Corporate or Product Diversification
- Margarethe F. WiersemaMargarethe F. WiersemaThe Paul Merage School of Business, University of California, Irvine
- and Joseph B. BeckJoseph B. BeckThe John L. Grove College of Business, Shippensburg University
Corporate or product diversification represents a strategic decision. Specifically, it addresses the strategic question regarding in which businesses the firm will compete. A single-business company that expands its strategic scope by adding new businesses becomes a diversified, multibusiness company. The means by which a company expands its strategic scope is by acquiring businesses, investing in the development of new businesses, or both. Similarly, an already diversified firm can reduce its strategic scope by divesting from or closing businesses.
There are two fundamentally different types of corporate diversification strategy, depending on the interrelatedness of the businesses in the company’s portfolio: related diversification and unrelated diversification. Related diversification occurs when the businesses in the company’s portfolio share strategic assets or resources, such as technology, a brand name, or distribution channels. Unrelated diversification occurs when a company’s businesses do not share strategic assets or resources and do not have interrelationships of strategic importance. Companies can pursue both types of diversification simultaneously, and thus have a portfolio of businesses both related and unrelated. In addition to variations in the type of diversification, companies can vary in the extent of their diversification, ranging from business portfolios with very limited diversification to highly diversified portfolios.
Decisions regarding the diversification strategy of a firm represent major strategic scope decisions since they impact the markets and industries in which the company will compete. Companies can increase or reduce their level of diversification for a variety of reasons. Economic motives, for example, include the pursuit of economies of multiproduct scale and scope, whereby per-unit costs may be lowered through the increase in sales volume or other fixed-cost reducing benefits associated with growth through diversification. In addition, companies may diversify for strategic reasons, such as enhancement of capabilities or superior competitive positioning through entry into new product markets. Similarly, economic and strategic reasons can motivate the firm to refocus and reduce its level of diversification when the strategic and economic rationales for being in a particular business are no longer justified.
The performance consequences of corporate diversification can vary, depending on both the extent of the firm’s diversification and the type of diversification. In general, research indicates that high levels of diversification are value-destroying due to the integrative and complexity-associated costs that administering an extremely diversified portfolio imposes on management. Nevertheless, related diversification, where the company shares underlying resources across its business portfolio (e.g., brand, technology, and distribution channels), can lead to higher levels of performance than can unrelated diversification, due to the potential for enhanced profitability from leveraging shared resources. Corporate diversification was a major U.S. business trend in the 1960s. During the 1980s, however, pressure from the capital market for shareholder wealth maximization led to the adoption of strategies whereby many companies refocused their business portfolios and thus reduced their levels of corporate diversification by divesting unrelated businesses in order to concentrate on their predominant or core business.
What Is Corporate Diversification?
Researchers within the fields of finance, economics, and strategic management have long sought to address the definition and measurement of corporate diversification, the theoretical understanding of why firms initially chose to expand their strategic scope through diversification, and the organizational outcomes of such decisions. Edith Penrose, in The Theory of the Growth of the Firm was among the first to define diversification, as follows (Penrose, 1959, pp. 108–109):
[A] firm diversifies its productive activities whenever, without entirely abandoning its old lines of products, it embarks upon the production of new products, including intermediate products, which are significantly different from the other products it produces to imply some significant difference in the firm’s production or distribution programmes.
Corporate diversification (and, by extension, corporate refocusing) are fundamental aspects of a company’s strategy as these activities determine in which industries the company will compete. There are two dimensions to this construct: the extent or level of diversification and the nature of diversification (related versus unrelated). Companies can differ along either or both of these dimensions. For instance, Berkshire Hathaway, a highly diversified conglomerate, has a portfolio of unrelated businesses, with no shared resources or managerial knowledge. These businesses are in different industries and operate independently. On the other hand, Disney’s parks/resorts, studio entertainment, and consumer product business units are closely related and share a significant number of underlying resources and capabilities. General Motors has very low levels of diversification, with the majority of its sales in its core automotive business. The number of business units and the distribution of sales across the business units reflect the extent or level of diversification. The degree to which there are shared underlying resources or commonalties in the customer markets between the business units reflects the relatedness of the portfolio.
Diversification Construct and Its Measurement
Diversification has been measured using categorical measures (such as the Wrigley/Rumelt typology) and a discrete count measure (the number of businesses in which the firm operates), as well as continuous measures such as the concentric index and the entropy measure. To measure corporate diversification, researchers examine the businesses in which the firm operates (in other words, the business portfolio of the firm). As the field of strategy has evolved, researchers have sought to understand not only the amount of diversification in the portfolio, but the manner in which the businesses within that portfolio are related to each other as well. This distinction is important in understanding if and how corporate diversification confers a competitive advantage, and thus whether it contributes to superior performance. Corporate diversification strategies can differ significantly between companies, not only in the number of businesses in which each competes, but also in the nature of the relationships between those businesses. While the definition of the general concept of corporate diversification may be fairly straightforward, defining it as a measurable construct and capturing the “relatedness” of a firm’s business portfolio have been more problematic.
As alluded to previously, scholars have noted that a firm can vary either in the level (extent) of diversification or in the nature (type) of diversification (related or unrelated). The level of a firm’s diversification can be operationalized very simplistically by counting the number of businesses in which the firm operates. The more businesses in which a firm competes, the higher a level of diversification it is considered to have. More robust operationalizations (e.g., the entropy or concentric measure) of the extent of diversification are based on the distribution of the firm’s revenue across its various businesses. A single-business firm with 100% of its sales in one industry would represent a firm with no diversification, while a firm with revenue spread across multiple lines of business in different industries would represent the other extreme in terms of the level of diversification.
In order to clearly differentiate between the types of relationships among the businesses in a firm’s portfolio, researchers need a means by which to define and categorize those relationships. In related diversification, the lines of business in a firm’s portfolio are similar enough that resources and capabilities associated with technologies, production processes, distribution channels, and other elements can be shared among them. In contrast to related diversification, there is no underlying sharing of resources and capabilities between lines of business in a firm using an unrelated diversification strategy, although there may be a “parenting advantage”, through which corporate-level core competencies are shared with the individual business units (Campbell, Goold, & Alexander, 1995, p. 120). This conceptual distinction between related and unrelated diversification is difficult to operationalize in practice, due in part to the limited availability of information and data regarding the firm’s businesses and the extent to which their underlying resources and capabilities are shared.
Regarding the operationalization of diversification, continuous measures such as the concentric and entropy indices are the predominant means used to capture the firm’s level of diversification, as well as the extent of the firm’s related and/or unrelated diversification. These measures capture diversification utilizing the two-digit, three-digit, and four-digit Standard Industrial Classification (SIC) of the industries in which the firms operate.1 However, these are alternative approaches to measuring diversification (as well as conceptualizing “relatedness”), and “they can produce contradictory results because they differ in their sensitivity to underlying dimensions of portfolio strategy” (Robins & Wiersema, 1995, p. 43). Thus, measurement of the theoretical constructs of related and unrelated diversification creates content validity issues, which can result in ambiguity regarding the interpretation of empirical results (Robins & Wiersema, 1995).
There is, as should be evident, no perfect measure of diversification. All of these approaches have their drawbacks. The Wrigley-Rumelt model, being a ranked series of (at most) nine levels of diversification, allows us to grasp only a very rough sense of how firms with varying degrees of diversification differ from each other. Unrelated diversification, for example, is one category into which all unrelatedly diversified firms are lumped. There is no mechanism present to allow the researcher to distinguish how firms with varying levels of unrelated diversification would differ from each other. In addition, the placement of firms into the respective categories is dependent upon a subjective analysis of firm characteristics, which interjects an unavoidable element of bias into the process.
The concentric index and the entropy measure have considerable advantages over a categorical measure, such as the Wrigley/Rumelt typology or the simple count measure. Both are objectively reliable measures based upon the SIC system. The information used in their construction comes from firm line-of-business data as reported in the 10K form submitted to the Securities and Exchange Commission (SEC). The resulting standardized classification of data allows research to be replicated and accumulated over time and removes questions of interrater reliability from consideration (Robins & Wiersema, 1995). In addition, these continuous measures allow more fine-grained comparisons of the differences between the diversification strategies of individual firms, as well as the measurement of longitudinal changes in the diversification strategies of particular firms over time.
Basing the two continuous measures on the SICs of a firm’s portfolio of businesses raises its own problems, however. Although the concentric measure and the entropy measure are calculated differently, both rely on similar underlying assumptions regarding the SIC system, and the validity of these assumptions is questionable. In the SIC system, industrial activities are grouped at a four-digit level (industry) and aggregated to a three-digit level (industry groups) and then a two-digit level (major groups). In the classification of industrial activities into these numerical two-digit, three-digit, and four-digit levels, there is an implicit assumption that these categorizations are equidistant from each other. Researchers implicitly assume that this categorization rests on an underlying scale of “relatedness”, with numerical values assigned to hypothetical points along said scale. Within each level of the SIC system (e.g., two-digit or three-digit), there is an assumption of homogeneity with regard to the “relatedness” exhibited by the underlying resource portfolio. Furthermore, the “diversification distance” between classification levels is assumed to be accurately measured by the underlying scale of “relatedness.”
These assumptions are extremely problematic and call into question the accuracy of the resulting measurement of a firm’s extent, as well as identification of the nature (e.g., related versus unrelated) of diversification (Robins & Wiersema, 1995). Bryce and Winter (2009) have constructed a “general inter-industry relatedness index” based only upon the four-digit level of the SIC system, thus avoiding the assumptions regarding the “diversification distance” between classification levels; however, the assumption of homogeneity with regard to the “relatedness” of the underlying resource portfolio at the four-digit level remains.
Measurement error is not the only issue with which these constructs must contend; there are questions of content validity as well. The SIC coding system is production-based, and thus is better suited for the capture of relatedness based on operational similarities (e.g., manufacturing processes) than it is for capturing relatedness based on market similarities (e.g., for beverage companies, packaging alternatives such as bottles and cans are highly related, but because they involve completely different production technologies, they have distinctly different SIC codes), or the relatedness of underlying intangible resources such as marketing or research and development (R&D) capabilities. “When the very strong assumptions required by the concentric and entropy indices are applied to this weak source of information, the resulting measures have little validity as indicators of strategic interrelationships within corporate portfolios” (Robins & Wiersema, 1995, p. 281).
The fundamental objection to these measures of corporate diversification and the manner in which SIC data is employed in their construction is that the degree of resource relatedness is not accurately reflected in the empirical results of studies that use them. The primary argument for the existence of the multibusiness firm is the existence of beneficial outcomes derived from shared strategic resources and capabilities, and a valid measure of these relationships must capture the underlying basis for the relatedness exhibited by these resources and capabilities. While the concentric and entropy indices can capture the degree of product-line diversification and diversification type, they do not capture the degree of resource relatedness (Hoskisson, Hitt, Johnson, & Moesel, 1993).
Although no satisfactory direct measures of resource relatedness have been identified, several studies have utilized indirect indicators (i.e., occupational data) of this construct to assess strategic interrelationships across firms (Brumagim, 1992; Farjoun, 1994; Klavans, 1990). These types of indicators are able to supplement SIC-coded data with information of strategic importance about industries, as well as helping to explain firm performance. Robins and Wiersema (1995) developed and utilized a resource-relatedness measure based on the pattern of technology flows across industries, and found that highly interrelated portfolios outperformed those with lower levels of relatedness. Most recently, Nocker, Bowen, Stadler, and Matzler (2016) have developed firm-level measures of relatedness based upon technological and market-side resource similarities, which have been found to exhibit positively significant correlations with firm performance.
The fundamental issue here is that a perfect measure with which to capture corporate diversification, as is has been conceptualized since the late 1950s, does not exist. Even with the existence of such a measure, there are problems with the classification of the underlying data itself. Companies report their businesses according to the SIC industrial classification, which does not necessarily reflect distinct markets. Furthermore, companies themselves are not uniform in their reporting of company data; thus, the data is not reliably comparable across firms. Finally, because firms do not always report data consistently from year to year, the data is not reliably comparable even across firm-years. Nevertheless, these are the measures that we have, and while it is important to be mindful of their limitations, it is equally important to recognize that valuable insights have been and will continue to be gained from empirical studies that have employed them in the past and will employ them in the future.
Corporate Diversification: Trends and Status
Corporate diversification as a strategy appeared in the 1920s and gradually became more common through the 1950s, and 1960s until it hit its peak in the late 1970s and early 1980s (Comment & Jarrell, 1995; Schachner, 1967). Comment and Jarrell (1995) found that roughly 60% of publicly traded firms in 1979 were diversified into at least two industries. By 1988, that percentage had declined to about 44%. In their 10-year study (1984–1994), Bowen and Wiersema (2005) found that over 70% of multibusiness companies had significantly reduced their level of corporate diversification, with 20% of these companies retrenching around a single core business. Thus, by 1994, 60% of their sample of over 900 publicly listed companies were single-business firms. More recent research indicates that this trend toward less corporate diversification continued until the end of the 20th century, at which time the percentage of diversified firms had declined to about 17%, where it remained throughout the first decade of the 21st century (Basu, 2010).
Motivations Underlying Corporate Diversification and Refocusing
There are a number of theoretical perspectives on what determines the strategic scope of a firm. These perspectives seek to explain why firms choose to increase their levels of diversification, as well as what may motivate a reduction in diversification levels. Transaction cost economics (TCE), the resource-based view (RBV), and agency theory are the three major theoretical perspectives that provide a rationale for such strategic scope decisions.
Transaction Cost Economics
One of the dominant perspectives on strategic scope motivation is provided by transaction cost economics (TCE). First explicitly articulated by Coase (1937), and later more fully developed by Williamson (1985), TCE maintains that there are transaction costs associated with what Coase termed the “price mechanism,” which Williamson referred to as “market governance.” The essence of this argument is that there are costs associated with negotiating and contracting transactions (transaction costs) on the open market that can be reduced by organizing these otherwise independent transactions under the umbrella of a single corporate entity. Contractual economies of scale would exist, for example, when the cost associated with a single contract could be spread over multiple transactions. As Coase (1937, p. 21) put it, “[a] factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating within the firm, as would be necessary, of course, if this co-operation were as a direct result of the working of the price mechanism. For this series of contracts is substituted one.”
Then there is the element of uncertainty. While a single, long-term contract may be less expensive to negotiate than a series of short-term contracts, the difficulty associated with the prediction of future environmental conditions makes it unpalatable to spell out the specific details of future transactions. This situation then may occasion the transactional details of the contract to be expressed in general terms, with the specifics to be supplied at a later date, when it becomes clearer as to what those specifics are to be. “When the direction of resources (within the limits of the contract) becomes dependent on the buyer in this way, that relationship which I term a ‘firm’ may be obtained” (Coase, 1937, p. 21). Williamson (1985) clarifies the conditions under which this relationship is more likely to occur, the most important of which he terms “asset specificity.” “Transactions which are supported by [costly] investments in durable, transaction-specific assets experience ‘lock-in’ effects, on which account autonomous trading will commonly be supplanted by unified ownership” (Williamson, 1985, p. 53). TCE essentially posits that a firm will diversify and grow so long as it is less expensive to contract internally, under the corporate umbrella, than externally, on the open market.
With regard to diversified firms specifically, Williamson (1975) postulates that there are transaction cost efficiencies that an internal capital market (i.e., a “miniature” capital market) possesses that the external capital market does not. For example, internal audits by corporate headquarters are less costly and easier to implement than disclosure demands made by stockholders. Thus, the identification of opportunistic, value-destroying behavior on the part of divisional management is less expensive to ascertain by an internal capital market than would similar behavior in a single-business firm by the external capital market. Beyond the cost-reducing transaction cost efficiencies, however, Williamson (1975, p. 148) theorizes that internal capital market competition can result in the more effective allocation of firm resources (cash flows) to “high yield uses” than can the external capital market. While the external capital market has access to relatively limited knowledge regarding a large number of investment opportunities, the internal capital market has access to relatively extensive knowledge regarding a small number of investment opportunities. This depth of knowledge is critical. Williamson’s point of view is summed up by a quote from Alchian and Demsetz (1972, p. 29): “Efficient production with heterogeneous resources is a result not of having better resources but in knowing more accurately the relative productive performances of those resources.”
Because TCE posits internalization of business activities to be the result of a calculated analysis of the relative difference between the transaction costs of market governance and the bureaucratic costs of internal governance, a change in either set of costs could lead to either a decision to diversify further or, alternatively, to refocus. A decrease in the transaction costs of market governance (or an increase in the bureaucratic costs of internal governance), for example, could lead to a reduction in corporate diversification.
Agency theory provides a different perspective on strategic scope decisions, proposing that managerial decisions regarding the scope of the firm may be less than optimal due to conflicts of interest between the agents (managers) and the principals (shareholders). Proponents argue that the separation of ownership (embodied within the “principals”) and management (embodied within “agents”) can result in the expropriation of firm value (agency costs) by said agents (Berle & Means, 1932; Morck, Shleifer, & Vishny, 1988). Corporate diversification can work to the benefit of managers at the expense of shareholders in a number of ways. Managerial compensation, for example, increases with the firm’s size and strategic scope (i.e., higher levels of diversification), though such higher diversification levels may not necessarily result in improved profitability (Murphy, 1985). Furthermore, the risk of total firm failure is reduced in a diversified firm, and thus managerial employment risk is subsequently reduced. Scope decisions made under circumstances such as these impose agency costs on the firm, in that diversification activities driven by such motives serve managerial financial self-interests (higher compensation and job security), while providing no financial benefit to shareholders (Amihud & Lev, 1981).
Then there is the concept of “managerial entrenchment” (Shleifer & Vishny, 1989, p. 123). Managers may specifically direct diversification activities into businesses that increase the firm’s dependence on said managers’ particular skills, thus increasing the firm’s dependence on them as specific individuals. Personal position, again, is enhanced at the expense of shareholders.
A final example is in the agency cost of free cash flows (Jensen, 1986). Cash flow in excess of the amount sufficient to fund all positive net present value opportunities presents a temptation to managers. Arguably, that excess cash flow should be returned to shareholders, to do with as they see fit. Such a course of action would, however, represent a dilution of managerial power by reducing the amount of resources under managerial control. Diversification into a line of business with a negative net present value, while detrimental to shareholders, presents managers with a means through which to retain control over said resources.
The essence of the agency theory argument is that there are many ways in which managers can benefit from a strategy of diversification (even if shareholders do not). Managerial opportunism and the existence of free cash flows are thus seen as significant motivating factors underlying decisions to pursue corporate diversification. Appropriate corporate governance structures, through which managers are effectively monitored, as well as incentivized compensation schemes, through which managers’ interests are aligned with those of shareholders, can reduce such agency costs.
The external capital market, with the threat of hostile takeovers of poorly performing firms, can provide a further deterrent to value-destroying diversification strategies. The takeover constraint, the risk that managers face of the company being acquired, can limit the extent that managers will pursue value-destroying strategies. Evidence suggests that such market pressures have led to refocusing strategies through which such conflicts of interest have been mitigated and performance improved (Jensen, 1986, 1989).
The Resource-Based View
The resource-based view of the firm argues that corporate diversification derives from the existence of underutilized resources (those with excess capacity) with value-creating potential in other lines of business (economies of scope), and the concomitant desire of managers to exploit that value-creating potential (Penrose, 1959). In other words, firms have strategic reasons to diversify that go beyond simple efficiency-based justifications. As the name suggests, the resource-based view of diversification focuses on resource attributes that require a diversification strategy in order to realize the value-creating potential of said resources. First and foremost among these resource attributes is the “indivisibility” of the resources in question. As Teece (1980, 1982) points out, this indivisibility leads to a “market failure,” in which the “excess capacity” of the underutilized resources cannot simply be sold off or rented out to another user. The realization of any value-creating potential contained within the underutilized portion of the resource base requires the active participation of the top management team of a firm in possession of the entirety of the resource base. The realization of that value-creating potential in another line of business thus necessitates a strategy of corporate diversification. Teece (1980, p. 224), for example, proposed “an efficiency rationale of corporate diversification”; specifically, the “internalization of the [indivisible] supply of knowhow and other inputs common to two or more production processes.” Proponents of this view argue that a diversified firm is able to capture managerial economies of scale, whereby the cost structure of the enterprise is reduced by spreading the fixed cost of managerial human capital (an indivisible resource) over multiple production processes. Beyond the indivisibility of underutilized assets, however, are other resource attributes that can help explain both the extent and nature of diversification that a firm undertakes.
Fungibility is defined as the degree to which value-creating potential declines the further away from the original context a resource or capability is deployed (Levinthal & Wu, 2010; Montgomery & Wernerfelt, 1988). Low-fungibility resources and capabilities are implicitly defined as those with no closely related business applications, and which consequently have lower value-creating potential than high-fungibility resources and capabilities. Conversely, high-fungibility resources have both a greater number of closely related business applications and a relatively lower rate of decline in value-generating potential, as they are deployed away from their original context. The fungibility of the resource portfolio thus influences the nature (related or unrelated) of diversification engaged in by the firm.
Scalability, then, captures the degree to which resources and capabilities are available for use in additional business contexts (Levinthal & Wu, 2010; Mahoney & Pandian, 1992; Penrose, 1959). A resource or capability with unlimited scalability (i.e., scale-free) can be utilized in additional business activities without detracting from its use in current applications. A resource or capability with limited scalability (i.e., non-scale-free), on the other hand, when applied to an additional context, would require a reduction of its use in current applications. A trade-off is thus implied in the utilization of resources and capabilities with limited scalability, and consequently, it influences the amount or extent of diversification in which the firm engages.
Thus, according to the resource-based view, the existence of economies of scope through which a firm can utilize resources and capabilities in multiple businesses, as well as the desire of managers to profit from those economies of scope, provide the motivation for the firm to expand its strategic scope by diversifying into related businesses. The resource-based view also suggests that when economies of scope (or the lack thereof)) no longer provide an economic benefit to the firm (or if there are negative synergies between business units within the firm’s portfolio), there should be a corresponding reduction in the firm’s diversification.
In addition to the three theoretical perspectives above, there are several alternative explanations for corporate diversification. One alternative view is the market power theory of diversification. According to this perspective, large diversified firms have at their disposal the means by which to negatively impact smaller, more focused rivals in the various industries in which they compete (Caves, 1981; McCutcheon, 1991; Montgomery, 1985; Palich, Cardinal, & Miller, 2000; Scherer, 1980; Shubik, 1959; Sobel, 1984). Predatory pricing would be such an example. A diversified firm could subsidize artificially low prices in one product market in which it faced competition from many rivals with the profits from another in which competition was weak. Once rivals were driven from the more competitive market, the diversified firm could increase market share, increase prices, and enjoy subsequently greater profit margins, particularly if barriers to entry were present (Caves, 1981; Berger & Ofek, 1995; Bolton & Scharfstein, 1990; Saloner, 1987; Scherer, 1980).
In addition, there is the theory of what has been termed “defensive diversification,” enunciated by Bass, Cattin, and Wittink (1977). This perspective hypothesizes that firms in industries that are declining or are growing very slowly (e.g., mature industries) engage in corporate diversification in order to pursue growth opportunities in other markets.
With regard specifically to research on the benefit of refocusing strategies, the finance literature has advanced the “core focus hypothesis”. Managerial capabilities may be well-suited to the management of the core business, but not to the management of non-core businesses. Removal of non-core businesses allows managers to focus attention on the core operations that they are better suited to administer (Daley, Mehrotra, & Sivakumar, 1997).
Diversification Strategy and Performance Outcomes
The relationship between corporate diversification and firm performance is one of the most examined empirical linkages in the strategic management literature (see Palich, Cardinal, & Miller, 2000, for a review), yet the results of the empirical evidence have been far from conclusive. In general, however, studies that have examined the relationship between firm performance and a continuous measure of corporate diversification such as the concentric index have found a negative correlation, or at best no relationship, between the two variables (Montgomery, 1985; Palepu, 1985; Rhoades, 1974; Utton, 1977). Wernerfelt and Montgomery (1988), for example, used Tobin’s q as their measure of firm performance and the concentric index as their measure of corporate diversification in an empirical analysis of a random sample of 167 firms in 1976. They found a “positive focus effect”; in other words, a negative relationship between average firm performance and increasing levels of corporate diversification (Montgomery & Wernerfelt, 1988; Wernerfelt & Montgomery, 1988). Similarly, Palepu (1985) ran an analysis on 30 firms from the food products industry using return on sales as the measure of firm performance and the total entropy measure as the measure of corporate diversification and found that those firms with low total diversification appeared to be more profitable than those with high total diversification. A final example is the work of Lang and Stulz (1994), who looked at a sample of over 1,400 firms and the relationship between firm performance (calculated as Tobin’s q) and three different measures of total corporate diversification: the discrete count measure of business segments and two variations of the Herfindahl index (from which the concentric index is adapted). All three analyses yielded the identical result: total corporate diversification is negatively correlated with firm performance.
These results and conclusions beg the question, however, of whether it is simply the extent or the amount of diversification that affects firm performance, or if the nature of diversification has an independent effect on firm performance. This reflects the perspective of the resource-based view, which maintains that heterogeneity in resource portfolios mandates heterogeneity in strategies, including diversification strategies. For example, firms that have resources with high fungibility should pursue strategies of related diversification, while those firms with resources of low fungibility should pursue a strategy of unrelated diversification. A few studies have attempted to ascertain in what manner these various diversification strategies can affect firm performance. Berger and Ofek (1995) compared the average profitability, measured in terms of operating margin [earnings before interest and tax (EBIT)/sales] and return on assets (EBIT/assets), for three groups of corporate entities: single-segment firms (undiversified firms); business segments of diversified firms in which all segments were in the same two-digit SIC category (complete related diversification); and business segments of diversified firms that had at least some degree of unrelated diversification in the line-of-business portfolio (at least one segment in a different two-digit SIC category from the remaining segments within the portfolio). The results of this particular study indicate that single-segment firms (undiversified companies) are more profitable than either firms that pursue complete related diversification or firms that undertake some degree of unrelated diversification; however, firms that pursue complete related diversification perform better than firms that undertake a degree of unrelated diversification.
Despite the general weight of evidence supporting the proposition that diversification, in general, negatively affects firm performance, the fact that so many firms do pursue a strategy of diversification, coupled with the strong logic of the resource-based view in particular, has led many scholars to question the approaches that have been taken to investigate the relationship. Robins and Wiersema (1995), for example, examined a sample of 84 firms using three different approaches to capturing the underlying relatedness of the resource portfolio and its relationship to firm performance (measured as return on assets). In their analyses using the concentric index and the related component of the entropy measure to capture the “relatedness” of the firm’s business portfolio, they found no significant relationship to firm performance. In an effort, however, to devise a more effective method of assessing the hypothesized benefits of resource relatedness, the authors created a third measure with which to analyze the relationship between firm performance and related corporate diversification. This new measure captures underlying strategic resource relationships across a firm’s business portfolio by utilizing the patterns of technology flows across industries. The relationship between this measure of related diversification and firm performance was positive and significant. In other words, when conceptualized and measured in this manner, related corporate diversification is associated with improved firm performance. This study provides evidence that a resource-based index of relatedness yields significantly different results compared to those derived from the traditional measures of relatedness based on the SIC system, and that such a measure can help to explain variability in firm financial performance induced by corporate diversification strategies.
The empirical investigation of the relationship between corporate diversification and firm performance has become more refined over time. Initial studies of this relationship were problematic, due largely to inconsistent operationalization of the key constructs of diversification and firm performance, as well as the lack of industry-level controls (see Hoskisson & Hitt, 1990; Ramanujam & Varadarajan, 1989 for reviews). More recent studies have provided relatively consistent evidence that capital markets value firms with more focused corporate strategies more highly than firms with more diversified portfolios (Lang & Stulz, 1994; Montgomery & Wernerfelt, 1988), while firms that have undergone corporate refocusing have improved both their financial performance and their market value (Berger & Ofek, 1995; Bhagat, Shleifer, & Vishny, 1990; Comment & Jarrell, 1995; Markides, 1992). The distinction between related and unrelated diversification has also been examined extensively, although measures of relatedness have been a point of contention. When a resource-based approach was utilized to model and test these relationships, it was found that firms with more related diversification outperformed firms with less related diversification (Robins & Wiersema, 1995). This finding is consistent with the diversification premium that Villalonga (2004) found in her market-value analysis of firms that pursued related diversification.
The consensus in the theoretical literature is that a firm derives economic benefits from product market diversification through the shared use (across markets) of the firm’s underlying resources and capabilities (Montgomery & Wernerfelt, 1988; Peteraf, 1993). However, as the businesses within a firm’s portfolio become more diverse and complex, the costs associated with the implementation of more internal control and coordination mechanisms escalate (Coase, 1937; Hoskisson & Johnson, 1992; Hoskisson & Turk, 1990; Jones & Hill, 1988; Williamson, 1985). At some point, the rising managerial and administrative costs of increasing the firm’s product market scope will outweigh the economic benefits. The argument has thus been made that the relationship between corporate diversification and firm performance should be curvilinear and resemble an inverted U-shape. Some empirical studies examining the linkage between corporate diversification and firm performance have indeed found such evidence. Palich et al. (2000) found from their meta-analysis of empirical studies that firms with moderate levels of product diversification exhibited the highest levels of financial performance, while highly diversified firms and single-business firms had lower levels of performance.
Corporate Refocusing, Divestiture, and Diversification
Our understanding of corporate diversification has also been enriched by scholars studying corporate refocusing, through which managers reduce the diversity of the firm’s business portfolio by eliminating business units. Comment and Jarrell (1995) examined a sample of roughly 2,000 firms over about a 12-year period ranging from 1978 through 1989. Using five different measures of focus, they determined that over this time period, firms were becoming less and less diversified. In terms of number of business segments, for example, only 38.1% of the sample were single-business firms in 1979; by 1988, this percentage had increased to 55.7%. Moreover, they also found that “shareholder wealth,” as measured by stock returns, increased in firms that became less diversified, decreased in firms that became more diversified, and stayed roughly the same in firms that maintained a constant level of diversification. Another explanation for why corporate refocusing strategies lead to higher market value can be found in the concept of the “diversification (or ‘conglomerate’) discount” (Berger & Ofek, 1995; Lang & Stulz, 1994; Servaes, 1996). If it is cognitively difficult for financial analysts to comprehend the value of a diversified firm, for example, the uncertainties inherent in the estimation of the market value of individual business units may result in a devaluation of the firm’s stock price. To unlock this unseen value and make it more visible to these analysts, the firm may find it necessary to separate these business activities from each other. Corporate refocusing strategies can be the result.
Another related line of investigation is that of the divestment literature. Corporate divestment constitutes the sale (sell-off) or spin-off of the full range of such corporate assets as business units, product lines, manufacturing plants, or retail outlets, and represents a common method through which firms reduce their levels of corporate diversification. The research into corporate divestiture has examined many of its possible antecedents, and the most consistent result found has been that poor performance (either of the individual business unit or of the firm as a whole) is the primary influencing factor (Brauer, 2006). These results also feed the most common narrative that is advanced to explain corporate diversification and its consequences. Managerial opportunism and/or hubris result in less than optimal strategic decision-making with regard to the scope of the firm, leading to “over-diversification”. Poor firm performance is the result. Course corrections are then made (specifically, the decision to refocus), resulting in the divestiture of poorly performing or strategically irrelevant operations, thus enhancing firm value.
Corporate Diversification: Other Lines of Inquiry
Despite the strength of this narrative, however, many researchers insist that unresolved issues and unanswered questions remain. Villalonga (2004), for example, disputes the generally accepted notion of the “diversification discount” itself, asserting that the corroborating findings are a product of a faulty segment classification process (SIC codes) embedded with the sources of data (COMPUSTAT) commonly employed in those studies. To demonstrate, the author used an alternative data source (BITS) that allowed an alternative method of constructing segments. When the same sample of firms was analyzed using both methods of segment construction, the analysis of COMPUSTAT segments yielded the same result as earlier studies: a diversification discount. However, when analyzed using the BITS data and its associated alternative segmentation method, a diversification premium was found. The results indicated that diversified firms performed better than single-business firms. The bottom line here is that in order to get reliable results, an accurate method of measurement is needed. What that accurate method of measurement is remains a point of disagreement.
In order to fully understand corporate diversification and its consequences for firm performance, one must also take into account not only decisions regarding in which product markets firms choose to compete, but also decisions regarding the geographic scope of the firm (i.e., in which geographic markets to compete). Although both transaction cost theory and the resource-based view of the firm suggest that decisions regarding the geographic and product market scope of the firm are likely to influence each other, empirical studies in both product and international diversification literatures have largely ignored this interdependence. Almost without exception, prior international business and strategic management research has failed to recognize or incorporate the mutual interactions between international diversification, product diversification, and firm performance when conceptualizing these relationships and when deriving estimates of the empirical linkages. This failure has serious implications for the statistical validity of prior findings and may be responsible for a long history of inconsistent empirical results. Most prior studies have inferred the relationships between these strategic scope decisions by examining how product diversification moderates international diversification’s impact on firm performance (Geringer, Beamish, & Dacosta, 1989; Tallman & Li, 1996). However, interaction analysis is unable to detect how the firm’s geographic and product market scope are related since the validity of this analysis rests on the assumption that these scope decisions are made independently: changes in the firm’s product market scope have no impact on geographic scope and vice versa. Furthermore, since decisions regarding the firm’s strategic scope are themselves dependent on firm performance, it is critical to control for variation in firm performance when conceptualizing and empirically testing the relationship between international and product diversification—a fact overlooked in all prior theoretical and empirical work. Without holding firm performance constant, it is not possible to determine whether changes in the firm’s geographic and product market scope represent trade-offs or complements with regard to their impact on firm performance. Thus, the manner in which managerial decisions regarding the firm’s strategic scope impact firm performance, as well as that in which managerial decisions regarding the firm’s geographic and product market scope interact, represent major unresolved research questions in both the international business and strategy fields (Glaum & Oesterle, 2007; Peng, 2004). Bowen and Wiersema (2009) addressed the methodological shortcomings of prior work by controlling for endogeneity biases arising from simultaneity and firm heterogeneity. They find that the relationship between product diversification and firm performance is nonlinear, with low levels of product diversification having a positive effect on firm performance, whereas high levels of product diversification are associated with worse firm performance, confirming the results of prior studies (e.g., Palich et al., 2000).
Furthermore, because related and unrelated diversification represent separate types of diversification strategy that differ fundamentally in terms of the manner in which underlying resources are shared, differences in the choices that firms make regarding the degree to which these distinctive strategies are implemented are likely to have implications for subsequent decisions, especially those concerning corporate divestiture. While much work has been done on the relationship between the total level of corporate diversification and the decision to divest, that research has been contradictory and confounding, with the majority of studies finding no evidence that the level of a firm’s diversification has an impact on corporate divestment (Bergh, 1995, 1997, 1998; Bergh & Holbein, 1997; Chatterjee, Harrison, & Bergh 2003).
Rationales for divestment may have much to do with the need to raise cash for existing core operations or for the exploitation of better opportunities elsewhere. Moreover, no study has explicitly examined the antecedent influence of related versus unrelated firm-level diversification on corporate divestment. A gap exists, therefore, in our empirical understanding of precisely how the extent and nature of corporate-level diversification strategy impacts corporate divestment.
The complexity inherent in the relationships between these various constructs of corporate scope and the attendant effects on firm performance outcomes is epitomized in a recent study by Adner and Zemsky (2016). These authors argue that the degree of resource relatedness that exists between industries actually drives the decision to diversify. Because synergistic possibilities exist in the merger of business activities from resource-related industries, firms seeking a competitive advantage in any of these related industries are likely to diversify into the others eventually. Those which diversify first (the first movers in such a strategy) will benefit, and firm performance will improve. These first-movers into related diversification have, in essence, profitably differentiated themselves from single-business enterprises. Over time, however, those single-business holdouts themselves choose to diversify out of competitive necessity.
As the number of competitors following a similar strategy of related diversification in a cluster of resource-related industries increases, so does competitive rivalry; and as competitive rivalry in said cluster increases, the performance of all competitors is negatively impacted. Furthermore, as the degree of resource-relatedness within a cluster of industries decreases, the performance of firms within said industries will actually improve—not as a result of diversification strategy per se, but because the number of firms pursuing such a strategy within these industry clusters decreases, thus reducing the intensity of competition among competitors.
To summarize this discussion, much of the empirical work that has been done appears to show that corporate diversification is detrimental to average firm performance, supporting the agency theory viewpoint. Nevertheless, adherents of efficiency-based logic (e.g., transaction cost economics) and synergy-based logic (resource-based view) insist that their theoretical arguments are sound. These researchers argue that the most commonly used substantiating methodologies are seriously flawed, to the extent that they obscure the true relationship between corporate diversification and firm performance. Most of the prior empirical research has been carried out using SIC-based data and measures. More work using alternative data sources and measurement systems is needed if this critical issue is to be satisfactorily resolved. In addition to these methodological arguments, however, are arguments over the causal relationships themselves. How do different types of scope decisions, such as the decision to diversify the firm’s product line and the decision to expand internationally, interact with each other? How does firm performance affect the decision to diversify? Do different types of diversification strategies affect the refocusing decision differently? Does the relationship between a particular diversification strategy and firm performance vary over stages in the evolution of an industry? All these questions have been addressed to some extent but, at the end of the day, have not yet been fully resolved. More work remains to be done.
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1. The SIC code has been supplanted by the six-digit North American Industry Classification System (NAICS code), which was released in 1997. For the purposes of this article, we will use the term SIC, as it is the preferred one used in research to describe the system.