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The Pattern and Valuation Effects of Corporate Diversification: A Comparison of the United States, Japan, and Other East Asian EconomiesStijn Claessens, Simeon Djankov, Joseph Fan, and Larry Lang1 October 17, 2000 AbstractWe document that firms in eight East Asian countries and Japan diversify into more segments and engage into more related businesses¾as measured by the degree of vertical relatedness and complementarity¾than firms in the United States. Using data for the 1990-1996 period, we observe a trend towards complementary diversification in the United States and the eight East Asian countries, and a trend towards more vertical integration in Japan. The increase in relatedness for US firms is due to the divestiture of unrelated assets. In contrast, the increase in relatedness for firms in Japan and East Asia is due to expansion into related businesses. We also document the valuation effects of the diversification level, vertical relatedness and complementarity. We observe that diversification hurts the valuation of East Asian firms less than the valuation of firms in the Unites States and Japan. However, vertical diversification hurts the valuation of companies in East Asian more than the valuation of US and Japanese firms. Complementary diversification is not detrimental to corporate value, and even enhances value in the United States, Japan, Korea, and Singapore. 1 World Bank, World Bank and CEPR, Hong Kong University of Science and Technology, and the Chinese University of Hong Kong, respectively. This paper is a substantially revised version of a previous paper circulated under the title “Diversification and Efficiency of Investment by East Asian Corporations.” Joseph P.H. Fan and Larry H. P. Lang gratefully acknowledge the Hong Kong UGC Earmarked grant for research support. The authors would like to thank the anonymous referee, Gregor Andrade, Joel Houston, Shin-yang Hu, Sabrina Kwan, Tatiana Nenova, Rene Stulz, seminar participants at the IMF, World Bank, the 1998 World Bank conference in Kuala Lumpur, and the 1999 Western Finance Association meetings for helpful suggestions. For comments, please contact Stijn Claessens at CClaessens@worldbank.org, Fax: 202 522-2031, 1818 H Street Washington DC 20433. The Pattern and Valuation Effects of Corporate Diversification: A Comparison of the United States, Japan, and Other East Asian Economies 1. Introduction While a substantial literature has emerged on the valuation effects of corporate diversification in developed as well as developing countries, we still know little about how firms diversify and which types of diversification have the largest effect on corporate value. In light of the strong evidence that corporate diversification hurts firm valuation in the US,2 a number of recent studies have investigated the effects of diversification and found mixed evidence on the valuation effects of diversification in the international context.3 A criticism of these studies is that they do not document the precise nature of diversification, both across countries and over time. In this paper we offer two extensions to the literature. First, using data for the United States as a benchmark, we document the diversification patterns of corporations in Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. Prior studies for the US and other countries have only used the number of segments to measure diversification levels. In this study, we distinguish between vertical and complementary diversification and study the differences in the types of diversification across the eight East Asian countries, Japan, and the United States, and the changes over time. Second, we investigate which types of diversification influence firm valuation in these countries, and what the magnitude of this valuation effect is. 2 See Lang and Stulz (1994), Comment and Jarrell (1995), Berger and Ofek (1995), Servaes (1996), Scharfstein and Stein (1997), Denis, Denis and Sarin (1997), and Rajan, Servaes and Zingales (1999), among others. 3 See, for example, Fauver et al., 1999 and Lins and Servaes (1999a, 1999b). We accomplish the first objective by documenting the degree of vertical and complementary diversification in the ten sample countries. We use the inter-industry commodity flow data in the 1992 input-output table for the US as a common benchmark to construct vertical relatedness and complementarity indices between the primary and the secondary businesses of all firms. These measures allow us to describe the degree of vertical diversification, joint procurement, and/or sharing marketing and distribution channels for any pairs of businesses in each firm.4 We find that firms in East Asia and Japan diversify into more segments and gear towards more related diversification, as measured by vertical relatedness and complementarity, than US firms. We show that corporations in the United States have adopted more focused corporate strategies over time. We also observe a trend towards complementary diversification for US and East Asian firms and vertical diversification for Japanese firms. The increase in relatedness for US firms is due to the divestiture of unrelated assets. In contrast, the increase in relatedness for firms in Japan and East Asia is due to expansion into related businesses. To accomplish the second objective of the paper, we analyze the impact of the number of segments, vertical relatedness and complementarity on firm valuation. A monotonically decreasing valuation as a function of the number of segments is documented for US and, to a lesser degree, Japanese firms. Our regression results also show significant diversification discounts for Singapore, Taiwan and Indonesia. We find no evidence of diversification discounts for the other East Asian countries, especially for firms with more than two segments. The overall results suggest that diversification of East Asian firms does not necessarily diminish value as it 4 Complementarity is broader than horizontal diversification in that the latter only covers diversification in the same industry. does for US firms. These findings challenge the conventional wisdom on the costs and benefits of diversification, as the results for US firms do not generalize to most other countries. We show that vertical diversification hurts valuation in Korea, Malaysia, and Indonesia. In contrast, excess values increase with vertical relatedness in Japan, Hong Kong, and the United States. We do not observe any systematic relation between complementary diversification and excess value in the univariate comparative statistics. The regression analysis reveals, however, that complementary diversification is generally not detrimental to corporate value. In fact, it increases value in the United States, Japan, Korea, and Singapore. The paper proceeds as follows. Section 2 documents the data sources. In Section 3, we construct our relatedness measures and document patterns of diversification. We examine the relationships between diversification and valuation in Section 4. Section 5 concludes. 2. The Data 2.1. Data Sources Our primary data source for East Asian corporate information is the Worldscope database, which contains financial and segment information on publicly traded companies from 51 countries.5 We selected all companies from the nine countries covered by the September 1991-1998 CD-Rom version of annual Worldscope database. The 1991-1998 Worldscope database covers firms from 1990 to 1997, and we select firms with fiscal year ending from January 1990 to December 1996. We do not use sample firms whose fiscal year ends outside this range. In each CD-Rom, Worldscope provides current and historical financial data and current segment data. Since we frequently encounter missing segment information, we collect 5 The database has been used in La Porta et al. (1997), Fauver, Houston, and Naranjo (1999), and Lins and Servaes (1999a, 1999b). additional segment data from the autumn edition of the 1994-1998 Asian Company Handbook and Japan Company Handbook. All financial data were converted to US dollars using fiscal year end foreign exchange rate.6 The disclosure requirements for segment information in East Asia differ significantly across countries (Table A1). The accounting standards regulatory bodies in Hong Kong, Japan, Malaysia, and Singapore all have guidelines that require compliance with the International Accounting Standard (IAS) No. 14, except on the disclosure of segment assets. Publicly-traded companies report sales, net income, and operating expenses for each segment that accounts for more than 10% of total sales. Some industries are, however, exempted from reporting. For example, banking and shipping companies listed on the Hong Kong Stock Exchange do not report segment information. Corporations (listed as well as unlisted) in Korea are required to report segment information on sales revenues and operating expenditures, while corporations in Taiwan are required to report sales revenues and net income by segment. Listed companies in Indonesia and Thailand are required to report sales revenues and net income. Finally, Philippine companies report only sales revenues by segment. Since sales revenues are the only variable consistently reported in the ten sample countries, we use it to weigh the relative importance of each segment. For US firms, we use the Compustat financial data. Segment data are obtained from the Compustat Industry Segment (CIS) database.7 From the CIS database, we select all companies 6 Worldscope, the Asian Company Handbook and the Japan Company Handbook provide information on whether subsidiaries are consolidated, whether consolidation covers only the most significant subsidiaries, or whether report is on a cost basis (unconsolidated). If a company changes its consolidation practice, this change is recorded in the data. Since non-consolidated companies are a relatively small fraction of all firms (23% on average) and to increase sample size, we include all firms in the sample. in the United States from 1990 to 1996. We exclude firms with missing segment Standard Industry Classification (SIC) codes and sales, and firms primarily in the finance sector (SIC 6000-6999). In addition to segment financial data, Compustat assigns a four-digit SIC code for each segment according to the segment’s business deion. Since we only have two-digit information for most East Asian firms, we define segments at the two-digit SIC code level. Accordingly, we aggregate segment sales to the two-digit SIC level. This procedure involves two steps. In the first step, we assign two-digit SIC codes reported by Worldscope to appropriate segments. As Worldscope reports SIC codes and segment data separately, we do a manual matching. For some companies, the number of reported SIC codes is not the same as the number of reported segments. If a segment cannot be associated with a single code, we determine the segment’s code according to its business deion. If a segment is associated with multiple codes, it is broken down equally so that each segment is associated with one SIC code. We classify firms as single-segment if at least 90 percent of their total sales are derived from one two-digit SIC segment. Since we require that each segment have sales volume, the consolidation of accounting data does not affect our segment-level analysis. Following on Fauver et al. (1999) and Lins and Servaes (1999a) we classify firms as multi-segment if they operate in more than one two-digit SIC code industries and none of their two-digit SIC code segments accounts for more than 90 percent of total firm sales. We then define the primary segment of a multi-segment firm as the largest segment by sales. The remaining segments are defined as 7 Beginning in the fiscal year ending December 15, 1977, FASB No. 14 requires that multi-industry firms must disclose industry segment information on sales, assets, operating profits, depreciation, and capital expenditures if the segment comprises more than 10% of consolidated sales, assets, or profits. secondary segments. In a small number of cases the two largest segments have identical sales. We select the segment with the lower two-digit SIC code as the primary segment. We exclude multi-segment firms from the sample when they do not report segment sales and we also exclude firms whose primary business segment is financial services (SIC 6000-6999). This is because segmental financial figures are not comparable to those of non-financial firms. We keep firms that have secondary financial segments in the sample since the problem of incomparability is less severe for these firms. More importantly, finance segments can be vertically or complementarily related with the primary segments, and we need to capture this relatedness. To increase sample size, we do not enforce a minimum size threshold for firms to be included in the sample.
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