We thought we’d spend some time discussing one of the most obscure screens amongst the Quality stock screen category, R&D Breakthroughs Screen. It’s a stock selection strategy that seeks to match up companies with cheap share prices compared to what they are spending on R&D.

Why this one?

Well, we’ve not really covered it before and frankly it has been going like a rocket ever since we started tracking its performance along with the other screens on December 15. It’s enjoyed a 25.80% gains vs. 7.9% for the FTSE 100, with a -2.85% maximum drawdown. That makes it the third best performing of all 61 of our screens, closely following the leader, earnings upgrade momentum (see here for a list of all the screens sorted by their performance to date).

What's this Screen all about? 

This screen is designed to find potential growth stocks before the market catches on. It does it by seeking out attractively priced shares and applying some neat accounting analysis to see which ones are spending the most on research and development. The metrics involved are inspired by a screen developed by US investment commentator and author of Your Next Great Stock, Jack Hough, and the theory behind it is supported by substantial academic and professional research.

First, the theory. The screen leans heavily on the phenomenon that stock mispricing can easily occur because of the way that companies account for R&D. Given the choice, most firms would prefer to book their R&D expenses as capital investments on the basis that they are hoping that R&D will eventually lead to some profitable conclusion further down the line. By booking these costs as an investment it would qualify them as intangible assets, which could then be depreciated over a period of time. In some cases, companies do book ‘development’ as an intangible but they have to regularly vouch for each project being commercially viable. What ends up happening in a lot of cases – because of accounting and tax rules – is that R&D has to be booked as an expense (much the same as computers, entertaining and paperclips) in the year it occurs.

What is important about this situation is that heavy R&D costs can weigh against company earnings, which inevitably drags down the share price. So a company may be investing hard on future development that will hopefully…

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