Winner take all. Sounds good, doesn't it? Who wouldn't want a few of those in the portfolio? In my last column , I argued that in the slow-growth, low-inflation, harshly competitive global economy that will characterize the next decade, companies already at the top of their industries have a chance to increase their dominance. Because these companies are currently more efficient and more profitable, many will be able to put more money into even more well-organized plants and into developing new products than their competitors. So how do you identify even a few of these potential winners for your portfolio?
R&D Is Key
The most reliable indicator is a company's spending on research and development. R&D represents a company's internal projections of its future opportunities. Companies that see big future markets up for grabs tend to spend more on developing products that can capture those markets. Companies that increase their spending, especially when times are tough, have the kind of aggressiveness that's needed to win it all. Not that R&D numbers are easy to use. They're unfamiliar to most investors because they aren't widely or prominently reported. And unless they're put in context, they're worse than useless. Just knowing how much a specific company spent on R&D or even the recent trend in R&D spending at a company can be misleading in isolation, making companies look weaker or stronger than they are. Let's start by developing six rules that will help us use R&D spending to find winner-take-all stocks. When we're done, the rules, in turn, will lead to a list of five potential candidates for my portfolio.
The perfect winner-take-all stock does exist, but it's rare. The company has a dominant market share plus accelerated R&D spending that could bury competitors with a big-cap name that every investor recognizes. Johnson & Johnson (JNJ), for example, raised R&D spending every year from 1999 through 2002 in both absolute dollar terms and as a percentage of revenue. R&D spending that was already a huge $2.6 billion in 1999 climbed to $4.1 billion in 2002. From 9.5% of revenue in 1999, R&D spending grew to 11.3% in 2002. In a period when the company saw revenue grow by 32%, rather than easing off on spending to develop new products, Johnson & Johnson pushed the pedal to the floor. That aggressiveness builds market share, even for a company that is already a dominant player in many of its business segments. In the last three years, Johnson & Johnson is the only company out of 111 stocks that shows the kind of year-on-year increase in R&D that offers such perfection.