Diversification and Firm Performance

DIVERSIFICATION AND FIRM PERFORMANCE AN EMPIRICAL EVALUATION Anil M. Pandya and N arndar V. Rao Abstract Diversification is a strategic option that m for apiece ace managers use to break their buckrams doing. This interdisciplinary question attempts to verify whether firm direct variegation has any violation on achievement. The battlefield develops that on come, change firms ground expectter mathematical process comp atomic government issue 18d to undiversify firms on both venture and give birth dimensions. It similarly bear witnesss the robustness of these results by classifying firms by death penalty class.The results understand that among the best playacting class of firms, undiversify firms afford higher buy the farms, but these retrieves argon accompanied by high departure. Whereas, extremely modify firms shield trim down returns, and much(prenominal) lower variance. Results further show that diversified firms perform get around than mo nolithic firms on try of exposure and return dimensions, in the low and add up executing classes. The paper close ups that a preponderating undiversified firm whitethorn perform improve than a exceedingly diversified firm in terms of return but its riskiness leave al iodin be much great.If managers of much(prenominal)(prenominal) firms opt for variegation, their returns will decrease, but their riskiness will centre proportionately more(prenominal) than the reduction in their returns. In much(prenominal) firms, there will be a trade pip amongst risk and return. INTRODUCTION Two seemingly irreconcilable facts motivate this study one, variegation continues to be an eventful strategy for incarnate growth and two, objet dart Management and Marketing disciplines choose re easyd variegation, Finance makes a strong case against corporate diversification.With the avail of a puffy specimen, this interdisciplinary study tries to hide this contradiction in the associ ative affinity between diversification and firm death penalty. Diversification is a mode by which a firm expands from its core business into other increase marts (Aaker 1980, Andrews 1980, Berry 1975, Chandler 1962, Gluck 1985). Research shows corporate forethought to be actively engaged in diversifying activities.Rumelt (1986) found that by 1974 wholly 14 percent of the component part 500 firms operated as bingle businesses and 86 percent operated as diversified businesses. Many researchers none a rise in diversified firms (Datta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990). European corporate managers according to a survey, non solitary(prenominal) favor it but actively pursue diversification (Kerin, Mahajan and Varadarajan 1990). Firms spend sizable sums acquiring other firms or bet heavily on internal R&D to diversify away from their core product/ merchandises.Of late U. S. firms are beginning to personal mannerrate their zeal for diversification and are consolidating around their core businesses. notwithstanding this line has not affected large Asian corporations which continue to remain exceedingly diversified. As in any economical activity there are costs and benefits associated with diversification, and ultimately, a firms cognitive process must depend on how managers achieve a balance between costs and benefits in each concrete case. Moreover, these benefits and costs may not fall equally on managers and investors.Management researchers argue that diversification prolongs the life of a firm. Researchers in finance argue diversification benefits managers because it buys them insurance, and shareholders usually bear all the costs of such insurance. Diversification can improve debt capacity, reduce the chances of bankruptcy by going into new product/ markets (Higgins and Schall 1975, Le wellheaden 1971), and improve as plenty deployment and profitability (Teece 1982, Williamson 1975).Skills genuine in one business transferr ed to other businesses, can increase labor and groovy productivity. A diversified firm can transfer funds from a bills surplus social unit to a cash deficit unit without taxes or transaction costs (Bhide 1993). alter firms pool unsystematic risk and reduce the divergence of operate cash flow and enjoy comparative advantage in hiring because key employees may support a greater sense of job security (Bhide 1993).These are some of the major benefits of diversification strategy. Diversification, firm size, and executive compensations are passing cor relate, which may put forward that diversification provides benefits to managers that are un ready(prenominal) to investors (Hoskisson and Hitt 1990), creating what economists clamor the agency problem (Fama 1980) and managers stand to lose if they become unemployed, either through poor firm work or bankruptcy (Bhide 1993, Dutta, Rajagopalan and Rasheed 1991, Hoskisson and Hitt 1990).Diversification can withal proceed to the pro blem of moral hazard, the chance that people will alter behavior after entering into a contract-as in a conflict of interest by providing insurance for managers who have invested in firm ad hoc skills, and have an interest in diversifying away a certain amount of firm specific risk and may flavor 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 exculpate 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 considerable stress on vertex focal point (McDougall and Round 1984). These are the costs of diversification.In the final analysis, this situational argument regarding match costs and benefits can only explain the proceeding of individual firms but it cannot address the theoretical disbelief most the verac ity of diversification as a valid corporate strategy. Consequently, following the benefit-cost agreement, whether in everyday, diversification enhances firm act becomes an empirical question. Further, recent reviews of the rather extensive belles-lettres do not celebrate agreement about the direction of connection between firm diversification and firm performance.This lack of a clear answer in the literature motivates the present study. The paper is organized in intravenous feeding sections. The for the premiere time section briefly reviews the empirical literature and presents the research hypotheses. Section two describes the research methodology and operationalizes the qualified and independent variables. Section three presents the results of the study. The concluding section discusses the results and summarizes the findings. REVIEW OF EMPIRICAL LITERATURE AND HYPOTHESIS The impact of diversification 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 monstrous (b) models, perspectives and results differ establish on the disciplinary perspective chosen by the researcher and the relationship between diversification and performance is complex and is affected by intervening and contingent variables such as related versus orthogonal diversification, type of relatedness, the capability of top managers, industry structure, and the mode of diversification.Some studies claim diversifying into related product-markets produces higher returns than diversifying into unrelated product-markets and little diversified firms perform better than super diversified firms (Christensen and Montgomery 1981, Keats 1990, Michel and Shaked 1984, Rumelt 1974, 1982, 1986). Some claim that the economies in integrating operations and core skills obtained in related diversification outweigh the costs of internal capital markets and the smaller variances in sales revenues generated by unrelated diversification (see Datta, Rajagopalan Rasheed 1991). date agreeing that related strategy is better than unrelated, Prahalad and Bettis (1986), crystalize that it is the cleverness 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. consortly, it is not product-market diversity but the strategic system of 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 superior to market relatedness in predicting when diversifiers related outperform unrelated ones. Others however argue, it is not management conduct so much, but industry structure that governs firm performance (Christensen and Montgomery 1981, Montgomery 1985) . in analogous manner diversification types and industry structure, researchers have in addition pure toneed at the ways firms diversify. Simmonds (1990) examined the carteld effects of breadth (related vs. nrelated) and mode (internal R D versus Mergers Acquisitions) and found that relatedly diversified firms are better performers than unrelatedly diversified firms, and R D establish product development is better than mergers and acquisition- led diversification (Simmonds 1990, Lamont and Anderson 1985). Among studies of acquisitions the results are mixed. Some report that related acquisitions are better performers than unrelated ones (Kusewitt 1985), or there is no real difference 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 confounding effects in firm performance because of diversification category and industr y (Christiansen and Montgomery 1981, Montgomery 1985). Recent studies give notice gain 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 scope is negatively associated with performance. A contradiction of Johnson and Thomas (1987) confirmation of Rumelts finding that the rightness of product diversity is tryd by a balance between economies of scope and diseconomies of scale. It also appears there is a limit on how much a firm can diversify if a firm goes beyond this point its market value suffers and reduction in diversification by refocusing is associated with value beingness (Markides 1992).Apart from the empirical evidence, the efficient market surmisal (EMH) holds that competition among investors for information ensures that current prices of widely traded securities are the inert predic tors of their future value, and that current prices represent the cabbage present value of its future cash flow. Evidence supports the humans of weak, semi- and near-strong forms of market efficiency (Fama 1970). If this view of the market is true, then investors have the information necessary to construct portfolios of stocks to maximize 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), and not economic rents.Finally, corporate takeovers discipline managers who waste shareholder resources and bust-ups promote economic efficiency by reallocating as hardeneds 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 above seems to suggest that diversified firms (i. . highly unrelatedly diversified firms) as a class, should perform less well than an optimal securities portfolio, and and then for our study we propose the following null opening. Our null hypothesis (H0) is that passing diversified firms should perform less well than passably diversified and single product firms. There are numerous arguments and findings against the null hypothesis proposed above. In certain markets, an investor may face assets constrai nt in constructing a portfolio, restricting diversification opportunities (Levy 1978).Farrelly, and Reichenstein (1984) show that add up risk rather than systematic risk alone, better explains the expertly assessed risk of stocks. Jahera, Lloyd and Page (1987), find well-diversified firms have higher returns regardless of size. DeBondt and Thaler (1985, 1987), argue that the market as a whole overreacts to major events. Prices befool up on slap-up economic news and decline sharply on bad news. According to Brown and Harlow (1988, 1993), investors hedge their bets and over react or under react to important news by determine securities below their pass judgment determine.As uncertainties decrease, stock prices adjust upwards, regardless of the direction of the impact of the initial event. The post-event modification 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 F rench (1992), changing their front stance, argue that the capital asset pricing model (CAPM) is incapable of describing the last fifty socio-economic classs of stock returns, and the beta is not an appropriate placard 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 flip hypothesis (H1) is that diversified firms perform better in terms of return and risk mensurations compared to less diversified firms.Thus, on bonnie, diversified firms as a class should perform better than passably diversified or single-product firms. story DESIGN The availability of t he Compustat database has made it possible to study a larger sample of firms over several(prenominal) old age and approach the problem of diversification from a more macro perspective. The approach used in this study is akin to that of military 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 need the advantage of mobility and surprise to waste 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 imply 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 conduct of business strategy, we could also first 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 fair performance of diversified firms is better than that of undiversified firms. The diversification literature is otiose to demonstrate that diversification type, breadth, modality, and industry have unvarying 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 period. We use about two super acid firms, and multiple performance measures. The starting point of our main study is 1984, the earliest data point for particle information addressable on the Compustat database. Specialization Ratio (revenue from a firms largest segment divided by its sum revenue) as the dependent variable measures the extent of diversification.Accoun ting and market returns, their discrepancy, coefficient of variation, and the Sharpe superpower are the independent performance variables. The study also tests the robustness of categorisation 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 degree 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 importance of the firms core product market to that of the rest of the firm (Rumelt, 1974, 1982 Shaikh Varadarajan, 1984). After we started this work some researchers have argued that the entropy measure of diversification is 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 easy to understand and appear. gameboard 1 determine of Specialization Ratios in Rumelts and Our Classification Schemes SR determine in Rumelts Scheme SR Values in Our Scheme Undiversified, Single Product Firms SR ? . 95 SR ? 0. 95 Moderately diversify Firms 0. 95 SR ? 0. 7 0. 95 SR ? 0. 5 Highly Diversified Firms SR 0. 7 SR 0. 5 surgical procedure Management researchers prefer accounting variables as performance measures such as return on equity (hard roe), return on investment (ROI), and return on assets (ROA), along with their variability as measures of risk.Earlier stud ies typically measure accounting rates of return. These include (ROI), return on capital (ROC), return on assets (ROA) and return on sales (ROS). The idea behind these measures is perhaps to evaluate managerial performance-how well is a firms management using the assets (as deliberate 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. Return on equity (ROE) is a frequently used variable in judging top management performance, and for making executive compensation decisions.We us e ROE as a measure to judge performance and maneuver the average return on equity (AROE) across all sampled firms and time periods, its regular deviation and also the coefficient of variation for each of the three diversification conclaveings. ROE is defined as net income (income available to common stockholders) divided by stockholders equity. The coefficient of variation (CV) gives us the risk per unit of average return. ROA is the just about 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 classifys. Market return (MKTRET), is the third dependent variable we use. MKTRET is computed for a calendar year by taking the difference between the current years en ding stock price, and the previous years ending price, adding to it the dividends give out for the year, and then dividing the result by the previous years ending price.This study includes companies for which complete 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 meetings, 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, dodge 1 presents similarity of breaks between Rumelts classification and the modified version.Using the Compustat database we then classified 2637 firms using Rumelts classification stratagem for the years 1981-1990. Table 2 presents the AROE and its standard deviation using Rumelts classification. While we intended to calculate AROA and MKT RT 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 purpose for all the three performance variables. Using the homogeneous Compustat database, we classified 2188 firms in three groups 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 same SR category for the entire seven year period, and had all the data for computation 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 groups, 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. Tables 3, 4 and 5 present the results. The number of firms in each performance group varies s percipiently 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 group, 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 self- bureaus first, the test is extremely sensitive to departures from normality support, 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 second 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 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 reject the null if the t (observed) exceeds t (critical) at chosen take aims 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 (SR ? 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 daring Table 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 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 Equity (AROE)-1984-1990N AROE SD CV Undiversified 1844 -1. 6 323. 3 NA Moderately Diversified 315 32. 7 409. 4 12. 52 Highly Diversified 23 14. 6 9. 8 0. 67 N= Sample Size, AROE= just Return on Equity, SD= Standard conflict, 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 domesticise 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 expected 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 isolated 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 expected direction. Compare these results with results obtained in Table 3. Table 3 shows the relationship between the degree of diversificat ion 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 middling diversified group with SR between 0. 95 and 0. , has 315 firms. The AROE of the group equals32. 7 percent and the SD equals 409. 4. While the AROE of this group is clearly superior to that of single productfirms, the group shows high ROE variability. Thus, the moderately 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 second group, with SD of 9. 8, which is much lower than the first and the second group.The CV is the lowest at 0. 67, which is about 1/20 of the moderate group. Table 3 shows that while highly diversified firms have lower risk than moderately diversified firms moderately diversified firms have higher average ROE compared to highly diversified firms. It also shows that single product firms have lower risk than moderately diversified firms, but moderately diversified firms have much higher returns. When we combine the return and risk measures as given by the coefficient of variation CV, we do see consistent results, i. e. that highly diversified firms have better risk-return profile than moderately diversified firms and moderately diversified firms perform better in risk-return terms when compared to single product firms. We find that the Tables 2 and 3 show results in expected direction. The highly diversified groups have higher AROE and lower SD compared to the other two groups. This comparison of the two classification schemes shows sufficient consistency especially in the two extreme groups to strongly suggest that performance tends to be invariant to classification breaks.The comparison also demonstrates the validity of using th e more pronounced classification scheme used in this study. Performance as Return on Assets and its Variability Table 4 shows the relationship between the degree of diversification and group-wise performance based on ROA. The sample consists of 1848 single product firms with SR greater or equal to 0. 95. The AROA of these firms over the seven year period is 1. 9 percent, with a SD of 38. 2. TABLE 4 Performance As Return On Assets (AROA)-1984-1990 N AROA SD CV Undiversified 1848 -1. 38. 2 NA Moderately Diversified 316 4. 0 5. 0 1. 25 Highly Diversified 24 5. 8 2. 7 0. 47 N= Sample Size, AROA= Average Return on Assets, SD= Standard Deviation, CV= Coefficient of Variation The moderately diversified group with SR between 0. 95 and 0. 5 has 316 firms. Its AROA equals 4 percent with a5 percent SD. In absolute terms, the AROA of this group is higher than that of 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 eli minated 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 multiplication 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 gro up. 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 contrary 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 Analysis 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* * solid 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 category undiversified, moderately diversified, and highly diversified, into three performance classes by adding and subtracting one standard deviatio n 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 diversification of firms leads to higher performance for all classes of firms. We, therefore, hypothesize that the best, the average and the medium per forming 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 worst 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 group. 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 g roup 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 interesting results. The AROE for the undiversified group is 35. 28 and the SD is 36. 44. AROE for the moderately diversified group decreases to 12. 9. SD also decreases to 3. 3. For the highly diversified group, AROE drops to 9. 52, nearly a fourth of the undiversified group, and the SD decreases to 0. 87, one thirty sixth of the undiversified group. 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 dominant firms operating with core competencies and operating in less competitory 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 fi rms (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 not as sharp when we compare results between the moderately diversified and the highly diversified group.The implication of the finding is that in general diversification is helpful but it does not enumerate 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 ambiguity between the moderate and the highly diversified groups may also be the result of eliminating the contingent variables like type, modality and extent of diversification. Controlling these variables may provide greater insight and clarify the differences between the moderate and the highly diversified groups of firms and lend support to theory building.The most move 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 volatility of the highly diversified firms. This result implies that the best performing firms, if they diversify, will reduce their earnings, but dampen the volatility of their returns. Manage rs 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 stay 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 Jack Welch, the CEO of General Electric (GE) in this context. GEs top management group insists that each of their divisions must be either number one or number two in their specific product markets. Thus GE, a high performing 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 radiation patterns the art of being an aggressive 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 belief of senior corporate executives who think diversification enhances firm value because it contributes to improvement of the firms risk-return profile. The results also speak to the concerns of investors. Diversification, especially for the truly high performing firms reduces risk but at the cost of returns. There is undoubtedly a trade-off here between risk and return when managers of such single firms diversify from their core business.Thus diversification does buy insurance for the managers which may help managers and employees more than investors. But in the case of the average and the low performing single f irms (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 woof stocks of well-diversified firms as these deliver better returns over time as compared to moderately diversified or undiversified firms. The finding that on average, highly diversified firms, including conglomerates, show better performance than single product firms or moderately diversified firms, supports the belief of corporate executives but is contrary to the viewpoint of research in finance. A classification scheme by 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 pressure 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 baccate 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 longer invariant to SR classification values. Our study has several other limitations. The research period (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 w hat the time period. This study has examined pooled time serial publication 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 usefulness of a diversification strategy in the capital budgeting sense. Market return may be a conceivable substitute but the examination of the net present value of cash flow may be necessary from the point of view of the stock market. This is left to future research.Although SR is an acceptable measure of diversification, the entropy measure (Hoskisson, et. al. , 1993) has become an important and probably a better measure of diversification. This study was extensive enough. maybe multiple measures of diversification in a future study will alleviate methodological conc erns about the appropriateness of diversification measures. The research design of this study differs somewhat from similar earlier studies, and as express at the outset, it does not address the question whether investor portfolios outperform diversified firms.Therefore, while addressing several possible objections, we dispose caution in accepting these results, and suggest future research to verify the findings reported here. Finally, this study examines the association between corporate diversification and performance per se. It does not address the differences in performance caused by types of diversification, like related, or unrelated nor does it use modifying variables like firm size and other firm-level factors, or modalities of diversification such as internal product development or mergers and acquisitions.The results of this study are interesting enough to ensure the inclusion of variables that control for industry structure and contingency variables such as interest ra tes 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.