R&D and Value investing

In value investing, technological innovations are a double-edged sword.

As businesses grow and improve spending on R&D, they find better ways of doing things. These product or process innovations are advantageous only if they improve their operating/net margin either though cost-savings or increasing the absolute profits (by a rise in volume). However the same innovation can be a bane if instead of keeping the cost-savings to themselves, businesses have to pass it over to the consumers. This is a double whammy - as the company spent tons of money for procuring the new technology and yet couldn't eat the fruits of their investment.

This doesn't mean that R&D is bad. As long as research leads to newer revenue lines or reduces costs and it's advantages needn't be passed on to the consumer (in other words, demand is price inelastic) - I'm all in favour of more investments in research. Lets take the PC industry. My father presented me a PC on my 7th birthday. It was an XT286 (from the 386, 486 line of computers). The PC was second hand and cost him a whopping 33,000 rupees (worth almost 90,000 rupees in today's money). Since then, technological innovations have put the XT286 on the extinction list. As the technology improved, the price of the PC didnt (it actually came down). For PC manufacturers like Dell, the margins dropped from 17% in the late 1990 to 4.5% in 2007 (lately, Dell has improved operating margins to 6.5%).

A value investor would look at these innovations carefully, to understand it's impact on the business (and his investment). So the next time, a company shouts at this new Plutonic-VBL-CV-Cyberquat101 technology that they have installed for cost-saving ... question them on whose pockets do the savings go to - the consumer or the shareholder?