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Comment&Jarrell

Corporate Focus and Stock Returns

Robert Comment and Gregg Jarrell
Journal of Financial Economics, January 1995

Executive Summary
Diversification appears to be bad for shareholders. It also documents a trend towards more focus and there is a positive relationship between focus and shareholder returns. Additionally, the paper shows that many of the purported benefits of diversification do not materialize.

THIS IS ONE OF MY FAVORITES:

 

The view of corporate diversification has changed dramatically since the 1950s-1960s when diversification was “in.” The diversification strategy has been replaced however with a focus on focus being seen as the best strategic move in many instances.

Data:
The authors look at approximately 2000 firms from the AMEX and NYSE for the years 1978-1989. (It appears they also looked at NASDAQ firms but do not report the results.)
The degree of focus is found using the Herfindahl index for both revenue and assets. This looks at square of revenue (assets) of each division divided by the total revenue. Thus, the revenue of division A is divided by the revenue of the entire firm and then squared.

Trends

The authors cite several studies (including Ravenscraft and Scherer 1987) that document the increased diversification that occurred in the 1950-1970 period.
Evidence that this conglomeration wave ended is provided in table 1:
From 1978 to 1989 the percentage of firms listing only 1 business segment raised from 36.2% to 63.9%, the average number of segments fell from 2.59 to 1.72, the number of SIC codes fell from 4.17 to 2.95. Even more convincing is the Herfindahl indices that increase from .684 to .832 for the Asset-based and .683 to .840 for the Revenue based.)
Most of these differences were statistically significant at the 5% level.

Wealth effect of focus
The authors write that ‘existing literature on the relation between focus and economic performance is inconclusive.” Copeland and Weston (1979) provide weak evidence that diversified firms do better, while Eckbo (1985), Sicherman and Pettway 1987), Morck, Schleifer, and Vishny (1990), as well as Kaplan and Weisbach (1992) show that there seems to be a “small penalty to diversification” when looking at event studies. Additionally, Wernerfelt and Montgomery (1988) and Lang and Stulz (1993) “find a positive correlation between levels of focus and q.” [Summarizer’s note: Q is Tobin’s Q and is calculated as the market value divided by replacement value usually approximated as Market-to-book value.]

In this paper, Comment and Jarrell report that asset turnover is higher at diversified firms so that book values are ‘market-to market more frequently’ which could reduce q (as conventionally measured).
The authors try to rectify this problem that looks at stock returns for multiple years “using a multivariate, pooled, time-series cross-sectional regression.”

They find that shareholder returns increase with focus. “Using the revenue-based Herfindahl Index, the sum of the estimates for the two years indicates an increase in focus of 0.1 is associated with an additional stock return of 4.3%. (2.9% in the same year and 1.4% in the prior year.

“Similarly, an increase in the asset-based Hefindahl index of .1 yields a 3.5% increase in
wealth.”

“Divestitures are associated with an additional 15% over the two years” (note long event window.)
The authors argue that this focus on focus is good and cite the fact that more focused firms were less likely to be targets of hostile takeover bids during the 1980s.
Williamson (1986) hypothesizes that inefficient external markets may be a force for diversification. Bhide (1990) suggests that as external markets become more efficient, there is less a need for internal markets. This may partially explain the 1980s focus on focus.

Looking at both diversified and undiversified firms, the authors find that diversified firms do not seem to use external markets less than focused firms.

Somewhat surprisingly, by looking at the book values of debt divided by book value of debt, market value of common and book value of preferred, the authors find that diversified firms do not have more debt. [Summarizer’s note: there is a potential bias here, but it biased for finding a difference. Rationale: if diversified firms are penalized, their ratios would be higher since the market value of common shares would be lower.]