Scientific Research & Experimental Development (SR&ED)

Scientific Research and Experimental Development (SR&ED) is a formal term for a specific subset of Research and Development (R&D) activities that aim to create new, or improve existing, materials, devices, products, or processes. Think of it as the disciplined, systematic quest for a technological or scientific breakthrough. While often used interchangeably with R&D, SR&ED typically refers to work that meets specific criteria laid out by governments for the purpose of granting tax credits or other incentives. For example, Canada’s SR&ED program is a well-known tax incentive that encourages businesses to conduct R&D that will lead to new or improved technology. For an investor, the SR&ED label on a company's activities signals an investment in deep innovation—a potential source of future wealth, but also a significant current expense that demands scrutiny.

For a value investor, a company's commitment to SR&ED is a double-edged sword. It’s an investment in the future that consumes cash today. The key is to figure out whether the company is planting seeds for a mighty oak or just digging a hole.

Successful SR&ED is the fountainhead of a durable competitive advantage, what Warren Buffett famously calls a moat. It creates valuable intangible assets that don't always appear on the balance sheet.

• Intellectual Property: SR&ED is the work that leads to patents, trade secrets, and proprietary know-how. This intellectual property can block competitors and allow a company to command premium prices for years to come.
• New Revenue Streams: The goal of all this research is to launch new products or services, opening up new markets and creating future growth long after existing product lines have matured.
• Cost Efficiencies: Not all SR&ED is about flashy new gadgets. A great deal of it focuses on developing more efficient manufacturing processes, which can lower costs, boost profit margins, and strengthen a company's position as a low-cost producer.

On the flip side, SR&ED is inherently uncertain and expensive. Many projects fail, and the cash spent is gone forever. A value investor must be skeptical of companies that endlessly promise future breakthroughs while burning through cash with little to show for it. The spending can depress short-term earnings, making a company look more expensive on a price-to-earnings (P/E) basis than it might be. This requires looking beyond simple metrics and assessing the quality and productivity of the spending.

Understanding how SR&ED is accounted for is crucial for comparing companies and assessing their true profitability.

How a company records its SR&ED spending on its financial statements can dramatically alter its reported profits.

• Expensing: Under U.S. Generally Accepted Accounting Principles (GAAP), most R&D costs are treated as an operating expense in the period they are incurred. This means they immediately reduce a company's net income. While this is a conservative approach, it can understate the true economic value of a company that is successfully building valuable future assets.
• Capitalizing: International Financial Reporting Standards (IFRS), used in Europe and many other parts of the world, allow for the capitalizing of development costs under strict criteria (e.g., when a project's future economic benefit is probable). This means the cost is added to the balance sheet as an intangible asset and then amortized (gradually expensed) over its useful life. This smooths out earnings but can potentially overstate a company's profitability and assets if the project ultimately fails.

An investor must be aware of these differences, especially when comparing a U.S. company to a European competitor. A savvy analyst might “add back” the expensed R&D to better gauge a company's underlying cash flow generation.

Don't just look at the total amount spent. Focus on the return on that investment.

1. Track Record: Does the company have a history of turning its research spending into successful, profitable products? Look back 5-10 years and connect past R&D spending to current revenue drivers.
2. Efficiency Ratios: Compare R&D spending as a percentage of sales to its direct competitors. A company spending far more than its peers with little extra to show for it may be inefficient. Conversely, a highly efficient innovator might spend less but achieve more.
3. Check the Notes: The notes to the financial statements often provide details on government grants and tax credits received for SR&ED. This is a direct cash benefit that reduces the net cost of the research and boosts the company’s financial strength.

SR&ED is the lifeblood of innovation and a critical component for building long-term value. For the value investor, it represents both opportunity and risk. It's not enough to see that a company is spending on research; you must dig deeper to judge whether that spending is a disciplined investment in a stronger, wider moat or simply a high-stakes gamble with shareholder money. Productive SR&ED creates the blockbuster products and unassailable competitive advantages of tomorrow.