work to introduce a revolutionary new product, disrupting cosmetic dentists’ trade in expensive tooth-whitening treatments.

In their attempt to unravel this seeming paradox, the research team took two approaches—one conclusive, the other inconclusive—and plumbed a relatively untapped source of data from the National Science Foundation’s Business R&D Innovation Survey, which has collected qualitative and quantitative data since 2008.

Two approaches

In their first approach, the researchers analyzed BRDIS data from more than 2,000 firms that invested in R&D. That analysis examined whether the apparent “small-firm advantage” stemmed from their conducting more productive forms of R&D, or whether the forms became less productive as firms got larger.

Using that approach, the team found that small firms did development (rather than research), radical innovation (rather than incremental innovation), and product innovation (rather than process innovation)—just as the prevailing theories have predicted. But the researchers found no evidence that those strategies made them more productive, or that those strategies became less productive as firms grew larger.

Then why do people think small firms are more productive? Because scholars have counted patents or products, rather than the returns from R&D.

Accordingly, in their second approach, the team tested a metric Knott has pioneered in her quest to measure the value of R&D investments: the “research quotient.” RQ is “the output elasticity of a company’s R&D”—the percentage change in revenues from a percent change in R&D. It relies  exclusively on firms’ financial data rather than unreliable and inconsistent measures such as the number of patents.

In that analysis, Knott and Vieregger found that large firms had higher RQ, no matter what form of R&D they chose. This is because large firms can exploit their size, spreading the cost of innovation across the operation. In the case of Crest Whitestrips, for example, P&G already had brand equity, distribution channels, a sales force and other assets, increasing the productivity of its investment in a new product. 

“The main takeaways are these: The idea that large firms can buy small firms to replace their own R&D is just disastrous. If we have to start rebuilding the R&D engine from scratch, it will be impossible,” Knott said. “The second is that large firms shouldn’t try to operate like small firms to become more productive—they already are more productive.”