Saturday 26 September 2009

Diversify or die-versify?

There are limited and specific conditions under which diversification enhances performance

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Guanyu said...

Diversify or die-versify?

There are limited and specific conditions under which diversification enhances performance

By KULWANT SINGH AND ISHTIAQ PASHA MAHMOOD
25 September 2009

Some years ago, the Singapore government encouraged local businesses to look beyond local markets and expand overseas. The call to go overseas has been taken up by several businesses. Many branched to emerging economies such as China and Vietnam; others to neighbouring markets such as Malaysia and Indonesia; and yet others to more developed economies such as the US.

Some of these expansions involve diversification. OSIM, for instance, expanded its business to the US by acquiring Brookstone, a speciality retail company, and establishing the GNC chain of outlets. While the latter sells vitamins and health supplements, somewhat consistent with OSIM’s healthy lifestyle positioning, Brookstone, which sells novelty products, is seen as a diversification for OSIM. The drain on OSIM’s resources with the acquisition and operation of a very different business is evident and earlier this year, OSIM announced its divestment from Brookstone.

Yet, despite the difficulties posed by operating in multiple businesses, many managers still view diversification as an attractive strategy. Research has shown that diversified firms are more likely to be profitable in emerging economies than in developed economies. The reason is that in emerging economies, financial and market intermediaries are inefficient or absent. Hence, diversified firms can gain scope and scale advantages from internalising functions typically provided by such institutions in advanced economies.

In contrast, firms with a single business cannot enjoy such benefits. As such, arguments have been advanced that firms in emerging economies, where institutional environments are less developed, should diversify to a greater degree than firms in relatively more developed economies.

At the NUS Business School, we studied whether firms can benefit from diversification when there are economy-wide uncertainties such as during an economic crisis. We studied two types of firms - those that are affiliated with business groups and those that are not.

One of the benefits of diversifying is the reduced risk from operating in more than one business. Would firms in emerging economies benefit from diversification when a major economy-wide shock broadly and radically alters the economic environment?

As the world is experiencing one of its worst economic crises globally, almost all firms - multinational or local, diversified or single business, independent or group affiliated - are reeling from the slowdown. Will diversified firms do better than less diversified firms? Further, would firms affiliated with large business groups enjoy greater diversification effects?

We studied over 3,000 firms from 19 manufacturing industries in six East Asia countries - Indonesia, Japan, Malaysia, Singapore, South Korea and Thailand. Of these, 942 were single-business firms. We used return on assets (ROA) as a measure how well a firm performed.

In general, we found that diversification offers limited benefits. Specifically, diversification can substituted for the inefficiencies in substantially less developed institutional environments, but does little in benefits when the economy is well developed. Diversification enhanced ROA for firms in Indonesia, a country with the least developed institutional environment. In contrast, diversification was negatively associated with performance for firms in Japan and Korea, countries with relatively developed institutional environments. For countries with relatively weak institutional environments - Malaysia and Thailand - diversification did not affect performance.

Guanyu said...

Second, firms affiliated with business groups do not appear to gain from diversifying except in less developed institutional environments, with Singapore being the exception. For example, in Japan and South Korea, firms affiliated with business groups suffered poorer performance with greater diversification. In Thailand, group affiliation had a positive impact on diversification outcomes. In Singapore, we observed that firms affiliated with business groups had better performance with greater diversification; while independent firms suffered poorer performance with greater diversification.

Third, we observed that diversification does not seem to affect performance during an economy-wide shock. The exception was Japan where diversification, during an economy-wide shock, had a negative impact on performance. No such effect was apparent in the other countries.

Fourth, group affiliation was not consistently helpful during an economic shock. In Japan and Malaysia, for example, group affiliation accentuated performance declines during an economy-wide shock for diversified firms. The exception is Singapore where diversification improved group-affiliated firms’ performance during an economy-wide shock.

Singapore is an anomaly in the effects of diversification for group-affiliated firms. Because Singapore has a relatively well developed institutional environment, diversification, in general, was not associated with improved performance regardless of whether there was an economy-wide shock.

However, for group-affiliated firms, diversification in Singapore brought about improved profitability both outside and during an economy-wide shock. At least two reasons account for this. First, group affiliation improves profitability in relatively developed emerging economy capital markets, of which Singapore is one. Second, firms affiliated with government business groups or multi-national companies (MNCs) may have enjoyed substantial reputation and resource access advantages in Singapore.

Though diversification may potentially offer some benefits, our findings suggest that there are limited and specific conditions under which diversification enhances performance, especially when there are major changes in the environment.

Even when diversification improves performance, it varies from country to country depending on how developed the institutional environment is and the stability of the economy. Generally, group affiliation does not improve the effect that diversification has on performance.

Kulwant Singh is deputy dean at NUS Business School. He specialises in corporate and technology strategy, and competition. Ishtiaq Pasha Mahmood is associate professor at NUS Business School. He specialises in diversification strategy and innovation