The Diversification Puzzle: Revisiting the Value Impact of Corporate Diversification for Pakistani Firms

Mushtaq Hussain Khan* (Corresponding Author)

MS Scholar

Mohammad Ali Jinnah University, Islamabad Pakistan

Ahmad Fraz

PhD Scholar and Lecturer

Mohammad Ali Jinnah University, Islamabad Pakistan

The authors thank Dr. Arshad Hassan, Dean Faculty of Management Sciences from the Mohammad Ali Jinnah University Islamabad Pakistan, Dr. Waseem Shahid Malik, Assistant Professor, from the School of Economics, Quied-e-Azam University Islamabad Pakistan, and Dr. Imtiaz Hussain Khan, Assistant Professor from the King Abdulaziz University Saudi Arabia for their insightful comments that helped in shaping this manuscript.

The Diversification Puzzle: Revisiting the Value Effect of Corporate Diversification for Pakistani Firms

Abstract

The existing literature argues that corporate diversification destroys firm value.This value destruction is usually explained as the managers implement diversification strategies to benefit themselves rather increasing firm value.This study provides empirical evidence that cast doubt on the agency theory based explanation of corporate diversification and its value impact. Evidence based on insider trading suggests that managers implement diversification strategies to enhance firm value. The result of present study found that insiders purchase more shares in their own firms from open market whendiversification is high. The findings of current study also reveal that in stock market of developing countries like Pakistan,the value impact of corporate diversification is better explained by information effect rather than agency effect.

Key Words: CorporateDiversification, Agency Perspective, Information Asymmetries, Insider Trading, Pakistan

  1. Introduction

Corporate diversification and its value impacthave received a great deal of attention from both academics and business communities. However, the literature on value impact of corporate diversification decision has focused on developed markets. The extant theoretical literature also suggests a diversification puzzle.A dominant part of literature supports the stance of agency theory that considers the corporate diversification as a value destructive strategy. Agency theory assumes that managers pursue their own private goals rather than to increase firm value (Jensen & Meckling, 1976; Fama & Jensen, 1983). Similarly, managers usually get benefit at the expense of shareholders through their corporate diversification strategies instead ofincreasing the firm value (Amihud & Lev, 1981;Denis, Denis & Sarin, 1997; Aggarwal & Samwick, 2003). We consider this the agency effect of corporate diversification which refers corporate diversification to a value-destructive strategy.

On the other hand, researchersalsoargue that it is not necessary to be aconflict of interest between managers and shareholders in case of the strategic decision of corporate diversification (see Fox & Hamilton, 1994; Davis, Schoorman & Donaldson, 1997; Denis, Denis and Yost, 2002).In the presence of information asymmetries, the shareholders may not be able to distinguish between cooperation and defection of managers (Gomez-Mejia & Wiseman, 2007). Thus, when managers diversify with the intention to increase the value of their firms, outside investors mayundervalue diversification strategiesdue to information asymmetries (Seyhun, 1986).We consider this the information effect of corporate diversification which refers corporate diversification to a value-enhancing strategy.

In general, still there is no consensus on literature of corporate diversification and its impact on firm value. We therefore argue that contradiction on this issue suggests that new approaches and empirical testing to the diversification debate are required.In this study, we examine the value impactof corporate diversificationin context of insider trading. In this regard,two research questions raised by Ataullah, Davidson, Le and Wood (2014) are investigated empirically. First, do insiders (directors) follow the strategies of corporate diversification primarily to benefit themselves? In answering this question, it is argued that when managers implement diversification strategies to benefit themselves rather than increasing firm value, they are likely to purchase less shares of their firm from open market (agency effect of diversification). Second, do investors think that managers use diversification strategies only to benefit themselves? In answering this question, it is argued that even if managers implement diversification strategies to increase firm value but outside investors may undervalue their diversification strategy due to information asymmetries. Hence, managers are likely to purchase more shares of their firm from open market (information effect of diversification).

Although there is a vast body of literature on corporate diversification in developed countries (e.g.Lang & Stulz, 1994; Berger & Ofek, 1995; Tallman & Li, 1996; Lins Servaes, 1999; Yiu, Bruton, & Lu, 2005; Lien & Li, 2013), there are few studies that focus on the issue in developing countries. To our best knowledge, this is the first study in Pakistan that examines the value impact of corporate diversification in context of insider trading.We conjecturethat the studies conducted in developed markets may not necessarily have any application in the context of developing countries like Pakistan because, the financial markets in developing countries unlike developed markets are characterized by weak corporate governance /control and inadequate disclosure. As a result, theweak corporate governance and inadequate disclosure promotes the agency problem, information asymmetries and insider trading in developing countries. This argument is supported by the statement of Tsai, Young and Hsu (2011), who are of the view that emerging markets of Asian countries have high information asymmetries and market inefficiencies such as less robust legal investor protection and disclosure systems.

The present study is important because it provides a comparison of both the effects of corporate diversification—agency and information to explore which effect is dominating in stock markets of developing countries.Moreover, both the effects of corporate diversification have different practical implications for corporate level policies and management literature. In case of agency effect, corporate diversification is considered as a value destructive strategy, thereby calling for more attention to improve corporate governance system to ensure that managers focus on core competencies of their firms to increase the value. On the other hand, in information effect, corporate diversification is not considered as a value decreasing strategy which calls for more attention on enabling managers to show the potential advantages of corporate diversification that generate a positive signal to shareholders.This argument regarding information effect of diversification is supported by the statement of Hope, Thomas and Winterbotham (2009), who are of the view that insiders (managers) may overcome information asymmetries related to diversification strategies by improving the disclosure system about each segment.

The currentresearch study is organized as follows. First section of the study is comprises of introductory text and theoretical underpinnings regarding corporate diversification and its value impact.Second section gives insight into the existingliterature and their findings. Third section is comprises of the data description, measurement of variables and model specification.Fourth section is of empiricalresults, interpretations and discussion. Finally, the fifth part consists of conclusionof the study.

  1. Prior Literature Review

Diversification is defined as a means of spreading the base of a business (Booz, Allen & Hamilton, 1985).Even though, the literature on corporate diversification is voluminous, diverse and quite old. But findings of existing research studies provide no consensus on the value impact of corporate diversification.Agency perspective suggests that corporate diversification destroys firm value. An extensive portion of existing literature suggests that a leading example of agency relationship between insiders and shareholders is corporate diversification. Jiraporn, Kim, Davidson and Singh (2006) reported a negative relationship between diversification strategies and shareholder rights. Similarly, most of the time companies simplydiversify over the optimal level, as a result the negative effect of diversification occurs that destroys shareholders’ wealth (Martin & Sayrak, 2003). Corporate diversification provides opportunities to increase non-pecuniary benefits for managers but the cost is bear by all shareholders (McConnell, McKeon & Xu, 2010). These personal or non-pecuniary benefits include the prestige and power to manage large firms (Jensen, 1988), increased managerial compensation because compensation has a direct relation with firm size (Jensen & Murphy, 1990) and managerial self-preservation by investing in those projects that require their particular skills (Shleifer & Vishny, 1989). The proponents of agency effect also argue that, firms with diversification are generally sold at discount than to a single segment firms (see Lins et al. 1999). We conjecture that in the agency effect of corporate diversification, insiders’ propensity to purchase shares in their own firm is likely to be low, as through implementing diversification strategies they benefit themselves rather increasing firm value.

On the other hand, information perspectivesuggests that managers usually implement diversification strategies to enhance firm value but due to information asymmetries, outside investors undervalue their strategies.It is documented that corporate diversification influences the level of information asymmetry between managers and shareholders (Thomas, 2002). This argument is consistent with the information transparency hypothesis. Hadlock, Ryngaert and Thomas (2001) the pioneers of this hypothesis argue that managers have access to segment level information of cash flows in diversified firms while outsiders receives less value-relevant information. It is also discussed in existing literature that insiders take informational advantage by purchasing undervalued “value stocks” and by selling overvalued “growth stocks” (Rozeff & Zaman, 1998). Similarly, Agarwal and Singh (2006) argued that insiders usuallyhold private information and take market positions (long or short) based on that specific information. Piotroski and Roulstone (2005) reported a negative relationship for insider purchase and firms’ current performance while a positive relationship for firms’ future performance.

In literature it is also documented that insider trading is dependent of the firm specific attributes that determines the of information asymmetries between managers (insiders) and outside investors (Jeng, Metrick & Zeckhauser, 2003). Smaller firm faces high reaction of outside investors to insider trading because insiders’ are considered to have large portion of relevantinformation, which is transmitted to the market through their trade (Seyhun et al. 1986). Similarly, firmsthat haveR & D expenditures are also found highmarket reaction because outside investors cannot value these tacit projects correctly with available information (see Coff & Lee, 2003). This study links the insider trading with corporate diversification through information asymmetries rather than firm specific attributes. It is expected that insider purchase conveys insiders’ private firm specific favorable information to the market, while insider sale conveys insiders’ private firm specific unfavorable information to the market. Previous literature is documented a significant positive relationship for stock prices reaction and insiders’ purchase while a negative reaction to their sales (Fidrmuc, Goergen & Renneboog, 2006). It is also reported that in case of high corporate diversification, insiders are found to purchase more shares of their own firms from open market (Ataullah et al. 2014). Moreover, the insiders may purchase more shares of their own firmsin order to disseminate positive signals in the market if they think that outsiders are underestimating their diversification strategies.

Based upon existing literature,we develop two competing hypothesis related to the value impact of corporate diversification. First, we conjecture that if the agency effect of corporate diversification dominates the information effect then:

Hypothesis 1: There is a negative relationship between corporate diversification and insider trading.

Second, we also conjecture that if the information effect of corporate diversification dominates the agency effect then:

Hypothesis 2: There is a positive relationship between corporate diversification and insider trading.

  1. Data Description and Methodology

3.1Data Description

The analysis of this study is conducted forordinary stocks traded at the Karachi Stock Exchange for the period of 12 years from 2003 to 2014which satisfies the following criteria:

  1. Stocks from non-financial sector are included in sample.
  2. Stocks with negative book value of equity are not part of the sample.
  3. Only those stocks are included which have evidence of reasonable liquidity that is stock which have an evidence of trading in at least 8 months during a year.

Moreover, secondary data regarding segment level sales (used for entropy measure), purchase and saleof shares (used for purchase ratio) and debt to equity ratio (i.e. firm leverage) are hand collected from companies annual reports as well as balance sheet analysis by state bank of Pakistan. Segment reporting is compulsory for public companies in Pakistan under IAS 14, which is now replaced with IFRS 8. It defines a geographical segment as a component of an entity that (a) provides products and services within a particular economic environment and (b) that is subject to risks and returns that are different from those of components operating in other economic environments (IAS 14.9). Finally, data related to market capitalization (i.e. firm size) and daily stock prices for standard deviation (i.e. firm risk) are collected from the websites of Karachi Stock Exchange, Business Recorder and Noor Maier-Mind Matrix.

3.2 Measurement of Variables

3.2.1Measurement of Corporate Diversification

Mostly segment level financial and accounting data of salesreported by firms in financial reports is used to measure corporate diversification. Researchers used entropy measure for corporate diversification due to its technical rigor, theoretical base as well as relatively less shortcomings (Sambharya, 2000). This study also follows previous research studies and uses corporate industrial entropy index ( as measure of corporate diversification. Haultz, Mayer and Standler (2013) and Ataullah et al. 2014 used entropy index for firm “i” in the year “t” as:

Where is the percentage of firm sales generated in the industry segment “j” in year “t” and the summation over the “n” industry segments in which the firm “i” operates. A greater value of entropy shows higher level of diversification. The entropy for single firm is considered as “0”.

3.2.2Measurement of Insider Trading

The current study measures the insider trading by using the purchase ratio, which is the number of shares purchased by insiders of a firm “i” in a calendar year “t” divided by the total number of shares traded by insiders of that firm in the same year (Poitroski et al. 2005). The purchase ratio is a proportion that lies in the interval of (0,1),but in linear regressions,the values might fall outside the closed interval and also cause the non-normality of data which in turn leads to less reliability of data (Ferrari & Cribari-Neto, 2004). Thus, to ensure that results are robust, this study uses ordered Probit and fixed effect panel data regression models (see Davidson & Makinon, 2004). For ordered Probit model the study follows Poitroski et al. (2005) and use purchase ratio to construct an ordinal variable, which takes on the value “1” when insider purchase the shares of own firm from open market, “2” when purchase ratio lies in the interval of (0 to 0.5)i.e. sell more than purchase, “3” when purchase ratio lies in the interval of(0.5 to 1)i.e. insider purchase more than sell and “0” when insider only sell. The ordinal variable measures the insiders’ consensus about corporate diversification as if insiders believe that outsiders undervalue their diversification strategies, and they are likely to purchase more from open market (Piotroski et al. 2014).

3.3Control Variables

It is important to control the variables other than explanatory variables that may influence the insider trading to overcome omitted variable bias (Davidson et al. 2004). Firm size is use for control variable in regression because, as documented earlier, smaller firms have more information asymmetries than larger firms. This study measured firm size as natural logarithm of market capitalization of each firm. Firm leverage is also use for control variable because high leveraged firms are considered to be monitored by debt holders that reduce the information asymmetries (Harris &Raviv, 1991). This study used ratio of interest bearing debt over total market value of equity as measure of firms’ leverage because in Pakistan the source of debt is usually commercial banks rather than bond markets.Finally, firm risk is also use for control variable becauseas mentioned earlier thatfirm specific risk also influences the insider trading. In this study firm risk is measured as the standard deviation of daily returns for each firm (see Coff et al. 2003).

3.4Model Specification

Econometrically, multivariate regression equations for ordered Probit and fixed effect panel data regression models are expressed as follows:

……………… (A)

……………...… (B)

Where,

Equation (A) is used for ordered probit model while (B) for fixed effect panel data model.

  • = Ordinal variable which is the measure of insider trading in context of ordered probit model.
  • = Purchase ratio which is the measure of insider trading in context of fixed effect panel data model.
  • = Industrial entropy as the measure of corporate diversification.
  • = Firm size that is the natural logarithm of market capitalization for each firm.
  • = Firm risk that is the standard deviation of daily returns for each firm.
  • = Firm leverage that is the ratio of Interest bearing debt over total market value of equity.
  • = Coefficient or Marginal Effect
  • = Error Term
  1. Empirical Results and Discussion

Table 1 presents the statistical behavior of the data for the period of 2003-2014 through comparison of diversified (multi-segment) firm-years and focused (single-segment) firm-years on the basis of firm specific variables. Diversified firms in our sample are larger and have low level of firm risk and higher leverage than focused firms. The meansof the entropy measure (corporate diversification) of diversified and focused firm-years are 0.432 and 0, respectively.

Table 2 present results for correlation analysis. Result indicates that corporate diversification (Ent_Index) is significantly and positively correlated with insider trading. The results are consistent with information effect of corporate diversification hypothesis which argues that corporate insiders are likely to purchase more shares in their own firms when diversification is high because they know that outside investors are undervaluing their strategies due to information asymmetries (see Bris, 2005; Bell, 2009; Berg, Geweke & Rietz, 2010). As for as the control variables are concerned, the firm risk is positively correlated with insider trading and the results are consistent with existing studies(see Coff et al. 2003;Ataullah et al. 2014). These researchers are of the view that corporate insiders purchase shares in their firms when they believe that the benefits of trading against less informed investors are more than the cost of taking idiosyncratic or firm specific risk taking by them. In case of developing countries like Pakistan, due to collectivist culture, most of the investors are noise or uninformed and follow the peers and family members in making investment decisions without processing information (i.e. herding behavior). That is why in Pakistani stock market the insider trading brings benefit more than the cost of taking firm specific risk.On the other hand, firm size and leverage are negatively correlated with insider trading. These findings are also consistent with the established theoretical relationship in previous studiesfor firm size, leverage and insider trading. As mentioned earlier, smaller firm faces the problem of information asymmetries, because in small firm insiders know about a significant portion of information and can manipulate that information to get access returns. It means if size increases, the information asymmetries decreaseswhich in turn reduces the informational advantage of insiders. Hence, the insiders are likely to purchase less when size of the firm increases. Similarly, when leverage increases, the monitoring by debt holders also increases which in turn decreases the information asymmetries. Therefore, the informational benefit of insiders to trade with noise traders also reduces in firm with high leverage.