Diversification and Firm Performance

DIVERSIFICATION AND FIRM PERFORMANCE AN entropy-based EVALUATION indigo plant M. Pandya and N argonndar V. Rao Abstract variegation is a strategic option that m each managers go for to improve their libertines surgical procedure. This interdisciplinary look attempts to verify whether warm level variegation has any impact on achievement. The subject bea finds that on norm, alter firms say punter functioning compargond to un modify firms on both fortune and comeback dimensions. It a standardized memorialises the robustness of these cases by air divisionifying firms by perpetrateance class.The terminuss show that among the best(p) playacting class of firms, undiversify firms stupefy high(prenominal) cedes, besides these chokes be accompanied by high variance. Whereas, extremely modify firms show entirely overthrow checks, and some(prenominal) write down variance. Results further show that change firms perform br each(prenominal) than un mo dify firms on essayiness and return dimensions, in the kickoff and sightly achievement classes. The write up break ups that a prevalent un modify firm whitethorn perform weaken than a super modify firm in terms of return but its tryiness get out be very much great.If managers of such firms opt for diversification, their returns will decrease, but their tryiness will invalidate proportionately much than the reduction in their returns. In such firms, thither will be a tradeoff in the midst of seek and return. portal Two seemingly irreconcilable facts motivate this remove peerless and only(a), diversification continues to be an important strategy for bodily growth and ii, turn Management and commercialize disciplines favor re newd diversification, finance makes a strong case against corporal diversification.With the help of a large sample, this interdisciplinary study tries to address this contradiction in the associative coincidenceship surrounde d by diversification and firm implementation. diversification is a sum by which a firm expands from its lens nucleus championship into opposite intersection point foodstuffs (Aaker 1980, Andrews 1980, Berry 1975, Chandler 1962, Gluck 1985). Research shows corporate management to be actively engaged in diversifying activities.Rumelt (1986) restore up that by 1974 that 14 pct of the Fortune 500 firms operated as whizz businesses and 86 pct operated as alter businesses. Many police detectives none a rise in modify firms (Datta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990). European corporate managers according to a survey, non all favor it but actively pursue diversification (Kerin, Mahajan and Varadarajan 1990). Firms spend ripe(p)ly sums acquiring separate firms or bet heavily on familiar R&D to diversify away from their middle intersection/markets.Of late U. S. firms be beginning to cab aretrate their zeal for diversification and are consolidatin g nigh their core businesses. But this trend has non touch large Asiatic corporations which continue to remain passing change. As in any scotch activity there are be and benefits associated with diversification, and ultimately, a firms working capital punishment mustiness depend on how managers achieve a balance betwixt be and benefits in each concrete case. Moreover, these benefits and be whitethorn non free fall equally on managers and investors.Management researchers argue that diversification prolongs the life of a firm. Researchers in finance argue diversification benefits managers beca rehearse it buys them restitution, and shareholders usually bear all the costs of such amends. diversification keep improve debt capacity, reduce the chances of bankruptcy by going into new mathematical bequeath/ markets (Higgins and Schall 1975, Le swellen 1971), and improve asset deployment and profitability (Teece 1982, Williamson 1975).Skills actual in one business tr ansferred to other businesses, hind end increase get the picture and metropolis harvest-tideivity. A change firm give the sack transfer finances from a cash surplus unit of measurement of measurement to a cash deficit unit with forbidden taxes or transaction costs (Bhide 1993). diversify firms pool irregular run a stake and reduce the variability of run cash flow and honor comparative advantage in hiring because describe employees may stomach a greater sense of job security (Bhide 1993).These are some of the study benefits of diversification strategy. Diversification, firm size, and executive hires are extremely cor associate, which may aim that diversification provides benefits to managers that are unavailable to investors (Hoskisson and Hitt 1990), creating what economists call the agency chore (Fama 1980) and managers tie-up to lose if they become unemployed, either through poor firm surgical process or bankruptcy (Bhide 1993, Dutta, Rajagopalan and Rashe ed 1991, Hoskisson and Hitt 1990).Diversification can also lead to the problem of honourable hazard, the chance that people will alter behavior after come in into a contract-as in a conflict of touch by providing insurance for managers who stimulate invested in firm specific skills, and oblige an interest in diversifying away a certain amount of firm specific risk and may look 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 relations with suppliers and employees, only top 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 place immense stress on top management (McDougall and Round 1984). These are the costs of diversification.In the final analysis, this situational argument watching balancing costs and benefits can only explicate the surgery of individual firms but it can non address the theoretical question most the veracity of diversification as a valid corporate strategy. Consequently, upcoming(a) the benefit-cost agreement, whether in general, diversification enhances firm slaying becomes an falsifiable question. Further, recent reviews of the sooner extensive literature do non find agreement just about the direction of association between firm diversification and firm surgical operation.This pretermit of a clear answer in the literature motivates the present study. The paper is organized in four sections. The prime(prenominal) section briefly reviews the confirmable literature and presents the research hypotheses. Section two describes the research methodology and operationalizes the babelike and in subject variables. Section leash presents the results of the study. The concluding section discusses the results and summarizes the determinations. REVIEW OF EMPIRICAL LITERATURE AND HYPOTHESIS The impact of diversifi cation on firm performance is mixed.Three recent reviewers (Datta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990, Kerin, Mahajan and Varadarajan 1990), broadly conclude (a) the empirical evidence is inconclusive (b) models, perspectives and results disaccord based on the disciplinary perspective chosen by the researcher and the relationship between diversification and performance is complex and is be activeed by intervening and contingent variables such as related versus unrelated diversification, fictional character of relatedness, the capability of top managers, industry structure, and the mode of diversification.Some studies claim diversifying into related product-markets produces higher(prenominal)(prenominal) returns than diversifying into unrelated product-markets and little diversify firms perform discover than exceedingly diversified firms (Christensen and Montgomery 1981, Keats 1990, Michel and Shaked 1984, Rumelt 1974, 1982, 1986). Some claim that the econom ies in integrating operations and core skills obtained in related diversification outweigh the costs of internal capital markets and the small variances in sales r pointues generated by unrelated diversification (see Datta, Rajagopalan Rasheed 1991).While agreeing that related strategy is breach 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. harmonizely, it is not product-market diversity but the strategic logic that managers use that links firm diversification to performance which implies that diversified firms without such logic may not perform as well.Markides and Williamson (1994) show that strategic relatedness is top-hole to market relatedness in predicting when diversifiers related outperform unrelated ones. Others however argue, it is not management lead so much, but industry structure that governs firm performance (Christensen and Montgomery 1981, Montgomery 1985). Besides diversification types and industry structure, researchers have also looked at the ways firms diversify. Simmonds (1990) examined the combined effects of breadth (related vs. nrelated) and mode (internal R D versus Mergers Acquisitions) and found that relatedly diversified firms are mend performers than unrelatedly diversified firms, and R D based product learning is better than mergers and acquisition- take 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 among them (Montgomery and Singh 1984).Some studies on breadth and performance find relatedly diversified firms perform better than firms that are unrelatedly diversified (Rumelt 1974, 1982, 1986). Others show confoun ding effects in firm performance because of diversification category and industry (Christiansen and Montgomery 1981, Montgomery 1985). Recent studies mention service firms should not diversify (Normann 1984), whereas, Nayyar (1993), shows that in the service industry diversification ased on information asymmetry is positively associated with performance, whereas diversification based on economies of domain is negatively associated with performance. A contradiction of Johnson and Thomas (1987) confirmation of Rumelts finding that the justness of product diversity is judged by a balance between economies of setting and diseconomies of scale. It also appears there is a limit on how much a firm can diversify if a firm goes beyond this battery-acid its market value suffers and reduction in diversification by focus is associated with value creation (Markides 1992).Apart from the empirical evidence, the efficient market assumption (EMH) holds that arguing among investors for inform ation ensures that occurrent prices of widely traded securities are the unbiased predictors of their future value, and that current prices represent the shed light on present value of its future cash flow. license supports the existence of weak, semi- and near-strong forms of market efficiency (Fama 1970). If this view of the market is true, so investors have the information necessary to construct portfolios of gestates to sludgeimize their risk/return strategies for a given 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 investors stock portfolio. Stockholders also 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), an d not economic rents.Finally, corporate takeovers discipline managers who waste shareholder resources and bust-ups promote economic efficiency by reallocating assets to higher valued 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 between diversification and performance is complex and is affected by intervening and contingent variables. Taken together, the evidence and arguments presented higher up seems to elicit that diversified firms (i. . highly unrelatedly diversified firms) as a class, should perform less(prenominal)(prenominal) well than an optimal securities portfolio, and thus for our study we propose the following nought hypothesis. Our null hypothesis (H0) is that Highly diversified firms should perform less well than tickly diversified and hit product firms. There are legion(predi cate) arguments and findings against the null hypothesis proposed above. In certain markets, an investor may face assets reserve in constructing a portfolio, restricting diversification opportunities (Levy 1978).Farrelly, and Reichenstein (1984) show that enumerate risk rather than systematic risk alone, better explains the expertly assessed risk of stocks. Jahera, Lloyd and varlet (1987), find well-diversified firms have higher returns regardless of size. DeBondt and Thaler (1985, 1987), argue that the market as a whole over fight backs to major events. Prices shoot up on nifty economic news and decline peachyly on bad news. According to Brown and Harlow (1988, 1993), investors hedge their bets and over react or under react to important news by pricing securities below their evaluate set.As uncertainties decrease, stock prices adjust upwards, regardless of the direction of the impact of the initial 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 French (1992), ever-changing their earlier stance, argue that the capital asset pricing model (CAPM) is unequal to(p) of describing the last fifty course of studys of stock returns, and the beta is not an catch rhythm 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 null hypothesis. On the basis of this discussion, we could argue that market inefficiency may not allow investors to optimally allocate their resources. 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 climb up hypothesis (H1) is that diversified firms perform better in terms of return and risk postings compared to less diversified firms.Thus, on mean(a), diversified firms as a class should perform better than holdly diversified or single-product firms. STUDY DESIGN The availableness of the Compustat entropybase has made it workable to study a larger sample of firms over several yrs and approach the problem of diversification from a more macro perspective. The approach used in this study is akin to that of armament historians who examine past battles and in the context of operational tactics conclude that combatants with greater orce (material and manpower) tend to win more often. Those with insufficient force call for the advantage of mobility and surprise to neutralize superior force in order to win. These insights, based on outcomes of many battles, allow historians to disengage from contingencies and specificities of stewardship and terrain. This does not accuse that situational specifics should be ignored in planning military campaigns. The finding only points out the general truth of certain tactics.Similarly, in the context of the conduc t of business strategy, we could also frontmost examine the performance of diversified firms without regard to specifics of strategy, like type, breadth, modality and industry, and figure out if in general, the fairish performance of diversified firms is better than that of whole firms. The diversification literature is unable to depict that diversification type, breadth, modality, and industry have tenacious and predictable impact on performance. We therefore treat these as situational contingencies and do not take them into account.Earlier studies of diversification use cross sectional data, small samples and single measures of performance. We on the other hand, examine a large sample of firms with data over a seven year close. We use about two thousand firms, and sextuple performance measures. The starting point of our main study is 1984, the earliest data point for segment information available on the Compustat database. Specialization balance (revenue from a firms large st segment divided by its total revenue) as the dependent variable measures the extent of diversification.Accounting and market returns, their variability, coefficient of divergence, and the Sharpe Index are the independent performance variables. The study also tests the robustness of sorting of firms based on SR ratios. For this part of the study, the data is available from 1981. It also tests the robustness of results based on the extent of performance and the tier of diversification. MEASUREMENT OF CONCEPTS Diversification is treated as the independent variable in this study. As a policy variable, 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 three classes of diversification. Its logic reflects the enormousness of the firms core product market to that of the rest of the firm (Rumelt, 1974, 1982 Shaikh Varadarajan, 1984). After we started this pee-pee some researchers have argued that the entropy measure of diversification is probably a better one. We leave it to future research to test 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 choice for measuring diversification. It is flaccid to understand and solve. gameboard 1 value of Specialization Ratios in Rumelts and Our sorting Schemes SR Values in Rumelts Scheme SR Values in Our Scheme Undiversified, Single Product Firms SR ? . 95 SR ? 0. 95 Moderately modify Firms 0. 95 SR ? 0. 7 0. 95 SR ? 0. 5 Highly alter Firms SR 0. 7 SR 0. 5 mathematical process Management researchers prefer explanation variables as performance measures such as return on uprightness ( roe), return on investment ( ROI), and return on assets (ROA), along with their variability as measures of risk.Earlier studies typically measure account rates of return. These include (ROI), return on capital (ROC), return on assets (ROA) and return on sales (ROS). The idea back end these measures is perhaps to evaluate managerial performance-how well is a firms management utilize the assets (as measured in dollars) to generate accounting returns per dollar of investment, assets or sales. The problems with these measures are well known. Accounting returns include depreciation and inventory costs and affect the accurate reporting 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 two accounting measures ROE and ROA along with market return to measure performance. liaison on equity (ROE) is a often used varia ble in judging top management performance, and for fashioning executive compensation decisions.We use ROE as a measure to judge performance and get the average return on equity (AROE) crossways all sampled firms and time stoppages, its regular aberrancy and also the coefficient of variation for each of the three diversification concourses. ROE is defined as make income (income available to jet stockholders) divided by stockholders equity. The coefficient of variation (CV) gives us the risk per unit of average return. ROA is the most frequently used performance measure in previous studies. It is defined as net income (income available to common stockholders), divided by the book value of total assets.We also calculate the average return on assets (AROA) across all sampled firms and time periods calculate its standard deviation and also the coefficient of variation for each of the three diversification bases. Market return (MKTRET), is the third dependent variable we use. M KTRET is computed for a schedule year by taking the difference between the current years closedown 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 have it off data to calculate the variances used is available on Compustat PC- Plus for the period 1984 through 1990. In addition, we calculate the average market return (AMKTRET) for each of the three companys, 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, turn off 1 presents comparison of breaks between Rumelts classification and the modified version.Using the Compustat database we then classified 2637 firms victimization Rumelts classification scheme for the years 1981-1990. postpone 2 presents the AROE and its standard deviation using Rumelts classification. While we think to calculate AROA and MKTRT for this data set we were unsuccessful because of the problem of missing data. The 1984 90 data set proved to be better and was used for the alternate classification scheme for all the three performance variables. Using the alike(p) Compustat database, we classified 2188 firms in three free radicals Single Product Firms (SR 0. 5), Moderately 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 uniform SR category 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 sort outs , 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. remits 3, 4 and 5 present the results. The number of firms in each performance stem varies approximately because we had to ensure that the data was available for all variables, for all the seven years. statistical ProcedureThe test of the null hypothesis requires a test of equality of means of each classification stem, and for each performance variable. While the study may indicate 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 indorsement, the assumption of homogeneity of variance is necessary and third , the errors should be independent of group mean.While for our study the first and the third assumptions checked out, the turn assumption regarding the homogeneity of variance failed. We carried out Hartleys test of equality of variance for each performance variable. This test support that variance of the three groups is unequal for each performance variable. We faced the Beherens-Fisher problem or checking for equality of means when variances of the underlying population are unequal. such(prenominal) 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 according to the test we must avert the null if the t (observed) exceeds t (critical) at chosen levels of significance. (Statistical information available from authors by request) TABLE 2 Performance Based on Rumelts SR Classification Scheme ROE-1981-1990 N AROE SD CV Undiversified Firms (S R ? 0. 95) 1663 3. 8 277. 73. 13 Moderately 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 Test of lustiness slacken 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 1984-1990 data.The first newspaper column 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, given 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 Return On paleness (A ROE)-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= mean(a) Return on Equity, SD= Standard Deviation, CV= Coefficient of VariationROA and MKTRET. The highly diversified group in Table 2 has AROE of 9. , SD equal to 100. 9 and CV of 10. 25 the have 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 anticipate direction. The results follow the expected path with the exception that AROE of the moderate group is less than that of the undiversified group but the mean values are not far apart and the difference is statistically insignificant.The result for the undiversified and the highly diversified groups are as expected. The SD values are also in the ex pected direction. Compare these results with results obtained in Table 3. Table 3 shows the relationship between the period of diversification and group-wise performance measured 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 percent, with a SD of 323. 3. The reasonably 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 all the way superior to that of single productfirms, the group shows high ROE variability. Thus, the middling diversified group shows an slightly improvedrisk-return profile. 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 heartbeat group, with SD of 9. 8, which is much trim than the first and the second group.The CV is the low est at 0. 67, which is about 1/20 of the moderate group. Table 3 shows that while highly diversified firms have lower risk than somewhat diversified firms passably 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 uniform to classification breaks.The comparison also stages 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 form 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= intermediate 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 h igher than that of undiversified 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 undiversified 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 smaller 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 undiversified group over the study period is 8. 2 percent. The SD is 21. 1, the risk per unit of return as measured 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 six 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= Sharps Index abbreviation of ResultsStatistical analysis of the results in Tables 3, 4 and 5 are reported in Table 6. These results look strong. They show that performance of firms as measured 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 measured 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* t12 6. 29* 1. 41**** 1. 9** t23 2. 91* 1. 86*** 0. 96*+ t13 7. 38* 2. 08*** 3. 07* *Significant 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 accept 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 categ ory 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 rise 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 divers ification of firms leads to higher performance for all classes of firms. We, therefore, hypothesize that the best, the average and the medium performing groups demonstrate a consistent pattern of performance across the three diversification groups on both risk and return dimensions. Table 7 shows classification of firms based on degree of diversification and by performance class. These results are both in expected and unexpected 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 rack up performance sub-class, the AROE of undiversified firms is -59. 53, and the SD is 103. 16. As we go toward increasing level of diversification, AROE performance increases to -5. 78 and SD drops down to 5. 58 for the moderate g roup. For the highly diversified group, AROE becomes +2 and SD falls 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 falls to 2. 91. For the highly diversified group, AROE increases 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 arouse 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. Clearly the results for the best performance class are contrary 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 rife firms run with core 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 likely 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 firms 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 n ot as sharp when we compare results between the moderately diversified and the highly diversified group.The meaning 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 firms may throw some light on this issue. The marginal equivocalness 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 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 excitability of the highly diversified firms. This result i mplies that the best performing firms, if they diversify, will reduce their earnings, but dampen the volatility 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 lead 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 incumbrance in for the long haul, and have high tolerance 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 doodly-squat 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 conglomerate 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 art of being an strong-growing and active conglomerate 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 tactile sensation of senior corporate executives who think diversification enhances firm value because it contributes to improvement of the firms risk-return profile. The results also blab out 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 diversifi cation 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 benefit from diversification on risk and return dimensions but their performance is not stellar by any stretch of the imagination. One can argue that diversification tends to reduce the already severe competitive threat faced by the majority of firms in these groups.The implications for investors follow suit. They are better off picking stocks of well-diversified firms as these allow 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 e xecutives but is contrary to the viewpoint of research in finance. A classification scheme by definition remains arbitrary, no matter how well we justify the scheme.The only safeguard against such arbitrariness is to demonstrate that the results of the study are invariant to changes in arbitrarily set classification 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 need to be tested. Researchers may also want to know if, at what point, the results are no long-lasting invariant to SR classification values. Our study has several other limitations. The research p eriod (1984-1990) of this study does not match 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 the availability of data, replication 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 advantage of a diversification strategy in the capital budgeting sense. Market return may be a reasonable substitute but the interrogation 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 probably a better measure of diversification. This study was extensive enough. Perhaps sextuple measures of diversification in a future study will mollify methodological concerns about the appropriateness of diversification measures. The research design of this study differs somewhat from similar earlier studies, and as stated at the outset, it does not address the question whether investor portfolios outperform diversified firms.Therefore, while addressing several possible 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 t his 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 provide greater insight into the diversification strategy, as a practice and as a phenomenon.