Sungyong Chang, Bruce Kogut, Jae-Suk YangColumbia Business School, Columbia University

Academy of Mangement Conference

10 August 2015

Global Diversification Discount and Its Discontents:

A Bit of Self-selection Makes a World of Difference

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§Motivation§ Theory§Data and Methodology§ Results§Conclusions

Table of Contents 2

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Global Diversification Discount

§ Industrial Diversification Discount (Berger and Ofek, 1995; Campa and Kedia, 2002; Villalonga 2004)

§Denis, Denis, and Yost (2002, Journal of Finance) found evidence for a global diversification discount.§ “Commentators today often extol the virtues, if not the competitive

necessity, of global diversification. … However, much like the situation with conglomerates in the 1960s, we find no evidence that these global diversification strategies have created shareholder value, on average.” (Denis et al., 2002: p.1977)

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Research Questions

§Methodological question§ If we control the endogeneity of global diversification choice, do we

find the discount for global diversification?

§ Theoretical question§ If we find a premium or discount, what is the rationale behind this

valuation effect?§ We argue that operating flexibility from restructuring the global

subsidiary portfolio when a firm faced a shock of the financial crisis.

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§Motivation§ Theory§Data and Methodology§ Results§Conclusions

Table of Contents 5

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Valuation Effect of Global Diversification (1) Discount

§ (1) Liability of foreignness (Hymer, 1960; Zaheer, 1994)

§ (2) Information asymmetry from complexity (Harris, Kreibel, and Raviv, 1982; Myerson, 1982)

§ (3) Monitoring cost: Costs increase in distance between headquarters and subsidiary due to the difficulty to monitor supports because of increased agency activities (Bodnar et al., 1999; Kalnins and Lafontaine, 2013).

§ (4) Divisional politics leading to sub-optimal subsidization across divisions (Meyer, Milgrom and Roberts, 1992; Rajan, Servaes, and Zingales, 2000)

§ (5) Managers’ incentive to adopt and maintain value-reducing diversification (Jensen, 1986; Stulz, 1990)

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Valuation Effect of Global Diversification (2) Premium

§ (1) Increasing operating flexibility (Kogut and Kulatilaka, 1994; 1998):

from shifting production to the country in which conditions are more favorable.

§ (2) Exploiting firm specific assets (Caves, 1971; Morck and Yeung, 1991):

internalization theory of synergy § (3) Satisfying investor preferences (Errunza and Senbet, 1981; 1984; Lessard,

1973): completes for the financial market for investors

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Summary on Costs and Benefits of Global Diversification and Industrial Diversification

GlobalDiversification

Industrial  Diversification

Costs

Liability of  Foreignness/Newness   o o

Information Asymmetry o o

Monitoring cost o o

Sub-­‐optimal subsidization o o

Managers’  incentive  for  value-­‐destroying  diversification o o

Benefit

Operating  flexibility o  (same activities) x  (different  activities)

Synergy creation  by  exploiting  assets o o

Completing financial  market  for  investors ∆  or x x

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Benefits from Operating Flexibility

(1) Incremental profit

From when a firm can flexibly respond to changes in the state variable by choosing globally where to assign its activities between two subsidiaries located in countries X and Y.

(2) Option value

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Self-selection in Global Diversification

§As first argued in Shaver’s (1998) article on endogeneity in foreign investment, the self-selection design is consistent with a theoretical statement that the decision to invest overseas is the product of the strategizing by managers to improve the profitability of the firm.

§Campa and Kedia (2002) found that the industry discount disappeared or became milder once the econometric specification accounted for selection.

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§Motivation§ Theory§Data and Methodology§ Results§Conclusions

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Data and Methodology (1)

§ Sample Selection (Following Denis et al., 2002)§ The sample consists of all firms with data reported on the Compustat

Industry Segment database from 2005 to 2011.§ We exclude

§ (1) utility (SIC 4900-4999) and financial firms (SIC codes 6000-6999), § (2) firms incorporated outside of the United States§ (3) any industrial segment has sales less than $20 million§ (4) sales of any business segment is not within one percent of total sales.

§ The final sample consists of 12,640 firm-years associated with 3,002 firms.

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Data and Methodology (2)

§Measure of Diversification§ Global Diversification (Dummy): More than or equal to one foreign

subsidiary (from the Orbis Database)§ Industrial Diversification (Dummy): More than or equal to two

business segments (from Compustat)

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Data and Methodology (3)

§Excess Value§ We estimate EVit (i represents firm id and t represents year) using the

industry multiplier approach described in Berger and Ofek (1995), Campa and Kedia (2002), Denis et al. (2002).

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Actual market value

Imputed market value

Weighted by Sales

Median of (Market value to Sales ratio)

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Data and Methodology (4)

§Control Variables§ Market value, long-term debt, capital expenditure, EBIT, R&D,

advertising

§ Instrumental Variables§ Percentage of industrially diversified firms in the industry§ Percentage of sales of industrially diversified firms in the industry§ Dummy takes 1 if the firm is listed on major exchange markets

(NYSE, Nasdaq, and AMEX)

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§Estimation Methodology§ (1) OLS

§ (2) Heckman’s two-step model§ 1st Probit regression with firm characteristics and instrumental variables

§ 2nd Step OLS with Inverse Mills Ratios

Data and Methodology (4) 16

IDit* GIDit*

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Sample statistics 17

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§Motivation§ Theory§Data and Methodology§ Results§Conclusions

Table of Contents 18

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Results (1) Valuation effect of global diversification

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Self-selection correction flips the valuation effect for global diversification.

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Results (2) First-stage Probit regression

Instrumental Variables: According to the type of diversification, different characteristics affect the choice on the diversification type.

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Results (3) Effect of Financial Crisis 21

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Results (4) 22Global diversification premium during the crisis

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Result (4) 23

Number of churnsreached the peakduring the crisis

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Results (5) 24

Larger net flow to the less affected countries than the others.

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Results (6) 25

Larger net flow to the less affected countries than the others.

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Country level analysis

Without controlling self-selection With controlling self-selection

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The self-selection correction flips the signs and changes the size of valuation effects of many countries

Red:  Discount,  Blue:  Premium,  Yellow:  Insignificant,  White:  No  data

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§Motivation§ Theory§Data and Methodology§ Results§Conclusions

Table of Contents 27

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Conclusions (1)

§Our results show that selection effects matter for understanding global diversification in three ways: § (1) reversing the finding of a global discount, § (2) proposing and supporting a theory of operating flexibility as the

explanation§ (3) integrating the choice of diversification within a broader theory

of strategy and capability.

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Conclusions (2) Operating Flexibility and Macroeconomic shock

§Multinational firms benefited positively from a strategy to diversify globally during a period of increased volatility and macroeconomic uncertainty.

§ This is not luck. It is the operating flexibility gained through a strategy to invest in a global network.

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Appendices 30

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Theory of Global Diversification

§ The two well-documented assumptions on global diversification set out by Stephen Hymer 50 years ago.

§ (First) The “liability of foreignness” (Zaheer, 1995).§ (Second) An offsetting competitive advantage that can be transferred

from one country location to another at a cost that does not wither away the benefits of the competitive asset (Caves, 1971; 1996, Morckand Yeung, 1991).

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Firm characteristics 32

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Churn related findings 33