Efficient Corporate Diversification: Methods and Implications

Raphael H Amit · Joshua Livnat

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Corporate Finance and Governance Financial Analysis and Corporate Governance Firm Innovation and Growth

Abstract

This study develops and tests a measure of efficient corporate diversification (ECD) that compares the variability of a firm’s revenues with the variability of a minimum-variance portfolio of businesses that maintain the same sales growth rate. According to ECD, which incorporates the exposure of a firm to business cycle fluctuations, a firm is considered more efficient the higher its ratio of minimum variance to the realized variance. The empirical results indicate that efficient diversifiers manage to reduce the variability of their returns without sacrificing profitability. Moreover, such firms have a more favorable trade-off between risk and return in the equity market. Further, efficient diversifiers are found to be less diversified as measured by the extent of operations in different SIC industries. Instead, they operate in related business segments that have differential responses to business cycle changes and thereby enjoy the benefits from related diversification while minimizing their operating risk.

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1937The Nature of the Firm 1975Markets and Hierarchies 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1981Risk Reduction as a Managerial Motive for Conglomerate Mergers 1974Strategy, structure, and economic performance 1989From Competitive Advantage to Corporate Strategy 1983Real Business Cycles 1982Towards an economic theory of the multiproduct firm

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