DIVERSIFICATION AS REAL OPTIONS AND THE IMPLICATIONS ON FIRM-SPECIFIC RISK AND PERFORMANCE

The management literature posits that firms can create value through diversification. In contrast, the established finance literature concludes that diversified firms destroy value.

This paper suggests a way to reconcile these two warring camps by articulating a new theory of the way in which diversification can add value not by increasing performance, but by reducing risk in ways mat investors cannot replicate.

Specifically, diversification, understood dynamically, provides a way for companies competing in especially turbulent industries to hedge the competitive risk attendant to “convergence” phenomena. That is, in industries where the optimal operating scope of a firm is in question because the promise of convergence cannot be exploited using market-mediating mechanisms, firms will “over diversify” as a hedge against uncertain future reconfigurations of industry boundaries.

In other words, these firms diversify as a way to create “real options” on future integration. These options create a form of “strategy insurance” that investors can not recreate with a portfolio of focused firms: investments in two separate, focused firms do not create an option on a single firm that encompasses the activities of those two companies. As uncertainty spawned of convergence begins to fade, strategically-hedged firms will re-focus their operations by exercising or abandoning their options on integration in a manner appropriate to the demands of their newly-defined marketplaces.

Option-creating diversification has potentially profound implications on operating performance and risk profile. Most significantly, options-based diversification is asserted to cause the operating performance of such firms to fall as they diversify and increase as they focus, in keeping with the observations of the finance literature. Yet the firms will have created value for shareholders by compensating for significant strategic risks that investors cannot otherwise hedge.     

Opportunity costs,industry dynamics,and corporate diversification: Evidence from the cardiovascular medical device industry, 1976–2004

This paper examines how demand conditions across alternative markets impact diversification decisions and firm performance by influencing the opportunity costs of deploying non‐scale free capabilities. Using data within the cardiovascular medical device industry, this study shows that: (1) firms with a larger stock of pre‐entry innovation experience are more likely to diversify; (2) firms in a current market with greater relative demand maturity are more likely to diversify; (3) diversification is associated with a performance decrease in the current market; and (4) diversification is associated with a performance increase at the corporate level. These findings shed new light on the self‐selection process of corporate scope, the conceptualization of firm capabilities, and the connection between industry dynamics and resource deployment. Copyright © 2013 John Wiley & Sons, Ltd.     

Diversification strategies,business cycles and economic performance

Two major diversification strategies of firms are examined: diversification into related businesses and diversification into unrelated businesses. The first strategy attempts to exploit operating synergies. In the second, the firm attempts to gain financial benefits from its ability to increase leverage due to a greater stability of cash flows. The study utilizes a large sample affirms to assess empirically the benefits and costs of these two diversification strategies by developing a new measure of diversification across business cycles and economic sectors. This new measure is compared with Berry—Herfindahl type measures of total diversification and recent measures of diversification into related businesses. The results indicate that pure financial diversification is associated with (a) more stable cash flows, i.e. lower operating risk; (b) increased levels of leverage; and (c) lower profitability. These observations are in accord with the theory. We also reaffirm that firms which diversify into related businesses have, on the average, higher profitability than non-diversified firms, although these results are not always statistically significant.     

Corporate diversification and the value of individual firms: A Bayesian approach

Research summary: Prior theory suggests that the performance effects of a firm's diversification strategy depend on a firm's individual resources and capabilities and the setting within which it is operating. However, prior tests of this theory have examined the average diversification‐performance relationship across all firms, instead of estimating the diversification‐performance relationship at the individual firm level. Efforts to estimate this average relationship are inconsistent with a central assumption of much of strategic management theory—that firms maximize value by choosing strategies that exploit their heterogeneous resources and individual situation. By adopting an approach that allows an evaluation of the diversification‐performance relationship for individual firms, this article shows that firms, both focused and diversified, tend to choose that diversification strategy—focus, related diversification, or unrelated diversification—that maximizes value. Managerial summary: Instead of a universal diversification discount or premium, this article shows that the effect of diversification on performance is heterogeneously distributed across firms and that firms tend to be rational in their diversification decisions. Copyright © 2015 John Wiley & Sons, Ltd.     

Building product diversification through contractual R&D agreements

Firms engage in contractual R&D agreements for several reasons, including product innovation motives, firm performance goals, and technological diversification. This article demonstrates that firms also might enter into external collaborations to penetrate new markets. This study therefore explores both the effects and the strategic risks of contractual R&D agreements and their related knowledge structures for a firm's capacity to diversify into new markets. Drawing on a novel panel data set obtained from 102 Fortune high‐tech firms, the authors demonstrate that strategic alliances enable knowledge‐integrated firms to penetrate new businesses; however, these organizations should be cautious about engaging in licensing‐in agreements, which have negative effects on product diversification.     

ORGANIZATIONAL STRUCTURE AND THE DIVERSIFICATION DISCOUNT: EVIDENCE FROM COMMERCIAL BANKING*

We provide evidence on organizational structure and performance at bank holding companies (BHC's). First, we show that a BHC's member banks benefit from access to internal capital markets. Second, we ask if these benefits are best realized within loosely structured, decentralized organizations or more consolidated, centralized firms. We find that BHC's with many subsidiaries are less profitable and have lower q ratios than similar BHC's with fewer subsidiaries. However, because we study multi‐unit firms in a single industry, our results suggest that the diversification discount reported in the corporate finance literature reflects not only industry diversification, but also organizational structure.     

Diversification and diffusion: A social networks and institutional perspective

We examine the diffusion of a major firm strategy, unrelated diversification, among a population of Chinese listed firms during the 1991 to 2002 period. We propose that a firm??s social network can serve as both an information disseminator and a channel of influence in the diffusion of the diversification decision. Further, we investigate how the institutional environment alters the role of a network over time. We find that firms are more likely to diversify into conglomerates if (1) they occupy a central position in the network; (2) they have higher levels of government shareholding; and (3) the firms with which they have network ties diversify. Moreover, as the institutional environment strengthens over time, the influence of a firm??s network partners decreases. Consistent with these results, we contend that diversification is not only a response to economic and agency concerns, but also a function of the social and institutional context in which a firm is embedded.     

Synergy,coordination costs,and diversification choices

Sharing common inputs across business lines can potentially generate synergy that justifies related diversification. The pursuit of such synergy through diversification is, however, fundamentally driven by the indivisibility of inputs between firms. Following Penrose's insight, I argue that to realize this synergy, a firm needs to actively manage the interdependencies between different business lines, which, in turn, increases its coordination costs. The coordination costs may increase faster than synergy and set a limit to related diversification. This is particularly salient when the firm's existing business lines already have complex interdependencies among them. I test these arguments on a dataset of U.S. equipment manufacturers for the period 1993 to 2003. The results show that a firm is more likely to diversify into a new business when its existing business lines can potentially share more inputs with the new business; however, the firm is less likely to diversify into any new business when its existing business lines are complex. Importantly, the firm's likelihood of diversifying into a new business decreases more with the complexity in the firm's existing business lines if they share more inputs with the new business. These results suggest that increasing coordination costs counterbalance the potential synergistic benefits associated with related diversification. Copyright © 2010 John Wiley & Sons, Ltd.     

Within‐business diversification in technology‐intensive industries

This study extends diversification research to a new level of analysis, examining how within‐business diversification, which occurs when firms extend existing product lines or expand into new ones, affects organizational survival. While prior research suggests that corporate‐level diversification accounts for relatively little variation in performance, within‐business diversification matters a great deal, by influencing which start‐ups survive and which firms better cope with rapid environmental change. Specifically, we find that the relationship between within‐business diversity and survival is contingent on the amount of environmental change wrought by a firm's competitors as they simultaneously diversify their own product portfolios and innovate technologically. Analysis of the population of U.S. personal computer manufacturers from the industry's founding in 1975 through 1994 supports our premise: Regardless of its effects across businesses, diversification matters a great deal within them. Copyright © 2004 John Wiley & Sons, Ltd.     

Implementation strategy and performance outcomes in related diversification

Strategy research has a long‐standing interest in the performance consequences of corporate diversification. In theory, resource sharing should yield economic benefits in related multi‐business firms, but the extensive empirical research remains equivocal. To explore this paradox, this paper examines the process of implementing a related diversification strategy. Working from existing theory, a formal model is constructed that describes the process and performance implications of a related diversification move. The model is analyzed using computer simulation, and the analysis suggests that successful diversification strategies require managerial policies that maintain organization slack. In the absence of such policies, related diversification can negatively impact firm performance even when substantial synergy opportunities exist. The analysis also demonstrates, contrary to existing theory, that diversification strategies based on a very high degree of relatedness can lead to lower performance than less related strategies in some circumstances. Counter‐intuitively, extracting potential synergies may require additional investment in shared resources. Copyright © 2005 John Wiley & Sons, Ltd.     

Demand‐side strategy,relational advantage,and partner‐driven corporate scope: The case for client‐led diversification

Research Summary: We advance research on corporate diversification by joining insights from the demand‐side and relational views in strategy to offer a novel theory of client‐led diversification. We propose that client‐led diversification results from a combination of the customer‐driven opportunities emphasized in the demand‐side view and the creation of added value through relational assets that is a central tenet of the relational view. Furthermore, we hypothesize that suppliers’ client‐specific knowledge, clients’ relational commitment to suppliers, and growth opportunities in clients’ markets (relative to the suppliers’ own markets) will magnify the client‐led diversification effect. We test our hypotheses using a longitudinal dataset on patent law firms and their diversification into new domains of patent prosecution work for their corporate clients. Managerial Summary: Explanations of why firms diversify into new lines of business have largely concerned the redeployment of underutilized resources, with little regard to opportunities or influences stemming from firms’ existing customers. In our article, we show how the changing scope of business needs from a knowledge‐based supplier firm's set of existing clients is a central driver of supplier‐firm diversification, and this is especially the case when the level of relational assets shared between a supplier and its clients is higher. In a competitive landscape where suppliers compete intensively for the business of clients, our results show how managers can increase the likelihood of capturing additional business from its existing exchange relationships rather than bearing the risks of seeking new exchange relationships.     

Skill relatedness and firm diversification

Because of the importance of human capital, a firm's choice of diversification targets will depend on whether these targets offer opportunities for leveraging existing human resources. We propose to quantify the similarity of different industries' human capital or skill requirements, that is, the industries' skill relatedness, by using information on cross‐industry labor flows. Labor flows among industries can be used to identify skill relatedness, because individuals changing jobs will likely remain in industries that value the skills associated with their previous work. Estimates show that firms are far more likely to diversify into industries that have ties to the firms' core activities in terms of our skill‐relatedness measure than into industries without such ties or into industries that are linked by value chain linkages or by classification‐based relatedness. Copyright © 2012 John Wiley & Sons, Ltd.     

Strategic control systems and relative r&d investment in large multiproduct firms

This paper hypothesizes that tight financial controls associated with large diversified M-form firms lead to a short-term, low-risk orientation and thereby lower relative investment in R&D. Further, it is hypothesized that increasing levels of diversification require different control systems which have significant implications for investing in R&D. Results of the study of 124 major U.S. firms suggest that less diversified U-form firms invest more heavily in R&D than more diversified M-form firms after controlling for size and industry effects. Additionally, dominant business firms invested more in R&D than either related or unrelated business firms. Finally, the relationship between R&D intensity and market performance was negative for related and unrelated firms. The findings suggest that the market evaluates R&D investment more positively for firms that are organized to seek synergy than for those that are organized to pursue a hedging (or diversification) strategy.     

Economies of Scope,Resource Relatedness,and the Dynamics of Corporate Diversification

Research summary: The dominant view has been that businesses that are more related to each other are more often combined within diversified firms. This study uses a dynamic model to demonstrate that, with inter‐temporal economies of scope, diversified firms are more likely to combine moderately related businesses than the most‐related businesses. That effect occurs because strong relatedness reduces redeployment costs and makes firms redeploy all resources to better performing businesses. The strength of that effect depends on inducements for redeployment measured as the current return advantage of one business over another business, volatilities of business returns, and correlation of those returns. This study develops hypotheses for those relationships and suggests empirical operationalizations, encouraging empiricists to retest the implications of relatedness for the dynamics of corporate diversification. Managerial summary: It is believed that diversified firms are more likely to combine more‐related businesses because relatedness enables sharing of resources between businesses. Indeed, a firm can apply knowledge created in one business to another business, avoiding costly duplication in knowledge development. Resource sharing also adds value when a firm offers several products, adding the convenience of one‐stop shopping and charging higher prices. However, resource sharing is not the only motivation for corporate diversification. In environments where profitability of businesses changes frequently, firms diversify by redeploying part of resources from an underperforming business to a better performing business. This study uses a dynamic model to demonstrate that, with that second motivation for corporate diversification, firms end up combining moderately related businesses rather than the most‐related businesses. Copyright © 2017 John Wiley & Sons, Ltd.     

Why Agency Costs Explain Diversification Discounts

We study diversificsation within the real estate industry because of its relative transparency: portfolio management of assets with well-defined market prices. Diversification is over property types and geographical regions. The major cause of the diversification discount is not diversification per se but anticipated costs due to rent dissipation in future diversifying acquisitions. Firms expected to pursue nonfocusing strategies do indeed diversify more, are valued ex ante at a 20% discount over firms anticipated to follow a focusing strategy, are predominantly privately controlled and use dual-class shares extensively. The ex ante diversification discount is, therefore, a measure of agency costs.     

Technological diversity,related diversification,and firm performance

Previous findings that related diversification creates value have been called into question over concerns about methodology and measures. Reviewing existing theory to consider how a firm's knowledge base interacts with its product market activity, I address several of these concerns by creating a measure of technological diversity based on citation‐weighted patents. The measure indicates a firm's opportunity for corporate diversification based on economies of scope in valuable knowledge assets, is defined for both single‐ and multibusiness firms, and is not correlated with more fundamental aspects of diversification, such as the number of businesses in the corporate portfolio. Evidence from a large sample of firms shows the positive relationship between diversification based on technological diversity and market‐based measures of performance, controlling for R&D intensity and capital intensity as further indicators of the type of assets underlying diversification. Results hold when controlling for the endogeneity of diversification and performance in a cross‐sectional sample or when controlling for unobserved factors using panel data. Copyright © 2006 John Wiley & Sons, Ltd.     

Diversification in the venture capital industry: leveraging knowledge under uncertainty

This study contributes to the research on the effect of diversification on performance under conditions of uncertainty. More specifically, we examine diversification in the context of venture capital firms. Drawing on the knowledge and organizational learning literature, we hypothesize that firms benefit from either low levels of diversification because of efficiencies in processing knowledge or high levels of diversification because of access to broad information that facilitates solving complex problems and the ability to direct a portfolio company down different trajectories. Consistent with our hypotheses, we find a U‐shaped relationship. Firms benefit from either low or high levels of diversification; moderate levels yield the poorest results. When uncertainty is highest (i.e., early stage investing, no coinvestors), the effects are most pronounced. Copyright © 2011 John Wiley & Sons, Ltd.     

The link between resources and type of diversification: Theory and evidence

In this paper we theoretically and empirically investigate the idea that firms diversify in part to utilize productive resources which are surplus to current operations. Knowledge of these resources allows us to make predictions about the direction of a firm's expansion. In particular, we suggest that excess physical resources, most knowledge-based resources, and external financial resources are associated with more related diversification, while internal financial resources are associated with more unrelated diversification.     

Product and international diversification among Japanese multinational firms

This paper examines the relationship of performance with product and international diversification on Japanese multinational firms from 1977 to 1993. We show the relationships between diversification and performance change over time through the use of multiple time periods and accounting for keiretsu membership. Results show that while diversity strategies vary between keiretsu and non‐keiretsu firms, performance is not much different. Across time periods, performance varies considerably, but strategies are less variable. Product diversity has weak effects on firm performance only in one time period, while international diversification has negative profitability and positive growth consequences in in some periods. These results suggest first that diversification strategies and their effects on performance vary across time periods and generally produce some unexpected findings. We do not find strong interactive diversity effects. Copyright © 2000 John Wiley & Sons, Ltd.     

Effects of intra- and inter-regional geographic diversification and product diversification on export performance: Evidence from the Chilean fresh fruit export sector

This study examines individually the effects of intra- and inter-regional geographic diversification on the export performance of firms from the Chilean fresh fruit sector. It also explores the direct effect of related product diversification on export performance and its role as a moderator in the relationship between geographic diversification and export performance. By employing panel trade data of 279 purely exporting firms over a six-years period (2010–2015), we found that both intra- and inter-regional diversification have an inverted U-shaped relationship with export performance, where moderate levels of diversification have positive effects on export performance, but higher levels may be counterproductive. Results also showed that related product diversification has a positive effect on firm export performance and a negative moderating effect on the relationship between inter-regional diversification and export performance. In the case of intra-regional diversification, we did not find any moderating effect from product diversification. By focusing on firms from the agricultural sector based in an emerging economy, this study offers practical implications for firm managers, trade organizations and private export associations, that may also be applicable to other export-based activities and emerging economies.