Investors in Cisco have not only had a very difficult year but also a lackluster decade. For several years Cisco's stock price (CSCO) has traveled relatively sideways and only the most active investors have been able to scrape profits from the stock. In the following report, I present a fundamental element which has been driving the returns of Cisco for the past five years and how you can capitalize on it.
In order to build into this analysis, we must start at a fairly high level. Cisco designs and manufactures a wide variety of technology products with a variety of business purposes. Since the nature of Cisco is to produce technology equipment, it stands to reason that research and development drives the innovation of the firm. As Cisco pours their revenues back into researching better products and more efficient methods, they accrue research and development expenses which detract from the net income of the business. This is a standard business quandary - should we spend our earnings on creating better products or should we reward our investors?
In the chart below, the research and development expenses for Cisco for the past 5 years can be seen.
Note that Cisco does not consistently spend on research and development. In some years they spend more on research and development and in some years they spend less. During the years in which they spend more on research, fewer earnings are available to investors and the opposite is true for when less capital is spent on research.
This has been very simple analysis up to this point, but here is where it gets really interesting. When a firm invests in research in development, they are doing so in the hopes that their investment will pay off with greater profits. During periods of greater profits, a firm typically experiences an increase in stock price. If a firm decides to invest heavily in research and development in a given year, they are doing it for future profits even though it might temporarily decrease the stock price. In order to test this simple idea, the table below shows the percent change in research and development expense in a given year and the change in stock price for the same year.
In the year 2008, Cisco increased their research and development expenses by 8%. This means that they sacrificed potential earnings to innovate and create new products. This sacrifice of earnings took directly from investors since these earnings were expensed rather than paid out as dividends or retained. The market responded with a 36% decrease in share price. In 2009, Cisco cut back on their research and development expenses which allowed their capital to once again be available for investors and the market responded with a 50% increase in share price. The cycle continued in 2010 when Cisco strongly increased their research expenses and the market responded with a 23% collapse in share price. This increase in research and development was significant in that elevated levels of expenses have continued since 2010.
In the previous two quarters, Cisco has once again started easing from heightened levels of research and development expense. What this essentially means is that for the moment, they are satisfied that they have temporarily innovated new ways to beat out the competition. With this understood, an alert investor should prepare to reap the benefits of Cisco's cyclicality. Since Cisco has invested their revenues into research and development, they will experience the benefits of heightened product and brand quality. Currently, Cisco is in the process of decreasing their research expenses and historically this has led to significant growth. I believe that in the immediate future, these expenses will be lowered more and revenues will once again be available to investors. As history has shown, this phase of Cisco's business cycle is where equity investors are most strongly rewarded.
In the chart below, investors can see the mirror image of research and development expenses next to the monthly stock performance of Cisco. It is truly fascinating that by examining the simple business functions of Cisco, we can explain and even predict future stock price movements. If Cisco lowers their research and development expenses, I believe that the stock price could rally at least up to the highest point achieved during current business cycle. The reasoning here is that since the fundamental nature of Cisco or the market has not changed in the past few years, research and development expenditures should result in equitable levels of shareholder benefit. This said, I believe that as Cisco continues to ease their expenses and allows more profits to pass through to investors, the stock price could increase to the previous comparable levels of around $22. This represents a 38% price increase from current levels.
The chart above powerfully demonstrates this strong relationship between research and development expenses and stock price performance. This relationship clearly shows that stock price is being driven by how the firm chooses to allocate its capital - future product development or reward investors. I believe that the expense chart clearly shows that Cisco is moving into a stage of rewarding shareholders rather than future product development and I believe that within the next few quarters, all shareholders will be greatly rewarded. My personal prediction is an increase of up to 50% in share price. If however the share price were to continue falling to a point below $14, I consider this analysis mistimed due to Cisco continuing heightened expenditures leading to lower earnings.