Is research and development mispriced or properly risk adjusted?

Research has established that research and development (R&D)-intensive firms are characterized by substantial future risk-adjusted stock returns. The reasons for this phenomenon and its policy implications, however, are widely debated. Some attribute the excess returns to investors' systematic undervaluation of R&D firms and argue for improved disclosure to mitigate the mispricing, whereas others claim that the excess returns are just compensating for an R&D-specific risk factor. We aim to provide insights into this controversy by examining R&D firms with substantial R&D outlays, that is, firms with R&D as an important ingredient in their strategy. Among such firms, we compare firms with high and low industry-adjusted R&D intensity. The high industryadjusted R&D intensity firms are more likely to engage in basic research activities, whereas the low industry-adjusted R&D intensity firms are likely to mimic and extend existing technologies. As such, compared with the low industry-adjusted R&D intensity firms, the high industry-adjusted R&D intensity firms are likely to suffer from higher information asymmetry. We find that high industry-adjusted R&D intensity firms generate larger risk-adjusted returns compared with low industry-adjusted R&D intensity firms in the first five future years, after which the excess returns for the high group converge to those of the low group in the long run. This reversal in returns is consistent with undervaluation of high industry- adjusted R&D intensity firms. The long-term excess returns are positive for both the high and the low industry-adjusted R&D intensity firms, and these excess returns are partly attributable to information risk. We also show that the future excess returns of high industry-adjusted R&D intensity firms are lower for those firms who provide voluntary disclosure (earnings guidance) suggesting that the short-term undervaluation is likely due to mispricing.