Assessing product-market diversification of U.S. firms.

Diversification has become an increasingly important aspect of corporate strategy over the last four decades, both in terms of product and market diversification.

Product diversification emerged in the early years of this century as a result of firms desiring to supply entire lines of inter-related products (Didrichsen 1972). Between 1949 and 1974 alone, the proportion of the largest 500 industrial firms which were diversified rose from 30 to 60 percent (Rumelt 1982).

International market diversification refers to firms which are horizontally- or vertically-integrated across different national sub-markets (Hisey/Caves 1985). This is a more recent development than product diversification. It made up 14.1 percent of the value of total assets controlled by foreign corporations in 1962, 22.3 percent in 1968 (Koptis 1979) and was estimated to be 31 percent in 1975 (Hisey/Caves 1985).

It is evident that the impact of corporate diversification on the risk-return performance has two dimensions: that of the product and of internationalisation.

The Role of Product Diversification in Firm Strategy

Two basic modes of product diversification can be identified: related and unrelated diversification (Wrigley 1970, Rumelt 1974, 1982). Related diversification is where firms diversify within industries while unrelated diversification is where firms diversify across industries. The relative costs and benefits of such diversification are likely to depend upon the inter-relationship between the different business activities of a firm.

The Economic Benefits of Related Diversification

The relative costs and benefits of corporate diversification are likely to depend on how the different business activities of a firm are related to one another. Where separate business activities use a common, indivisible input, a diversified firm can exploit economies of scope. Economies of scope arise not just from tangible input like a common R & D department or a common distribution system but also from intangible assets like brand names and production know-how. Businesses within diversified firms can therefore be related in at least one of two ways. They could be related either because they share markets, distribution systems, product and process technologies, or manufacturing facilities (Ansoff 1965, Rumelt 1974, Teece 1980), or because they rely on common technologies, managerial capabilities and routines and repertoires (Prahalad/Bettis 1986, Kazanjian/Drazin 1987, Winter 1987, Grant 1988). The use of these assets may be transferable at a negligible marginal costs.

The industrial organisation literature recognises that firms can enjoy synergy from diversifying into related businesses. Such diversification facilitates the exploitation of economies of scope where common indivisible inputs are used. Because there is the prospect of opportunism in small number trading relationship, or the existence of information impactedness, economies of scope are difficult to realise using the market mechanism (Kay 1982, Jones/Hill 1988). Hence, overcoming transaction difficulties in exploiting economies of scope via the market mechanism provides an economic rationale for hierarchical exchange through corporate diversification. Corporate diversification strategy can be seen as a way of reducing transaction costs in allocating resources, transferring and processing information, avoiding shirking, and overcoming agency problems (Williamson 1981).

A firm can gain certain kinds of comparative advantages if it has skills or resources that it can transfer into the new market (Porter 1987). A diversified firm can apply particular skills and knowledge acquired in one business to solve problems and exploit opportunities in other businesses (Salter/Weinhold 1978).

Consequently, a firm possessing primarily specific intangible assets is supposed to be a successful one in its national market and to be able to use these capabilities in foreign markets. International corporate diversification offers the opportunity to use the 'core skills' effectively and to exhaust all economies of scale in the distinct domain. The rationale is that the opportunity cost of using the core skills in new markets is close to zero, and can be considered underutilized as long as the earned marginal revenue is positive.

By contrast, unrelated diversification provides little synergy. When a firm moves into a market with only a weak connection to its primary line of business, it often lacks the know-how and management resources to prevail against the competition in this new field. The difficulty of internal administration also increases. Many of the most spectacular failures of diversification can be traced to a failure to take sufficient account of relatedness between business sectors at the corporate level (Grant 1988).

Implicit in the above discussion is the idea that related diversification should be the choice of firms seeking to capture and increase economic benefits through internalisation. A large number of firms, however, continue to adopt an unrelated diversification strategy to exploit market failure and achieve certain kinds of economic benefits. This implies that unrelated diversification may not incur transaction costs to the extent of related diversification (Jones/Hill 1988). Significant transaction costs are likely to mitigate against the sole pursuit of related diversification as a corporate strategy.

Organisational Problems for Related Diversification

The potential for benefits from relatedness does not imply, however, that these benefits will actually be realised (Reed/Luffman 1986). Obtaining economies of scale may, for example, require establishing operating relationships among businesses in diversified firms. Such relationships are problematic and costly (Carman/Langeard 1980, Hoskisson/Hitt 1988, Kanter 1989). The perceived, or real, loss of independence and autonomy that sharing may bring about also prevents co-operation among businesses (Bastien 1987).

The realisation of the benefits of relatedness requires the forging of new organisational relationships, changing existing ones and creating mechanisms to ensure co-operation among related businesses. These activities usually take a long period of time before harmoniuous relations can be formed. It seems rather difficult, especially for large diversified international firms, to attain the desirable relatedness and huge resources must be fully committed for this attainment. In addition, organisational learning difficulties inhibits development and adoption of new routines and repertoires necessary to successfully realise the potential benefits of relatedness (Kazanjian/Drazin 1987). These organisational problems may reduce the benefits from relatedness.

International Market Diversification

The concept of international market diversification has often been linked with risk reduction. It is suggested that the most important function of international market diversification is to reduce unsystematic risk at the firm level (e.g. Hughes et al. 1975, Lloyd 1975, Wolf 1975, Agmon/Lessard 1977, Rugman 1977, 1979, 1983, Miller/Pras 1980, Geyikdagi 1981, Michael/Shaked 1986, Buhner 1987, Geyikdagi/Geyikdagi 1989, Madura/Whyte 1990, Qian 1995, 1996).

Diversification across national boundaries should improve a firm's risk-re-turn opportunities when economic activity in different countries is less than perfectly correlated. International activities in any one country may be more risky than a comparable investment in a home country. The riskiness of international activities as a whole, however, may not be any higher and may even be lower than the riskiness of domestic investment. Firms that engage heavily in foreign activities should therefore exhibit a more stable stream of profits than comparable firms which are not internationally diversified. The overall variance of a firm's cash flow will be reduced if the income streams from its various international activities are less than positively correlated.

If there were no barrier to international capital flows and if capital markets were fully integrated, investors could diversify their portfolio holdings internationally by themselves and thus eliminate unsystematic risk on a global basis. In such circumstances, there is no need for diversification at the firm level.

Perfect information with no impediments to financial market transactions, however, does not occur in the real world. International capital markets are neither segmented nor integrated but lie somewhere between these two extremes (Grubel 1968, Levy/Sarnat 1970, Cohn/Pringle 1973, Subrahmanyam 1975, Biger 1979, Mathur/Hanagan 1983, Madura/Reiff 1985, Sweeney 1986, Eaker/Grant 1990).

Because capital markets are imperfect and partially segmented, investors may actually not diversify internationally. Firms going abroad may therefore perform a diversified service for investors. In this sense, international market diversification is a vehicle of realising a better risk-return performance.

An increased geographic scope of operation may increase a firm's ability to share or co-ordinate its international activities. Such benefits include economies of scale, scope and experience (Kogut 1985, Porter 1985, 1987). There is a growing similarity of countries in terms of infrastructure, distribution channels and marketing. At the same time, technology is playing an integrating role by permitting easier co-ordination of activities in different countries. International market diversification also offers the opportunity to exhaust economies of scale within a firm.

A broad area of operations, however, entails costs. It is suggested that institutional and cultural factors erect formidable barriers to the transfer of competitive advantage between countries (Kogut 1985). Geographically diverse operations may limit a firm's efforts to tailor its activities to serve a particular target segment, geographic area or industry. This may frustrate attempts to achieve lower costs or a differentiated position in the market (Porter 1985). The possible influence of regional differences and increased costs of geographical coordination may reduce the potential benefits associated with increased scope.

Determinants to International Diversification: Ownership and Internalisation Advantages

The requisite conditions should be met before the benefit of international diversification could be realised. It is generally believed that firms engaging in international diversification must possess ownership advantages not available to existing or potential local competitors (Hymer 1960, 1976, Kindleberger 1969, Caves 1971, 1982, Buckley/Casson 1976, Hood/Young 1979, Errunza/Senbet 1981, Cho 1985, Yu/Ito 1988, Kim et al. 1989, Morck/Yeung 1991, Markides/Ittner 1994). These ownership advantages, largely in the form of intangible assets (e. g. special know-how, management skills and marketing ability), represent a range of competitive strengths which are essential to their continued growth and ultimately to their survival (Dunning et al. 1986, Dunning 1993).

According to Morck and Yeung (1991), a firm's international diversification does not provide any significant value unless it possesses R & D and advertising-related intangible assets. They found that the positive impact of the intangibles related to R & D and to advertising on market value increases with a firm's multinational scale, but that multinationality per se does not have any significant impact. In other words, if a firm lacks such ownership advantages, international diversification should be of little value. Therefore ownership advantages are necessary for international diversification to make sense.

Both transaction costs and internalisation theories argue that the ownership advantages firms have enjoyed in an international arena derive from market imperfections in intermediate markets, especially for intangible assets. Because the imperfections change the costs of external market transactions relative to the costs of internal activities by the firm, there will therefore be an incentive to bypass them and create internal markets (Dunning 1973, 1979, 1980, 1981, 1988, Walliamson 1975, 1979, Buckley/Casson 1976, 1978, Magee 1976, Casson 1981, Rugman 1980, 1981, 1986, Hennart 1982, 1986, Teece 1983, 1986, Davidson/McFetridge 1984, Buckley 1985, 1988, Anderson/Weitz 1986, Hill et al. 1990, Brewer 1993). International diversification is therefore the result of the internalisation of the market for intangibles and other intermediate inputs (Dess et al. 1995).

It is especially important for firms, especially multinational enterprises (MNEs), to reduce transaction costs associated with international market imperfections. There is a net benefit from internalising an intermediate product market linking activities located in different countries (Casson et al. 1986). Firms simply utilise an internal market instead of an imperfect external one for international diversification purposes. Internalisation is therefore a device for retaining the benefits of ownership advantages within the firm and facilitating the direct transfer on a global basis.

The benefits of international diversification may be lost if the internal market is not strengthened and further developed. The continuous maintenance of an internal market will, to a great extent, safeguard the original advantage of international diversification possessed by the firm.

Therefore, a most important way to effect corporate international diversification is though the use of firms' internal markets. This is because only by doing this can the ownership advantages be well protected (Stopford/Wells 1972, Buckley/Casson 1976, Magee 1976, Calvet 1981, Caves 1982, Davidson 1982, Coughlan/Flaherty 1983, Coughlan 1985, Anderson 1985, Anderson/Coughlan 1987, Van de Ven/Poole 1989, Hill et al. 1990, Kim/Hwang 1992, Kogut/Zander 1993). The creation of an internal market thus facilitates the direct transfer of ownership advantages and regulate their use on a global basis. Knowledge, for example, is the most important source of ownership advantage. It is less likely to be imitated and also more efficiently transferred via internal channels (or markets) than by market means.

This discussion indicates that ownership and internalisation advantages are two most important advantages for a successful realisation of international diversification. Ownership advantage can be seen as propulsive force for a firm to reap considerable gains from exploiting it in as many countries as possible. Internalisation advantage can be seen as an important channel or an essential device to facilitate the activities of international diversification. The theoretical framework has therefore been formed by linking corporate international diversification closely and directly to both ownership and internalisation advantages.

The Methodology for Empirical Analysis

This study uses a sample of 169 largest U.S. industrial firms on the 'Fortune 500' listing. For a firm to be included in the sample, there needs to be performance data for the ten-year period. Each firm is assigned different product and market categories according to its diversification strategy. The time period 1981-1990 is employed because this allows short-term influences on firm risk-return to average out.

The initial base sample consists of all firms in the 'Fortune 500' listing in independent existence over this period. Because the composition of the top 500 firms has changed a great deal over this ten-year period and there were some missing data on many firms, the original sample size was reduced substantially, leaving the present sample of 169 industrial firms for which all of the requisite data for 1981-90 was available.

The two profitability measures employed are return on assets (ROA) and return on equity (ROE). ROA and ROE are often used by managers and external analysts as a measure of the effectiveness and efficiency of top management. The impact of strategy on a firm's performance is more directly reflected in accounting profit than in stock price which measures investor's expectations about future profits. Risk is measured by the standard deviations (SDs) of both ROA and ROE figures across the 10-year time period.

To analyse the data and test the hypotheses, the t-test is employed for testing the equality of means. Because the size of the sample is not small (size [greater than] 15) parametric assumptions underlying the test hold. The t-test is commonly employed for this type of analysis.

The objective is to examine average differences between different product-market combinations rather than inter-industry or intra-industry differences. This does not control for the effect of industry participation. The interpretation of all results must note carefully pooling across industries. This is because average characteristics across industries may be quite different from the characteristics in any particular constituent industry.

Measures of Related and Unrelated Diversification

Related and unrelated product groups are defined on the basis of a specialisation ratio ([R.sub.s]) and a related ratio ([R.sub.r]). The specialisation ratio, [R.sub.s], is the proportion of revenues accounted for by a firm's largest single business unit. The related ratio, [R.sub.r], is the proportion of revenues attributable to a firm's largest group of related business. Several important tests on product diversification are carried out in this study on the basis of [R.sub.s] and [R.sub.r].

Products belonging to different four-digit SIC industries within the same two-digit industry group are treated as related; products from different two-digit SIC industry groups are defined as unrelated. Diversification induces are computed using segment sales as reported by the firms in accordance with Statement 14 of the Financial Accounting Standard Board (FASD). Diversification indices are computed for each firm using the SIC and sales data for its principal products. Assignment to a product category is made on the basis of the share of a firm's total sales which can be attributed to the largest discrete (related to unrelated business) area. A firm's specialisation ratio and related ratio enables the procedure to differentiate between these business areas.

This study also uses two definitions of diversification: narrow spectrum diversification (NSD) and broad spectrum diversification (BSD) (Varadarajan 1986). The former represents related diversification and the latter unrelated diversification. There is a possibility of forming four groups of product diversification between NSD and BSD on the basis of the extent of diversification indices. The combinations are: low BSD/low NSD; low BSD/high NSD; high BSD/low NSD; and high BSD/high NSD.

In this study, these four groups are employed. The criteria for differentiating them are that for the NSD as a whole, any firm with [R.sub.r] below 0.5 is classified as low NSD while any firm with [R.sub.r] above 0.5 belongs to high NSD category. In terms of the BSD, any firm with [R.sub.s] below 0.5 is regarded as low BSD category while any firm with [R.sub.s] above 0.5 is classified as high BSD one.

It should be noted that, since no uniform criteria exist to differentiate product diversification, product classification is one of many available. It can provide, to a certain extent, an estimate of the effect of different product diversification strategies on the profitability of firms under study.

The Hypotheses of Related and Unrelated Diversification

Several theoretical considerations concerning the relationship between product diversification and risk-return performance lend support to the following hypotheses:

Hypothesis 1: On average, the profitability of low BSD/high NSD is greater than that of the other three groups.

Hypothesis 2: On average, the profitability of firms with high relatedness (HR) is greater than that of firms with both medium and low relatedness (MR and LD).

An important concern is to compare profitability between firms with different extents of relatedness in their product diversification. Based on the extent of [R.sub.r], the firms are divided into three subgroups: low, medium and high relatedness. The criteria used to measure each subgroup are [R.sub.r] [greater than] 0.5 for high relatedness (HR); [R.sub.r] between 0.5 and 0.3 for medium relatedness (MR); and [R.sub.r] [less than] 0.3 for low relatedness (LR). For the same reason, any biases which result from this subjective (arbitrary) classification cannot be avoided.

Measures of Total Product Diversification

The entropy measure of diversification recognises the degree of relatedness among various product segments (Jacquemin/Berry 1979). It allows the decomposition of a firm's total diversity into two additive components: an unrelated and a related component (Palepu 1985). Related diversification is the weighted sum of the shares of each product segment in a firm's sales in an industry. If a firm operates in several industries, net related diversification is the weighted sum of related diversification within each industry. Unrelated diversification is the weighted sum of the shares of each industry in total sales. The measure thus provides three indices for each firm: related diversification; unrelated diversification; and total diversification equal to the sum of the first and second indices.

The Total Product Diversification Hypothesis

According to the preceding theoretical discussion, the following hypothesis can be made.

Hypothesis 3: The higher the index of total product diversification, the better the profits a firm is likely to produce.

All firms in the list are divided into three subgroups on the basis of the index of total diversification: high total product diversification (HTD) having the index of above 1.3; medium total diversification (MTD) having the index of between 0.7 and 1.3; and low total diversification (LTD) having the index of below 0.7. HTD is expected to outperform both MTD and LTD.

Measures of Global Diversification

The most commonly measurement of a firm's multinationality is the ratio of a firm's foreign sales, including export sales, to its total sales (e.g. Wolf 1975, 1977, Rugman 1979). Even though these studies have recognised two different geographic market units, domestic (usually the U.S.) and foreign (Rest of World), their measures do not truly reflect the extent of international market diversification. This is because they fail to reflect the multiplicity of foreign markets served by firms. A bias is likely to occur because the measures do not distinguish between firms having 30 percent of their sales in one country and a similar amount in several countries.

Several studies attempt to correct this deficiency. The number of foreign countries in which a firm operates can be counted to capture the multiplicity of foreign markets (Cohen 1972). This is based upon the relative shares of sales in each foreign market. Entropy measures can be used (Hirsch/Lev 1971, Miller/ Pras 1980). These are based upon the ratio of a firm's holdings (the number of subsidiaries) in a region to its global holdings (the total number of its foreign subsidiaries). Accordingly, entropy measures reflect, not only the multiplicity of foreign markets, but also the equality or inequality of the size of foreign operations. More importantly, entropy measures not only quantify the dispersion of a firm's activities across dissimilar geographic regions but also measure the extent to which a firm's activities are spread across similar foreign countries within regions (Vachanis 1991). The similarities include physical and cultural proximity and level of economic development across the countries in which it operates.

Index of Diversification and Market Classification

International market diversification (D) is calculated as the entropy of each firm's relative country (or regional) holdings:

D = [S.sub.i]/[log.sub.e] (1/[S.sub.i])

Where [S.sub.i] is the ratio of a firm's holdings (number of subsidiaries) in country or region i to the total number of foreign subsidiaries.

Annual Reports and/or 10k Forms provide the main sources on corporate international diversification. In addition, the Directory of American Firms Operating in Foreign Countries and Mood's 'International Directory of Corporate Affiliations' also provide useful information on the countries in which U.S. firms are involved. These data sources are used to determine the scope of FDI in this study.

According to the theories of market imperfections and transaction costs, a firm's ability to earn profits from its intangible assets and to minimise its costs of managing is affected by similarities and differences between the countries in which it operates (Vachani 1991). The relevant geographic unit is one in which patterns of general economic conditions, fluctuations in demand and external restrictions have close similarities.

Six geographic regions are used to measure international market diversification by a large number of Fortune 500 firms. These market areas are EU; EFTA; North America; Other Developed Countries; Eastern Europe, China and Common Market Associates; and other developing countries (see The World Bank 1987). More pronunced differences are expected to occur between, rather than within each geographic region. These six international regions provide the basis for geographic specification. Each firm is assigned a value in terms of both the number of geographic regions in which it is involved and the number of its subsidiaries in each region.

Measurement Criteria for Market and Product Diversification

The study is designed to test market-product combinations; that is, the combinations of international market diversification and product diversification. This technique provides groups of firms which pursue distinct strategic modes of global diversification. These are:

Group I: Related diversifiers with high global diversification (RD-HG);

Group II: Related diversifiers with low global diversification (RD-LG);

Group III: Unrelated diversifiers with high global diversification (UD-HG); and

Group IV: Unrelated diversifiers with low global diversification (UD-LG).

Related and unrelated diversifiers are therefore also classified on the basis of their international market diversification.

The criteria for defining high and low global diversification in this study are based upon entropy measures (Miller/Pras 1980). If the composite index (D) is not less than 1.3, a firm is regarded as a high international market diversifier. Comparatively, if the composite index is not more than 0.7, it is treated as a low international market diversifier. In addition, the group between high and low international market diversification are also included; 'medium global diversifier' (MG) with a composite index (D) is between 0.7- 1.3.

The Global Diversification Hypotheses

The theoretical arguments lead to the proposition that the higher the global diversification of a firm, the better its chances of obtaining a superior risk-return performance. It is possible therefore to formulate the following hypotheses.

Hypothesis 4a: On average, the profitability of high global diversification (HG) is greater than that of both medium global (MG) and low global (LG) diversification.

Hypothesis 4b: On average, the profitability of MG is greater than that of LG.

Hypothesis 5a: On average, the profit stability of HG is greater than that of both MG and LG.

Hypothesis 5b: On average, the profit stability of MG is greater than that of LG.

These hypotheses also imply that the risk-return performance of firms pursuing the same strategic mode of product diversification varies according to the extent of their global diversification. This leads to the following hypotheses:

Hypothesis 6a: On average, the profitability of related diversifiers with high global diversification (RD-HG) will be greater than that of related diversifiers with low global diversification (RD-LG).

Hypothesis 6b: On average, the profit stability of RD-HG will be higher than that of RD-LG.

Hypothesis 7a: On average, the profitability of unrelated diversifiers with high global diversification (UD-HG) will be greater than that of unrelated diversifiers with low global diversification (UD-LG).

Hypothesis 7b: On average, the profit stability of UD-HG will be higher than that of UD-LG.

Empirical Studies of Product and Market Diversification

In this section, empirical tests are performed on the basis of the theoretical framework and methodology. The principal results and their implications are discussed below.

Related and Unrelated Diversification

This deals with corporate diversification associated with various product combinations by testing Hypothesis 1 that the profitability of low BSD/high NSD is greater than that of the other three groups. There may be synergistic benefits between the constituent businesses of a relatedly diversified firm. These may arise in the form of shared production, R & D, marketing costs and/or expertise. The very nature of unrelated diversification precludes the accumulation of expertise (e.g. production technology, marketing skill and scale economies) at the corporate level in all of the industries in which a firm participates. Firms which have diversified into related businesses are usually more profitable than other firms (Rumelt 1974, 1982, Christensen/Montgomery 1981, Amit/Livnat 1988). This test is based upon combinations of product diversification.

The results in Table 1 clearly support the hypothesis that low BSD/high NSD firms out-perform firms which are relatively less diversified along the NSD dimensions, as well as firms that are relatively more diversified along the BSD dimension. A significant difference in profitability is observed between low BSD/high NSD firms and their counterparts. The findings support the theoretical strategic management rationale and previous empirical results. Firms pursuing closely related product diversification strategies enjoy higher profits because they exploit their core skills effectively to gain the advantages of synergies.

Table 1. Profitability for Combinations of Product Diversification

Variable    Pairwise       Difference    t-Statistic   Significance
            comparison

ROA         LB/HN-LB/LN    2.18          2.31          0.0260
            LB/HN-HB/LN    1.85          3.17          0.0020
            LB/HN-HB/HN    0.85          1.59          0.1200

ROE         LB/HN-LB/LN    3.09          1.69          0.1000
            LB/HN-HB/LN    2.58          2.29          0.0240
            LB/HN-HB/HN    3.44          2.93          0.0057

Notes: LB/LN: low BSD/low NSD
LB/HN: low BSD/high NSD
HB/LN: high BSD/low NSD
HB/HN: high BSD/high NSD

The Extent of Relatedness

To provide a full investigation of product diversification, a further comparative study of firms with a varying degree of relatedness is undertaken to test Hypothesis 2. Because related diversification is expected to provide higher profits, firms pursuing related diversification strategies can therefore be viewed as a single entity. Table 2 shows the results of firms' profitability with three relatedness ratios.

Consistent with the a priori expectations, firms with high relatedness ratios are found to have the highest mean ROAs and ROEs. Firms with a high relatedness ratio appear to out-perform firms with both medium and low relatedness ratios (supporting Hypotheses 2). The only exception appears for differences in ROE in which the t-statistic is not statistically significant although it has the correct positive sign. It is evident that the extent of relatedness ratio supports the explanation of changes in profitability for firms pursuing different product diversification strategies. No difference in profitability has been found to exist between firms with low and medium relatedness ratios. This further suggests that the relative costs and benefits of corporate diversification are likely to depend upon how different business activities of a firm are related to each other. Where separate activities have a common indivisible input, a diversified firm can exploit economies of scope. The potential for exploiting economies of scope, however, depends crucially upon the closeness of the relationships between a firm's businesses. If they are loosely linked or poorly structured, they are less likely to complement or supplement each other or use similar resources and the potential for synergy will not exist. In other words, they cannot effectively exploit their core skills to gain the advantages of synergies.

Table 2. Profitability of Firms with Various Relatedness Ratios

Variable     Pairwise       Difference   t-Statistic   Significance
             comparison

ROA          HR-MR           1.49         2.05          0.0450
             HR-LR           1.29         2.27          0.0250
             MR-LR          -0.20        -0.27          0.7900

ROE          HR-MR           2.61         1.86          0.0700
             HR-LR           1.17         1.06          0.2900
             MR-LR          -1.44        -0.97          0.3300

Notes: HR: high relatedness
MR: medium relatedness
LR: low relatedness

Total Product Diversification

This is concerned with firms with different levels of total diversification (both unrelated and related) by testing Hypothesis 3. Table 3 reports the results of profitability between three groups of firms corresponding to high, medium and low levels of total product diversity. The results in Table 3 do not reveal significant differences in profitability between any of the three pairs of groups. The evidence is therefore not strong enough to support Hypothesis 3; that is, the high total diversification produces a superior profit compared to both medium and low total diversification. A possible reason for this weak result is that related and unrelated diversification is combined. When the relatedness ratio is chosen as an alternative measure, both the ROA and ROE of firms in the group of high relatedness ratio are greater than those of firms in the groups of both medium and low relatedness ratios. This implies that the inclusion of unrelated diversification obscures the comparison of each constituent. This also suggests that firms pursuing unrelated diversification may be less likely to achieve superior profitability. The inclusion of the index of unrelated diversification therefore reduces the likelihood that a significant difference may occur between each pair of group under study.

Table 3. Profitability of Firms with Total Product Diversification

Variable       Pairwise       Difference   t-Statistic   Significance
               comparison

ROA            HTD-LTD           0.41         0.56         0.5800
               HTD-MTD           0.99         1.60         0.1100
               MTD-LTD          -0.58        -0.87         0.3900

ROE            HTD-LTD           1.31         1.04         0.3000
               HTD-MTD           0.59         0.52         0.6100
               MTD-LTD           0.72         0.55         0.5800

Notes: HTD: high total product diversification
MTD: medium total product diversification
LTD: low total product diversification

The Extent of Global Diversification

This is concerned with a comparison of the risk-return performance for firms with a varying degree of international market diversification. Table 4 reports the results of such comparison. Hypotheses 4a, 4b, 5a and 5b are fully supported by the empirical tests. Both the profitability and risk measures are statistically significant at the 10 percent level. The results also indicate that the difference between any MI-LI pair is not statistically significant except for ROA. This clearly suggests that a firm must meet minimum requirements of international market diversification before it is able to perform differently from its counterparts.

Table 4. Risk-Return Performance and Global Diversification

Variable   Pairwise    Difference    T-Statistic    Significance

ROA         HI-LI         2.36         3.74             0.0003
            HI-MI         0.98         1.65             0.1000
            MI-LI         1.38         2.30             0.0240

SD of ROA   HI-LI        -0.87         1.68             0.0990
            HI-MI        -0.45         1.26             0.2100
            MI-LI        -0.42         0.73             0.4700

ROE         HI-LI         2.36         1.91             0.0600
            HI-MI         0.95         0.84             0.4000
            MI-LI         1.41         1.04             0.3000

SD of ROE   HI-LI        -2.06         1.66             0.1000
            HI-MI        -0.56         0.53             0.6000
            MI-LI        -1.50         1.09             0.2800

Notes: HI: high international market diversification
MI: medium international diversification
LI: low international diversification

Market and Product Combinations

This is concerned with the combination of market and product diversification by testing Hypothesis 6a, 6b, 7a and 7b. Table 5 provides the results of performance differences between firms characterised by varying levels of global and product diversification. Several observations are significant and therefore need careful explanation.

Table 5. Performance of Firms with Market-Product Diversification

Variable     Pairwise       Difference   t-Statistic   Significance
             comparison
ROA         RD/HI-RD/LI        2.64         2.15            0.0440
            RD/HI-UD/HI        1.53         1.69            0.1000
            RD/HI-UD/LI        2.95         3.18            0.0038
            RD/LI-UD/HI       -1.11        -0.97            0.3500
            RD/LI-UD/LI        0.31         0.27            0.7900
            UD/HI-UD/LI        1.42         1.73            0.0900

SD of ROA   RD/HI-RD/LI       -1.64        -2.33            0.0320
            RD/HI-UD/HI       -0.22        -0.46            0.6500
            RD/HI-UD/LI       -0.88        -1.71            0.0990
            RD/LI-UD/HI        1.42         2.07            0.0540
            RD/LI-UD/LI        0.76         1.07            0.3000
            UD/HI-UD/LI       -0.66        -1.33            0.1900

ROE         RD/HI-RD/LI        5.34         2.30            0.0300
            RD/HI-UD/HI        2.69         1.74            0.0940
            RD/HI-UD/LI        4.62         2.45            0.0200
            RD/LI-UD/HI       -2.65        -1.22            0.2400
            RD/LI-UD/LI       -0.72        -0.30            0.7700
            UD/HI-UD/LI        1.93         1.13            0.2700

SD of ROE   RD/HI-RD/LI       -4.15        -1.74            0.1000
            RD/HI-UD/HI       -1.24        -0.84            0.4000
            RD/HI-UD/LI       -2.36        -1.77            0.0890
            RD/LI-UD/HI        2.91         1.20            0.2500
            RD/LI-UD/LI        1.79         0.76            0.4600
            UD/HI-UD/LI       -1.32        -0.80            0.4300

Notes: RD/HI: related diversifiers with high international market
diversification

RD/LI: related diversifiers with low international market
diversification

UD/HI: unrelated diversifiers with high international market
diversification

UD/LI: unrelated diversifiers with low international market
diversification

For the firm sample, the means of some pairs of groups are significantly different. The performance of the RD/HI group is found to out-perform all other pairs of groups for most profitability and risk measures. The result is consistent with Hypotheses 6a and 6b. The risk reduction effect through international market diversification is strongly apparent.

Given the same level of global diversification for pairs of the RD/HI-UD/HI groups, changes in either related or unrelated product diversification do not alter the trend of profit stability. The results therefore do not exhibit significant difference (both t=-0.46 of ROA and t=-0.84 of ROE) for both comparisons.

For pairs of the RD/HI-UD/HI groups alone, the t-test shows that the former group was significantly greater than that of the latter in terms of profitability at the 10 percent level. Given the same level of international diversification, it is easier to identify the effect of product relatedness on profitability. The test result is strong enough to support Hypotheses 7a and 7b. This finding supports the strategic management research.

With two exceptions, the results do not exhibit significant differences for the remaining pairs of groups. The evidence thus, supports the hypothesis that related diversifiers in the case of high global diversification are closely associated with higher profitability and lower risks.

Summary and Conclusions

Diversification is an increasingly important component of the strategic management of firms. It has attracted the attention of both economists and business researchers, particularly the relationship between corporate diversification and financial performance.

International diversification reflects the extent of the global market dispersion of a firm's operations. A broad geographic scope of operations may yield competitive advantages by permitting a firm to exploit the benefits of performing more activities internally (Rugman 1981). On a priori grounds, international market diversification enables the use of firm-specific know-how to penetrate prospective foreign markets in firm's main lines of business. Increased geographic scope of operations may increase a firm's ability to share or co-ordinate activities of different geographic areas. Such benefits include economies of scale, scope and experience. The growing similarity of countries and the integrating role of technology are extremely important for international market diversification (Porter 1987). This is because of the availability of infrastructure, distribution channels and marketing. Information technology already permits easier co-ordination of activities in different countries.

As indicated, international diversification takes place once firms, especially MNEs, have secured internally transferable ownership advantages (especially intangible assets) in foreign markets. If firms lack such ownership advantages, international diversification should be of little value. According to the transaction costs theory, firms are geographically diversified because they have expanded abroad to internalise imperfect markets for intermediate inputs, including those for intangibles. The internal market of the firm is likely to be a superior method of carrying out international diversification on a worldwide scale. It becomes apparent that both ownership and internalisation advantages have provided necessary conditions for firms to engage in successful international diversification in both market and product dimensions.

Several empirical tests are carried out to examine corporate diversification in both product and market dimensions. Most of the findings are consistent with those of the hypotheses. The results lead to the following conclusions.

There is no significant cross-sectional difference between the profitability of firms with high, medium and low total product diversification.

Firm whose diversification strategy is characterised by low BSD (unrelated diversity) and high NSD (related diversity) outperform financially those firms whose diversification strategy is characterised by all other pairs of groups. The consistently low performance of the high BSD/low NSD pair suggests that a high level of broad spectrum diversity without commensurate narrow spectrum diversity is not conducive to superior performance.

There is a significant cross-sectional difference between the profitability of firms with a different extent of relatedness ratios. This further suggests that the closer the relations between different business activities of a firm, the more likely it is to be profitable. In the case of product scope, a firm whose different product divisions are closely linked by common customers, distribution channels or technologies will have a greater potential for exploiting economies of scope than a firm where such links are loose or absent.

Related diversifiers are found to outperform unrelated diversifiers in the case of high global diversification. RD-HIM firms are found to perform better than all three pairs of groups. This combination can be further separated into two parts. Given the level of HIM (high global diversification), firms pursuing related diversification are found to have a greater profitability than the other three pairs of groups. Given the level of RD, firms engaging in high international market diversification achieve a much higher profit stability (lower risks). This suggests that a broad geographic scope of operations may yield competitive advantages by permitting a firm to exploit the benefits of a superior risk-return performance. This is because increased geographic scope of operations may increase a firm's ability to share or co-ordinate activities in similar business segments or industries.

It should be acknowledged, however, that there may be several weaknesses in the methodology and possible biases in the test results because of subjective classification and data pooling. Despite these limitations, the findings lend empirical credence to findings reported in previous studies and provide additional insights.

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