Public R&D spending and cross-sectional stock returns

•We examine how public R&D spending influences cross-sectional stock returns.•Firms located in states with more public R&D spending earn higher stock returns.•A long-short portfolio constructed by public R&D spending earns a monthly abnormal return of 0.9%.•Productivity improvement, R&D spillovers, and cash flow risk can explain this public R&D spending effect. Empirical findings on the economic benefits of public research and development (R&D) spending are mixed. We adopt an alternative approach by examining the effect of public R&D spending on stock returns. We find that firms located in states with a greater amount of public R&D spending earn higher abnormal stock returns. The effect persists after accounting for conventional pricing factors and state-level variables, and becomes stronger for firms with greater absorptive capabilities. The abnormal stock returns are not only related to the positive effects of public R&D on firm productivity and incoming spillovers, but are also related to the increased cash flow risk. Policymakers should consider both risk and return effects when making any changes in public R&D investment.