Innovation Arms Race: The Invisible Risk

The innovation arms race is the race to be the most innovative company in the world. It's a competition where the prize is market share, customers, and profits. And the cost of entry is high.

This is a competition where there is no finish line.

To compete, companies must invest heavily in R&D. But not too much, else it destroys market value if you over-invest.

How Much Do Companies Invest in Innovation?

The size and growth of the investment in innovation are surprising.

Amazon's annual research and development expenses for 2021 were $56.0B, a 31.15% increase from 2020. For 2020, the R&D spend was $42.7B, an 18.95% increase from 2019.

This is an amount larger than many sovereign nations including the UK, whose annual research and development budget in 2022 will be £39.8 billion ($49.8 billion).

Compare that to the US, whose 2022 budget proposes a research and development spend of $171.3 billion, a 9 percent increase from 2021.

Who are the other big spenders in the innovation arms race (as of 2020)?

1. Amazon (AMZN), $42.74 billion
2. Alphabet (GOOG, GOOGL), $27.57 billion
3. Huawei, $22.04 billion
4. Microsoft (MSFT), $19.27 billion
5. Apple (AAPL), $18.75 billion
6. Samsung, $18.75 billion
7. Facebook (FB), $18.45 billion

Round out the top ten is Volkswagen (VWAGY), Intel (INTC), Roche (RHHBY), and Johnson & Johnson (JNJ).

What do we mean by the innovation arms race?

It is the race to find and fund the most impactful and valuable research.

It should come as no surprise that Amazon is one of the world's biggest spenders on research and development. They have been for a few years now.

The innovation arms race comes with its own risk. The escalating innovation arms race is value-destroying for the parties in the competition – evidenced by a decline in innovation investment efficiency. The result is less impact of innovation for the companies and investors involved, and slower economic growth for society.

Amazon's impact on others is proof of the negative impact of the innovation arms race. One obvious example is Sears. Sears quickly found itself behind and its investors and the market put pressure on the company to “catch up”. In order to regain its position, Sears sold its Craftsman brand to Stanley Black & Decker in 2017 for $900 million. The move was seen as a way to free up cash to invest in its own transformation.

While it may have been a necessary move it also signified the beginning of the end for Sears. In 2018, Sears filed for bankruptcy.

What is driving Amazon to Invest at this Level?

Amazon believes that the only way for it to succeed is to develop the technologies that will shape the lives of consumers ten years from now. This has meant that the company has been focused on long-term bets, such as its investment in artificial intelligence (AI) and robotics.

It's also important to note that Amazon's focus on R&D is not just about developing new products, but also about improving existing ones. For example, the company has used AI to improve its search engine and make recommendations more accurate.

In the past, Amazon has also been willing to invest in areas that may not have an immediate payoff but could pay off big in the long run. One example is its investment in renewable energy, which has helped the company reduce its carbon footprint.

This is what I call a well-balanced risk and reward innovation strategy. By making these investments, Amazon is not only preparing for the future but also hedging against potential disruptions to its business.

Amazon also has built a culture of “winning at all costs” which feeds an escalating innovation arms race.

The Trend In Corporate Research and Development

It is not just Amazon that is increasing its research and development budget to compete in the innovation arms race. Other companies are doing the same.

Alphabet, Google's parent company, annual research and development expenses for 2021 were $31.6B, a 14.47% increase from 2020.

Meta Platforms (Facebook) annual research and development expenses for 2021 were $24.7B, a 33.65% increase from 2020.

Even with the pandemic, it is estimated that global R&D spending increased by 4.3 percent in 2020, to $2.4 trillion. This is because many companies see increasing R&D investment as the way to gain and maintain a competitive advantage.

Innovation By Acquisition's Role In The Innovation Arms Race

Some companies have been able to achieve innovation through acquisition. For example, Facebook acquired WhatsApp and Instagram, which helped the company become a leader in the social media space.

However, not all acquisitions are successful. In fact, most acquisitions provide no real value to the acquiring company, especially when the acquisition is driven as a response to competitors' innovation success.

A recent example of this is Microsoft's $26B acquisition of LinkedIn in June of 2016. This was a way for Microsoft to compete with Google in the social media and business networking space. However, the acquisition has not provided Microsoft with any real competitive advantage and the company has been unable to generate any real value from LinkedIn.

When done right, acquisitions can help a company gain access to new technologies, products, and talent. They can also help a company enter new markets or expand its customer base.

Doing it right is by leading and not following. Being the first mover is important. Being the first to acquire a particular technology or product can give a company a competitive advantage that can be difficult for others to replicate.

When you are leading, acquisitions for innovation pushes rivals to invest more in innovation, both internally through research and development and externally through innovation by acquisition.

So, should your aim be to out-invest your competition in innovation?

No!

The Invisible Risk

Game theory gives us an excellent model for predicting the outcome of an innovation arms race. In game theory applied to innovation, the Nash Equilibrium is when both companies are investing the same amount in innovation and neither company has an incentive to increase its investment.

When one company is far outspending the others, this causes an escalating innovation arms race. This escalation is value-destroying for the parties in competition – evidenced by a decline in innovation investment efficiency. What do I mean by innovation investment efficiency? It is the percentage of an R&D budget that is converted into new products, services, or processes. Ideas and investments made real.

In a study published by Muhammad Farooq Ahmad (Université Côte d'Azur), Eric de Bodt (Caltech), and Jarrad Harford (University of Washington), the effects of the innovation arms race on market value reveals that it has a significant and negative impact.

On average, for every one percent increase in R&D spending by a firm's rivals, the firm's market value decreased by 0.36%.

The study also found that the effect of the innovation arms race on market value was more pronounced in high-tech industries and in firms with a high share of intangibles – such as trademarks, copyrights, and patents.

This finding has important implications for policymakers, managers, and investors. Policymakers should be aware of the negative impact of the innovation arms race on market value and take steps to mitigate its effects.

Managers should be aware of the value-destroying nature of the innovation arms race and take steps to avoid it. How? By taking a long-term perspective and making decisions that create value for the firm, rather than simply trying to keep up with the competition.

Investors should know the negative impact of the innovation arms race on market value and take steps to avoid investing in firms that are engaged in it.

Historical Innovation Arms Races

Some examples of past innovation arms races and their impact include:

PC Industry

In the 1980s, there was intense competition between IBM and Microsoft in the personal computer (PC) industry. This arms race led to the development of new technologies such as the graphical user interface (GUI), windows, and multitasking.

However, this arms race also had a negative impact on market value. For every one percent increase in R&D spending by IBM's rivals, IBM's market value decreased by 0.4%. Eventually, IBM, the market leader, sold its PC business to Lenovo.

Telecom Industry

In the 1990s, there was intense competition between AT&T and MCI in the telecommunications industry. This arms race led to the development of new technologies such as fiber optics and digital subscriber line (DSL).

However, this arms race also had a negative impact on market value. For every one percent increase in R&D spending by AT&T's rivals, AT&T's market value decreased by 0.3%.

Semiconductor Industry

In the 2000s, there was an escalating competition between Intel and AMD in the semiconductor industry. This arms race led to the development of new technologies, such as multicore processors and GPUs.

However, this arms race also had a negative impact on market value. For every one percent increase in R&D spending by Intel's rivals, the Intel's market value decreased by 0.2%.

What Are The Options?

While it seems counterintuitive, the leader risks encouraging an escalating response from others that actually destroys its own value.

What should market leaders do to not trigger an escalating innovation arms race?

Avoid A “Must Win” Strategy:

One option for market leaders is to avoid triggering an escalating innovation arms race by not having a “win at any costs” attitude.

By taking a long-term perspective and focusing on making decisions that create value for the firm, rather than trying to keep up with the competition, market leaders can avoid triggering an innovation arms race.

Collaboration With Competitors:

Collaboration can play a critical role in avoiding an innovation arms race. By collaborating with rivals, firms can share the costs of R&D and reduce the incentives for all-out competition.

Government Funding of Research and Development

One overlooked strategy to avoid the innovation arms race is to approach the government to fund research and development (R&D). This would reduce the incentive for firms to engage in an all-out competition.

Advice – Avoid An Escalating Innovation Arms Race

While some in the innovation game believe that those that spend the most will win. That is not the only way to win, and in fact, it may be the best way to lose. By reining in their own spending, market leaders can take a step back from the brink and allow themselves room to breathe, avoid becoming reactionary, and continue to innovate without fear of destroying value.

Leaders should take a long-term perspective and focus on creating value for their firm rather than trying to keep up with the competition. Invest based on your own firm's goals and objectives and not on some arbitrary metric.

I'm reminded of that famous quote from the 1983 movie, “WarGames” starring Matthew Broderick. When the computer realizes that it cannot win, it replies, “The only winning move is not to play.” Something to think about.