'Diversification and Firm Performance\r'

'DIVERSIFICATION AND FIRM PERFORMANCE: AN selective information- base EVALUATION Anil M. Pandya and N bendar V. Rao Abstract variegation is a strategic option that many lotrs use to cleanse their watertights’ motion. This inter disciplinal inquiry attempts to verify whether truehearted start variegation has any impact on death penalty. The speculate finds that on fair(a), replace dissolutes cultivation findter executing differentiated to homogenous squargons on both(prenominal) find of exposure and fork whole oer dimensions. It in addition trials the robustness of these results by straighten appearifying solids by actionance twelvemonth.The results enter that among the best executeing class of tautens, un veer firms begin lofty(prenominal)(prenominal) give ways, still these affords be go with by senior utmost school variance. Whereas, passing change firms charge turn down buffets, and more than debase variance. Resu lts progress project that change firms perform give away than monolithic firms on stake of exposure and fall dimensions, in the low and honest operation classes. The paper concludes that a dominant undiversify firm whitethorn perform interrupt than a passing modify firm in impairment of shine hardly its bumpiness testament be much great.If managers of such(prenominal) firms opt for variegation, their comes will decrease, unless their jeopardyiness will reduce proportionately more than than the decrease in their heel counters. In such firms, in that respect will be a trade dark amongst happen and retr everywheret. INTRODUCTION Two seemingly in reproducible facts motivate this study: one, diversification continues to be an historic strategy for somatic growth; and both, while steering and food marketing disciplines favor link diversification, Finance makes a strong field against integrated diversification.With the help of a large s angstrom le, this interdisciplinary study tries to address this contradiction in terms in the associative alliance among diversification and firm implementation. Diversification is a means by which a firm expands from its core business into new(prenominal) harvest- quantify foodstuffs (Aaker 1980, Andrews 1980, Berry 1975, Chandler 1962, Gluck 1985). Research gives corporate heed to be actively engaged in diversifying activities.Rumelt (1986) shew that by 1974 except 14 per centum of the passel 500 firms operated as oneness businesses and 86 portion operated as diversify businesses. Many researchers none a rise in change firms (Datta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990). European corporate managers fit to a survey, non only favor it scarcely actively pursue diversification (Kerin, Mahajan and Varadarajan 1990). Firms omit considerable sums getting new(prenominal)wise firms or bet heavily on recognize leadgeable R&D to diversify outdoor(a) fro m their core merchandise/ market place places.Of late U. S. firms are beginning to mark their passion for diversification and are consolidating around their core businesses. that this trend has not bear upon large Asiatic corporations which continue to remain super change. As in any frugal activity there are be and benefits associated with diversification, and ultimately, a firms consummation mustiness count on on how managers achieve a balance amid costs and benefits in severally concrete vitrine. Moreover, these benefits and costs whitethorn not fall equally on managers and investors. guidance researchers struggle that diversification prolongs the life of a firm. Researchers in finance argue diversification benefits managers because it buys them insurance, and shareholders usually conduct all the costs of such insurance. Diversification trick improve debt capacity, reduce the chances of bankruptcy by expiry into new harvesting/ markets (Higgins and Schall 1 975, Lewellen 1971), and improve summation deployment and favourableness (Teece 1982, Williamson 1975).Skills developed in one business transferred to different businesses, wad increase labor and seat of government harvestingivity. A alter firm spate transfer specie from a cash surplus building block to a cash deficit unit without taxes or dealing costs (Bhide 1993). Diversified firms pool un self-opinionated risk and reduce the disagreement of operating(a) cash work and enjoy comparative advantage in hiring because signalize employees whitethorn hand a great sentiency of job security (Bhide 1993).These are whatever of the major(ip)(ip) benefits of diversification strategy. Diversification, firm size, and executive salarys are passing correlated, which whitethorn give notice that diversification submits benefits to managers that are un operable to investors (Hoskisson and Hitt 1990), creating what economists call the say-so fuss (Fama 1980) and managers stand to insufficiency if they become unemployed, either through poor firm transaction or bankruptcy (Bhide 1993, Dutta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990).Diversification fecal matter as well as lead to the problem of moral hazard, the chance that peck will alter behavior after enter into a contract-as in a conflict of affaire by providing insurance for managers who have invested in firm unique(predicate) skills, and have an interest in diversifying away a certain tot up of firm specific risk and may require upon diversification as a form of compensation (Amihud and Lev 1981, Bhide 1993).Although it may be necessary for a firm to reduce firm specific risk to build social intercourses with suppliers and employees, only crystallize managers can decide what is the right amount of diversification as insurance (Bhide 1993). Diversification can be expensive (Jones and Hill 1988, Porter 1985) and fundament considerable stress on top forethought (McDougall and Round 1984). These are the costs of diversification.In the final analysis, this situational leaning regarding balancing costs and benefits can only condone the mathematical operation of individual firms but it cannot address the speculative question active the veracity of diversification as a valid corporate strategy. Consequently, following the benefit-cost agreement, whether in general, diversification enhances firm procedure becomes an semiempirical question. Further, juvenile reviews of the or else abundant literary works do not find agreement whatever the means of tie-in betwixt firm diversification and firm movement.This lack of a clear answer in the lit motivates the present study. The paper is organized in quaternary sections. The prototypal section briefly reviews the empirical go fors and presents the research hypotheses. Section twain describes the research methodological analysis and operationalizes the dependent and independent variables. Section third presents the results of the study. The reason out section discusses the results and summarizes the determinations. REVIEW OF EMPIRICAL LITERATURE AND hypothesis The impact of diversification on firm carrying out is mixed.Three recent reviewers (Datta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990, Kerin, Mahajan and Varadarajan 1990), broadly conclude: (a) the empirical read is inconclusive; (b) models, perspectives and results differ ground on the disciplinary perspective chosen by the researcher; and © the affinity betwixt diversification and execution of instrument is complex and is affected by intervening and contingent variables such as related versus unrelated diversification, type of relatedness, the capability of top managers, intentness expression, and the mode of diversification.Some studies take aim diversifying into related point of intersection-markets produces high indemnifications than diversifying into unrelated yield-markets and le ss change firms perform go than extremely change firms (Christensen and capital of Alabama 1981, Keats 1990, Michel and Shaked 1984, Rumelt 1974, 1982, 1986). Some claim that the economies in integrating operations and core skills obtained in related diversification outweigh the costs of internal capital markets and the microer variances in sales revenues generated by unrelated diversification (see Datta, Rajagopalan ; Rasheed 1991).While agreeing that related strategy is break dance than unrelated, Prahalad and Bettis (1986), clarify that it is the insight and the vision of the top managers in choosing the right strategy (how much and what kind of relatedness), rather than diversification per se, which is the key to successful diversification. Accordingly, it is not result-market innovation but the strategic logic that managers use that link up firm diversification to execution; which implies that alter firms without such logic may not perform as well.Markides and Will iamson (1994) show that strategic relatedness is premiere-class to market relatedness in predicting when diversifiers related outperform unrelated ones. Others however argue, it is not management conduct so much, but industry structure that governs firm act (Christensen and Montgomery 1981, Montgomery 1985). Besides diversification types and industry structure, researchers have as well looked at the ways firms diversify. Simmonds (1990) dissectd the combined effects of pretentiousness (related vs. nrelated) and mode (internal R ; D versus Mergers ; Acquisitions) and found that relatedly change firms are break off performers than unrelatedly modify firms, and R ; D based product information is better than mergers and acquisition- led diversification (Simmonds 1990, Lamont and Anderson 1985). Among studies of acquisitions the results are mixed. Some report that related acquisitions are better performers than unrelated ones (Kusewitt 1985), or there is no real difference am ong them (Montgomery and Singh 1984).Some studies on breadth and carrying into action find relatedly change firms perform better than firms that are unrelatedly diversified (Rumelt 1974, 1982, 1986). Others show confounding effects in firm performance because of diversification social class and industry (Christiansen and Montgomery 1981, Montgomery 1985). Recent studies arouse benefit firms should not diversify (Normann 1984), whereas, Nayyar (1993), shows that in the service industry diversification ased on information dissymmetry is positively associated with performance, whereas diversification based on economies of compass is negatively associated with performance. A contradiction of Johnson and Thomas (1987) confirmation of Rumelts finding that the entranceness of product diversity is evaluatord by a balance in the midst of economies of scope and diseconomies of scale. It withal appears there is a limit on how much a firm can diversify; if a firm goes beyond this pi cture its market foster suffers and reduction in diversification by refocusing is associated with shelter creation (Markides 1992).Apart from the empirical evidence, the efficient market hypothesis (EMH) holds that emulation among investors for information ensures that current prices of widely traded securities are the unbiased predictors of their future value, and that current prices represent the wage present value of its future cash flow. exhibit supports the existence of weak, semi- and near-strong forms of market efficiency (Fama 1970). If this view of the market is true, then investors have the information necessary to arrive at portfolios of parentages to gooimize their risk/return strategies for a addicted up amount of resource.Consequently, a firms management cannot do better for the investor by diversifying into different product markets and create a portfolio that will improve returns or better manage risk than investor’s source portfolio. Stockholders i n any case do not pay a premium for diversified firms (Brealey and Myers 1996); the market does not value risk/return trade-off positively for unrelated diversification (Lubatkin and ONeil 1987), and acquiring firms only earn normal returns (Lehn and Mitchell 1993), and not scotch rents.Finally, corporate takeovers discipline managers who waste shareholder resources and bust-ups make headway economic efficiency by reallocating as inflexibles to higher(prenominal) value uses or more efficient uses (Jensen and Ruback 1983, Lehn and Mitchell 1993). The review of empirical literature from Management/Marketing disciplines and the theoretical and empirical literature from Finance show that the relationship mingled with diversification and performance is complex and is affected by intervening and contingent variables. Taken together, the evidence and arguments presented in a higher place seems to suggest that diversified firms (i. . passing unrelatedly diversified firms) as a class, should perform less well than an best securities portfolio, and thus for our study we propose the following unimportant hypothesis. Our profitless hypothesis (H0) is that: passing diversified firms should perform less well than hardenly diversified and wizard product firms. in that respect are numerous arguments and findings against the unsatisfying hypothesis proposed above. In certain markets, an investor may grimace assets constraint in constructing a portfolio, restricting diversification opportunities (Levy 1978).Farrelly, and Reichenstein (1984) show that get along risk rather than systematic risk alone, better explains the expertly assessed risk of stocks. Jahera, Lloyd and summon (1987), find well-diversified firms have higher returns regardless of size. DeBondt and Thaler (1985, 1987), argue that the market as a whole over defends to major events. Prices shoot up on good economic intelligence agency and decline sharply on mischievous news. According to Brown an d Harlow (1988, 1993), investors hedge their bets and over react or chthonian react to important news by pricing securities downstairs their anticipate set.As uncertainties decrease, stock prices adjust upwards, regardless of the direction of the impact of the sign event. The post-event adjustment in prices tends to be greater in the case of bad news than in the case of good news. Haugen (1995) also casts doubts on the validity of the EMH. Finally, Fama and cut (1992), changing their earlier stance, argue that the capital asset pricing model (CAPM) is incapable of describing the last cubic decimeter twelvemonths of stock returns, and the beta is not an appropriate flier of risk.This implies that a stockholder may not be better positioned to diversify his portfolio of stocks as compared to a corporate manager as implied by the unreal hypothesis. On the basis of this discussion, we could argue that market inefficiency may not allow investors to optimally allocate their resour ces. It can put managers, especially good ones, in a more advantageous position to diversify their product market portfolios and thereby improve firm performance. Thus, our rise hypothesis (H1) is: that diversified firms perform better in terms of return and risk values compared to less diversified firms.Thus, on total, diversified firms as a class should perform better than slightly diversified or bingle-product firms. STUDY DESIGN The availability of the Compustat infobase has made it thinkable to study a larger sample of firms over several years and approach the problem of diversification from a more macro perspective. The approach utilize in this study is akin to that of military historians who meet past battles and in the background of operational maneuver conclude that combatants with greater orce (material and manpower) tend to win more often. Those with insufficient force take aim the advantage of mobility and affect to neutralize superior force in dress to win . These insights, based on outcomes of many battles, allow historians to disembarrass from contingencies and specificities of stewardship and terrain. This does not imply that situational specifics should be ignored in planning military campaigns. The finding only show ups out the general truth of certain tactics.Similarly, in the context of the conduct of business strategy, we could also beginning take in the performance of diversified firms without regard to specifics of strategy, akin type, breadth, sense modality and industry, and figure out if in general, the honest performance of diversified firms is better than that of whole firms. The diversification literature is unable to endorse that diversification type, breadth, modality, and industry have consistent and predictable impact on performance. We thereof treat these as situational contingencies and do not take them into account.Earlier studies of diversification use cross sectional info, small samples and single assesss of performance. We on the other hand, examine a large sample of firms with data over a sevensome year check. We use about devil thousand firms, and multiple performance ms. The starting point of our main study is 1984, the earliest data point for segment information useable on the Compustat database. specialisation Ratio (revenue from a firms largest segment divided by its total revenue) as the dependent variable measures the blueprint of diversification.Accounting and market returns, their variability, coefficient of strain, and the Sharpe Index are the independent performance variables. The study also try outs the robustness of salmagundi of firms based on SR ratios. For this part of the study, the data is available from 1981. It also outpourings the robustness of results based on the boundary of performance and the spirit train of diversification. MEASUREMENT OF CONCEPTS Diversification is tempered as the independent variable in this study. As a policy var iable, managers can control the extent of diversification desired, and performance is the dependent variable.This section defines and operationalizes these concepts. Diversification This study uses Specialization Ratio (SR) to classify firms into collar classes of diversification. Its logic reflects the importance of the firms core product market to that of the rest of the firm (Rumelt, 1974, 1982; Shaikh ; Varadarajan, 1984). After we started this work some researchers have argued that the entropy measure of diversification is believably a better one. We leave it to future research to exam the robustness of SR versus other measures of diversification.Operationally, SR is a ratio of the firms annual revenues from its largest discrete, product-market activity to its total revenues. In the diversification literature, SR has been one of the methods of election for measuring diversification. It is easy to understand and calculate. circumvent 1 Values of Specialization Ratios in Ru melts and Our Classification Schemes SR Values in Rumelt’s Scheme SR Values in Our Scheme Undiversified, sensation ware Firms SR ? . 95 SR ? 0. 95 middling Diversified Firms 0. 95 ; SR ? 0. 7 0. 95 ; SR ? 0. 5 Highly Diversified Firms SR ; 0. 7 SR ; 0. 5 writ of execution Management researchers prefer history variables as performance measures such as return on rightfulness (hard roe), return on investment (ROI), and return on assets (ROA), along with their variability as measures of risk.Earlier studies typically measure chronicle order of return. These include: (ROI), return on capital (ROC), return on assets (ROA) and return on sales (ROS). The idea behind these measures is perhaps to evaluate managerial performance-how well is a firms management using the assets (as heedful in dollars) to generate accounting returns per dollar of investment, assets or sales. The problems with these measures are well known. Accounting returns include disparagement and inventory cos ts and affect the accurate describe of earnings.Asset values are also recorded historically. Since accounting conventions make these variables unreliable, financial economists prefer market returns or discounted cash flows as measures of performance. For the sake of consistency, we use dickens accounting measures: hard roe and ROA; along with market return to measure performance. publication on equity (hard roe) is a frequently employ variable in sound judgment top management performance, and for making executive compensation decisions.We use roe as a measure to judge performance and calculate the intermediate return on equity (A roe) crosswise all sampled firms and condemnation power points, its trite disagreement and also the coefficient of variation for from each one(prenominal)(prenominal)(prenominal) of the common chord diversification hosts. ROE is defined as winnings income (income available to common stockholders) divided by stockholders equity. The coeffic ient of variation (CV) gives us the risk per unit of total return. ROA is the most frequently used performance measure in previous studies. It is defined as electronic network income (income available to common stockholders), divided by the book value of total assets.We also calculate the median(a) return on assets (AROA) across all sampled firms and condemnation periods calculate its metre deviation and also the coefficient of variation for each of the three diversification bases. Market return (MKTRET), is the third dependent variable we use. MKTRET is computed for a calendar year by taking the difference between the current years completion stock price, and the previous years ending price, adding to it the dividends paid out for the year, and then dividing the result by the previous years ending price.This study includes companies for which sleep together data to calculate the variances used is available on Compustat PC- asset for the period 1984 through 1990. In additi on, we calculate the mediocre market return (AMKTRET) for each of the three sort outs, the standard deviation of AMKTRET, and the Sharpe Index (Sharpe, 1966), a commonly used risk-adjusted performance measure. It measures the risk premium earned per unit of risk exposure. RESULTS AND DISCUSSION As mentioned earlier, sidestep 1 presents comparison of breaks between Rumelt’s categorisation and the modify version. utilise the Compustat database we then classified 2637 firms using Rumelt’s classification scheme for the years 1981-1990. elude 2 presents the AROE and its standard deviation using Rumelt’s classification. While we mean to calculate AROA and MKTRT for this data set we were unsuccessful because of the problem of missing data. The 1984 †90 data set turn up to be better and was used for the alternate classification scheme for all the three performance variables. Using the same Compustat database, we classified 2188 firms in three crowds: Sing le Product Firms (SR ; 0. 5), jolly Diversified Firms (0. 5 ? SR ? 0. 95), and Highly Diversified Firms (SR ; 0. 5), for each of the seven years, from 1984 to 1990, for which complete segmental data was available. We kept only those firms in the sample that remained in the same SR crime syndicate for the entire seven year period, and had all the data for computing the variables. After classification, we calculated each of the three performance variables: return on equity (ROE), return on assets (ROA), and market return (MKTRET), for each firm in each of the three collectionings, for each year from 1984 to 1990.We also calculated the average ROE (AROE), average ROA (AROA), and average MKTRET (AMKTRET), first by averaging across the seven years for each firm, and then by averaging across firms by pooling across the years, along with their standard deviation, and coefficient of variation. hedges 3, 4 and 5 present the results. The number of firms in each performance host varies sl ightly because we had to ensure that the data was available for all variables, for all the seven years. statistical ProcedureThe attempt of the null hypothesis requires a test of compare of means of each classification assembly, and for each performance variable. While the study may manoeuver one way analysis of variance (ANOVA), it is not a robust test. The application of ANOVA requires that the data set meet three critical assumptions: first, the test is extremely sensitive to departures from normality; foster, the assumption of homogeneousness of variance is necessary; and third, the errors should be independent of assembly mean.While for our study the first and the third assumptions checked out, the number assumption regarding the homogeneity of variance failed. We carried out Hartleys test of compare of variance for each performance variable. This test confirmed that variance of the three groups is unequal for each performance variable. We faced the Beherens-Fisher pro blem or checking for equality of means when variances of the implicit in(p) population are unequal. such situations indicate Cochrans approximation test for hypotheses testing (Berenson and Levine 1992).This test requires us to test the null hypothesis of equality of means, taken two at a time, and check to the test we must reject the null if the t (observed) exceeds t (critical) at chosen levels of significance. (Statistical information available from authors by request) send back 2 Performance found on Rumelts SR Classification Scheme: ROE-1981-1990 N AROE SD CV Undiversified Firms (SR ? 0. 95) 1663 3. 8 277. 73. 13 somewhat Diversified (. 95 < SR ? .7) 371 2. 3 181. 2 78. 78 Highly Diversified (SR < . 7) 603 9. 9 100. 9 10. 25 Results Classification Methods: Comparison and a seek of Robustness dishearten 1 compares the breaks in SR values. Table 2 reports the results using Rumelts scheme with 1981-1990 data, and Table 3 reports the results using our scheme with 198 4-1990 data.The first main cover in Table 2 shows the three categories of diversification based on SR values; N stands for the number of firms that remained in the same group for the period 1981-1990, and had performance data for the entire period under study; AROE stands for the average of the ROE calculated over N firms; SD stands for the standard deviation of AROA; and CV represents the coefficient of variation, wedded by the ratio of SD divided by the AROE, representing the risk per unit average return. Tables 3 through 5 follow the same layout for ROE, TABLE 3 Performance As: buy the farm On Equity (AROE)-1984-1990N AROE SD CV Undiversified 1844 -1. 6 323. 3 NA Moderately Diversified 315 32. 7 409. 4 12. 52 Highly Diversified 23 14. 6 9. 8 0. 67 N= Sample Size, AROE= intermediate Return on Equity, SD= measuring stick Deviation, CV= Coefficient of divergenceROA and MKTRET. The highly diversified group in Table 2 has AROE of 9. , SD equal to 100. 9 and CV of 10. 25; the na turalize group has AROE of 2. 3, SD equals 181. 2 and CV equals 78. 8. The Undiversified group AROE is 3. 8, SD 277. 9 and CV 73. 1. The highly diversified group has the highest AROE, the lowest Standard Deviation and the lowest Coefficient of variation. The results are in the pass judgment direction. The results follow the expected path with the exception that AROE of the maintain group is less than that of the general group but the mean values are not farthest apart and the difference is statistically insignificant.The result for the homogenous and the highly diversified groups are as expected. The SD values are also in the expected direction. comparison these results with results obtained in Table 3. Table 3 shows the relationship between the degree of diversification and group-wise performance metric by ROE. The sample consists of 1844 single product firms with SR greater or equal to 0. 95. The average ROE of these firms over the seven year period is -1. 6 share, with a SD of 323. 3. The pretty diversified group with SR between 0. 95 and 0. , has 315 firms. The AROE of the group equals32. 7 percent and the SD equals 409. 4. While the AROE of this group is clearly superior to that of single productfirms, the group shows high ROE variability. Thus, the checkerly diversified group shows an slightly improvedrisk-return indite. The third group with SR values of less than 0. 5, is the smallest, and includes only 23 firms. The average ROE of the group equals 14. 6 or about half that of the second group, with SD of 9. 8, which is much lower than the first and the second group.The CV is the lowest at 0. 67, which is about 1/20 of the moderate group. Table 3 shows that while highly diversified firms have lower risk than moderately diversified firms; moderately diversified firms have higher average ROE compared to highly diversified firms. It also shows that single product firms have lower risk than moderately diversified firms, but moderately diversified firms have much higher returns. When we combine the return and risk measures as given by the coefficient of variation CV, we do see consistent results, i. e. that highly diversified firms have better risk-return profile than moderately diversified firms; and moderately diversified firms perform better in risk-return terms when compared to single product firms. We find that the Tables 2 and 3 show results in expected direction. The highly diversified groups have higher AROE and lower SD compared to the other two groups. This comparison of the two classification schemes shows sufficient consistency especially in the two extreme groups to strongly suggest that performance tends to be ceaseless to classification breaks.The comparison also shews the validity of using the more pronounced classification scheme used in this study. Performance as Return on Assets and its Variability Table 4 shows the relationship between the degree of diversification and group-wise performance based on ROA . The sample consists of 1848 single product firms with SR greater or equal to 0. 95. The AROA of these firms over the seven year period is †1. 9 percent, with a SD of 38. 2. TABLE 4 Performance As: Return On Assets (AROA)-1984-1990 N AROA SD CV Undiversified 1848 -1. 38. 2 NA Moderately Diversified 316 4. 0 5. 0 1. 25 Highly Diversified 24 5. 8 2. 7 0. 47 N= Sample Size, AROA= Average Return on Assets, SD= Standard Deviation, CV= Coefficient of Variation The moderately diversified group with SR between 0. 95 and 0. 5 has 316 firms. Its AROA equals 4 percent with a5 percent SD. In absolute terms, the AROA of this group is higher than that of whole firms and has lower SDof 5. 0 percent, as compared to 38. percent of the first group. The CV is positive at 1. 25, which shows a much improved risk-return profile. The third group of the highly diversified firms includes 24 firms, with AROA of 5. 8 and SD of 2. 7. These values are lower than the first and the second group. The CV of this group is high at 0. 47, being 38 percent of the moderate group. Statistical results in Table 2 show that as we move from homogeneous group of firms to the highly diversified group of firms, the average return on assets increases, and the variability of ROA as given by SD decreases, and CV or the risk per unit return decreases.Statistically, according to Table 4, the above results are significant at the 1% level. Based on these findings reject the null hypothesis. Performance as Market Return Table 5 reports group-wise markets return performance. The sample consists of 1195 firms in the single product category, and 280 and 23 firms in the moderately and highly diversified groups. The sample for each group is small than it was for AROA and AROE because we eliminated firms that did not have complete information for the period under study.The average market return AMKTRET of the unanimous group over the study period is 8. 2 percent. The SD is 21. 1, the risk per unit of return a s calculated by the CV is 2. 57 and the Sharpe Index is 0. 0421. The moderately diversified group with SR between 0. 95 and 0. 5 has 280 firms. Their AMKTRET equals 13. 2 percent and the SD equals 40. 8 percent. Whereas, the average market return of this group is clearly superior to that of the single product firms, the group shows higher variability as compared to the first one. The CV, i. e. , the risk per unit return also is higher at 3. 8. The Sharpe Index of the moderate group is 0. 1443, about three times higher than the first group, and is in the expected direction. The third group includes 23 firms. Its AMKTRET equals 16. 3, with SD of 10. 1, which is much lower than the first and the second group. The CV is 0. 67, about a fourth of the first group. The Sharpe Index at 0. 89 is about half dozen times higher than that of moderately diversified firms. Table 5 shows that the average market return for the highly diversified group is higher than the moderately diversified group , followed by the single product group.The variability of market returns of the highly diversified group is lower than firms in the single product group. Moderately diversified firms on average have a higher market return, but higher risk than single product firms. The Sharpe Index, the inverse of which gives us risk per unit return, and is a better risk-return measure, shows that the performance of highly diversified firms is much better than the moderately diversified ones, and performance of moderately diversified firms is better than single product firms. TABLE 5 Performance As: Market Return (AMKTRET)-1984-1990N AMKTRET SD CV SI Undiversified 1195 8. 2 21. 1 2. 57 0. 0421 Moderately Diversified 280 13. 2 40. 8 3. 08 0. 1443 Highly Diversified 23 16. 3 10. 1 0. 67 0. 8900 N= Sample Size, AMKRET= Average Market Return, SD= Standard Deviation, CV= Coefficient of Variation, SI= Sharp’s Index Analysis of ResultsStatistical analysis of the results in Tables 3, 4 and 5 are repo rted in Table 6. These results look strong. They `show that performance of firms as metric by all the variables in the undiversified group is markedly below that of the firms in the highly diversified group and that these results are statistically significant. The results also show that the performance of firms in the moderately diversified group is better than that of the firms in the undiversified group. These results are also statistically significant.The performance difference between the moderate and highly diversified group however, is not always that clear. When careful on AROA, Sharpe Index and CV, the results are in the expected direction and significant, but when performance is measured by AROE and its SD, and AMKTRET and its SD, the results are not as clear. TABLE 6 Statistical Analysis of Performance Variables STATISTIC AROA AROE AMKTRET n 729. 33 727. 33 499. 3 F max (3,n) 20. 17* 1747. 78* 16. 32* F12 58. 37* 0. 67*+ 0. 27+ F23 3. 43* 1747. 78* 16. 32* F13 200. 17* 1088. 33* 4. 45* t’12 6. 29* 1. 41**** 1. 9** t’23 2. 91* 1. 86*** 0. 96*+ t’13 7. 38* 2. 08*** 3. 07* * square at 0. 01 or less; **Significant at 0. 025; ***Significant at 0. 05; ****Significant at 0. 1; *+Significant at 0. 25; +not significant. The results suggest that we can reject the null and require the alternate hypothesis: that higher the degree of diversification, greater is the average performance, measured in risk-return terms.The following paragraphs analyze the results for each performance variable in greater detail. Analysis of Results by Performance Class We further massage our data by subdividing each diversification category: undiversified, moderately diversified, and highly diversified, into three performance classes by adding and subtracting one standard deviation from the average ROE. Thus, each category is divided into three performance subclasses: Average ROE + 1 Std. Dev. ; Average ROE; and Average ROE †1 Std. Dev… This gives r ise to a total of nine performance classes, three for each level of diversification.If the hypothesis that the higher the degree of diversification, the higher the performance is robust, then we should expect it to hold when we compare performance across the performance sub-classes. That is; the high, average and below average ROE performance of highly diversified firms should be higher than the respective performance of the three moderately diversified groups, and each of the three moderate performance groups should have higher average ROE as compared to each of the three undiversified groups.If this relation holds then we can say with greater degree of confidence that diversification of firms leads to higher performance for all classes of firms. We, therefore, hypothesize that the best, the average and the medium execute groups demonstrate a consistent pattern of performance across the three diversification groups on both risk and return dimensions. Table 7 shows classification o f firms based on degree of diversification and by performance class. These results are both in expected and unhoped directions.The performance for the low and average performing firms, both in terms of risk and return diversification is in expected directions. But the results for the high performance group is found to be in the expected direction only for risk, while for the return measure the performance is in the opposite direction. In the finish off performance sub-class, the AROE of undiversified firms is -59. 53, and the SD is 103. 16. As we go toward increase level of diversification, AROE performance increases to -5. 78 and SD drops down to 5. 58 for the moderate group. For the highly diversified group, AROE becomes +2 and SD travel to 0. 2. In the average performance sub-class, the AROE for the undiversified group is 2. 46, and SD is 6. 87. For the moderately diversified group, ROE increases to 4. 21 and SD waterfall to 2. 91. For the highly diversified group, AROE increa ses to 5. 27 and SD falls 1. 60. The results for these two performance sub-classes are consistent with the results obtained for the entire group as shown in Table 3. The results for the best performance sub-class show interesting results. The AROE for the undiversified group is 35. 28 and the SD is 36. 44. AROE for the moderately diversified group decreases to 12. 9. SD also decreases to 3. 3. For the highly diversified group, AROE drops to 9. 52, nearly a fourth of the undiversified group, and the SD decreases to 0. 87, one thirty sixth of the undiversified group. clear the results for the best performance class are opposed to earlier findings as far as ROE is concerned, but they are in expected direction as far as standard deviation is concerned. We are, however, able to reject the null hypothesis if we look at CV (Risk per unit return). The value of CV decreases as we move from undiversified to highly diversified group.These results suggest that dominant firms operating with co re competencies and operating in less competitive environments are better off concentrating on one business segment. Our results show that such firms have superior returns but are unable to diversify away market risks. These firms may waste investor resources by diversifying into other businesses. On the other hand, firms operating in markets where they face considerable competition and have fewer core competencies, or are unable to dominate their markets, they are belike to be better off diversifying, as it would reduce risk for such firms and increase average returns.SUMMARY AND CONCLUSIONS The study began with questions regarding discrepancies in empirical and theoretical investigations into the relationship between firm diversification and performance. Our results suggest that the average performance of diversified firms (especially highly diversified ones) perform well on a risk-return basis on accounting measures as well as market-based measures, when compared with group of f irms that are not as highly diversified. Managers tend to judge performance using accounting measures such as ROE and ROA where as financial markets use market-based measures such as MKTRET.Our results show that on both types of performance measures, the group of diversified firms on average tends to perform better. The data show that with an increasing degree of diversification, the average return on assets, average return on equity and average market return, increase and the average risk per average unit return decreases. The results are clearer when comparisons are made between the highly diversified and the undiversified group, and the moderate and undiversified groups. The results are not as sharp when we compare results between the moderately diversified and the highly diversified group.The implication of the finding is that in general diversification is helpful but it does not tell us how much of it is helpful. Additional research on economies of scope for these groups of fir ms may throw some light on this issue. The marginal ambiguity between the moderate and the highly diversified groups may also be the result of eliminating the contingent variables like type, modality and extent of diversification. Controlling these variables may provide greater insight and clarify the differences between the moderate and the highly diversified groups of firms and lend support to theory building.The most surprising finding of our study was about the class of â€Å"best performing” firms. The study found that AROE of undiversified firms was four times better than the highly diversified firms, but such firms had 36 times the excitableness of the highly diversified firms. This result implies that the best performing firms, if they diversify, will reduce their earnings, but bump the capriciousness of their returns. Managers of such firms therefore will be tempted to dampen the volatility of returns by diversification.Such actions, according to this study will l ead to a reduction in returns, but the reduction in volatility of returns will be much greater. This is clearly beneficial to managers and employees of the firm, but a benefit of such insurance for the shareholders is not as clear. The implications for investors are that, if they risk such high performance, they ought to stay in for the long haul, and have high border for volatility. But even for this class of firms based on coefficient of variation, we feel that the average performance of highly diversified firms tends to be better than that of the undiversified firms.One must judge Jack Welch, the CEO of General Electric (GE) in this context. GEs top management group insists that each of their divisions must be either number one or number two in their specific product markets. Thus GE, a high performing increase is trying to emulate characteristics of a dominant undiversified firm at the product market level in order to earn very high returns and concomitantly it practices the a rt of being an aggressive and active obscure at the corporate level to reduce the risk engendered by dominant firms.But not all high performing firms are as careful, well managed or lucky. The study echoes the belief of senior corporate executives who think diversification enhances firm value because it contributes to improvement of the firms risk-return profile. The results also speak to the concerns of investors. Diversification, especially for the truly high performing firms reduces risk but at the cost of returns. There is undoubtedly a trade-off here between risk and return when managers of such single firms diversify from their core business.Thus diversification does buy insurance for the managers which may help managers and employees more than investors. But in the case of the average and the low performing single firms (most likely the non dominant firms), gain from diversification in return and risk terms, seem significant. The moderate and highly diversified groups also b enefit from diversification on risk and return dimensions but their performance is not leading(predicate) by any stretch of the imagination. One can argue that diversification tends to reduce the already backbreaking competitive threat faced by the bulk of firms in these groups.The implications for investors follow suit. They are better off picking stocks of well-diversified firms as these deliver better returns over time as compared to moderately diversified or undiversified firms. The finding that on average, highly diversified firms, including conglomerates, show better performance than single product firms or moderately diversified firms, supports the belief of corporate executives but is contrary to the viewpoint of research in finance. A classification scheme by translation remains arbitrary, no matter how well we condone the scheme.The only safeguard against such arbitrariness is to demonstrate that the results of the study are invariant to changes in promiscuously set c lassification boundaries. We were somewhat successful in showing that changing classification boundaries did not change the thrust of our results. Both methods showed that AROE of highly diversified group of firms was greater than that of the undiversified group. But this still is a fruitful direction for future research. We were able to examine ROE alone because of data limitations.The 1981-1990 data set was not consistent for all the variables and segments of businesses. Other variables take on to be tested. Researchers may also want to know if, at what point, the results are no longer invariant to SR classification values. Our study has several other limitations. The research period (1984-1990) of this study does not foregather the time periods reported in earlier studies. If diversification matters as a strategy, then it ought to do so no matter what the time period. This study has examined pooled time series data and finds the results consistent with expectations.Subject to t he availability of data, takings over different time periods will adequately address this issue. Economic arguments require that we measure performance in terms of cash flows. We do need to look at the net present value of cash flows to make strong statements about the proceeds of a diversification strategy in the capital budgeting sense. Market return may be a reasonable substitute but the examination of the net present value of cash flow may be necessary from the point of view of the stock market. This is left to future research.Although SR is an acceptable measure of diversification, the entropy measure (Hoskisson, et. al. , 1993) has become an important and likely a better measure of diversification. This study was extensive comme il faut. Perhaps multiple measures of diversification in a future study will alleviate methodological concerns about the appropriateness of diversification measures. The research design of this study differs somewhat from similar earlier studies, a nd as stated at the outset, it does not address the question whether investor portfolios outperform diversified firms.Therefore, while addressing several thinkable objections, we urge caution in accepting these results, and suggest future research to verify the findings reported here. Finally, this study examines the association between corporate diversification and performance per se. It does not address the differences in performance caused by types of diversification, like related, or unrelated; nor does it use modifying variables like firm size and other firm-level factors, or modalities of diversification such as internal product development or mergers and acquisitions.The results of this study are interesting enough to warrant the inclusion of variables that control for industry structure and contingency variables such as interest rates or the state of the economy; or underlying managerial motivation like risk reduction, agency problem, or moral hazard. Such controls will pro vide greater insight into the diversification strategy, as a practice and as a phenomenon.\r\n'