We examine how public R&D spending influences cross-sectional stock returns. According to National Science Foundation, public R&D spending in 2017 is about 171 billion dollars, occupied 30% of US aggregate R&D spending. Our project studies how public R&D spending affects the capital market performance and related policy implications.

Using US data between 1987 and 2010, we find that firms located in states with more public R&D spending earn higher stock returns. A long-short value-weighted portfolio constructed by public R&D spending earns a monthly abnormal return of 0.9%, which is equivalent to 11% annualized abnormal return. Generally, public R&D causes cost reduction in innovation and positive spillover effect that both increase the productivity and the average cash flow of firms, but this also causes high cash flow risk. We further suggest that policymakers should consider both risk and return effects when making any changes in public R&D investment.

Using US data between 1987 and 2010, we find that firms located in states with more public R&D spending earn higher stock returns. A long-short value-weighted portfolio constructed by public R&D spending earns a monthly abnormal return of 0.9%, which is equivalent to 11% annualized abnormal return. Compared with Fama and French＇s factor-mimicking portfolios for size (SMB), book-to-market equity (HML), operating profitability (RMW), and asset growth (CMA), Sharpe ratio upon our investment strategy is quantitatively similar to that of traditional factor-mimicking portfolios. Mixing our strategy and those traditional ones, we can improve the investment efficient due to the fact that correlation coefficients between them are below 0.4.

The industrial applications of this strategy are threefold: industrial policy, fund companies and the use of non-profit organization. First, whether a country＇s industrial policy could increase public R&D expenditures and to what extent the public R&D may benefit the society are important policy issues. Our research provides an academic basis for why the government should increase investment in basic scientific research. Secondly, information about public R&D can be used by investors, particularly mutual funds and hedge funds, that can use this portfolio strategy to generate significant profits. Finally, non-profit organizations, such as university endowment and pension funds, can follow this strategy to profit.