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The effect of multinationality measures upon the risk-return performance of US firms
International Business Review Vol. 5, No. 3, pp. 247-265, 1996
Pergamon
S0969-5931 (96) 00009-1
Copyright © 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0969-5931/96 $15.00 + 0.00
The Effect of Multinationality Measures upon the Risk-Return Performance of US Firms Gongming Qian Department of International Business, Faculty of Business Administration, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong Abstract -- This study analyses the effect of a firm's overseas activities upon its risk-return performance for a sample of US firms (including multinational enterprises and domestic firms) by using different multinationality measures. The test results indicate that firms with a greater share of overseas activities have a greater opportunity to achieve a better risk-return performance than those with little foreign involvement. More importantly, for a firm which meets the basic requirement of multinationality (for MNEs as a whole), the number of foreign markets served has a minimal influence on its performance. Copyright © 1996 Elsevier Science Ltd Key Words -- Multinationality, Risk-Return Performance, US Firms.
Introduction There has been an increasing trend in business involvement in overseas markets of the largest industrial firms, especially multinational enterprises (MNEs), from developed countries post World War II. They have been a major and increasingly important influence upon the shape of the international economy. One of the most important focuses in the study of MNEs is the relationship between multinationality (i.e. foreign operations) and its risk-return performance.t It is widely suggested that multinationality has played a Gongming Qian received his Ph.D. from the Management School of Lancaster University, UK, in 1994. He is currently assistant professor in the Department of International Business, Faculty of Business Administration, The Chinese University of Hong Kong, Hong Kong. He has published widely in both national and international journals. tThe study of the financial performance of MNEs can be made either from the same country or from different ones. The former is however, more comparable than the latter. This is because, when the risk-return performance of US MNEs and European counterparts is compared, for example, the results may turn out to be biased. This is because a significant proportion of the European-based MNEs are state-owned. State ownership is often associated with a multiplicity of objectives beyond profit making, such as reaction and maintenance of employment, regional development and the enhancement of the image of state (Haar, 1989). These state-owned MNEs must respond to the social and political goals of the government leaders. They are likely therefore to become an arm of government and vehicle for its current policy objectives ( R u g m a n , 1983). C l e a r l y , these p o l i t i c a l and social goals i n e v i t a b l y c o n f l i c t with considerations of efficiency. The implication is that European MNEs are less efficient than US (Footnote continued on p. 248)
247
Risk-Return Performance of US Firms
248 International Business Review 5,3
significant role in influencing this performance (Hirsch and Lev, 1971; Cohen, 1972; Hughes, et al., 1975; Wolf, 1977; Buckley, et al., 1978, 1984; Rugman, 1979; 1983; Miller and Pras, 1980; Kumar, 1984; Michel and Shaked, 1986; Buhner, 1987; Grant et al., 1988; Geyikdagi and Geyikdagi, 1989; Morck and Yeung, 1991; Vachani, 1991; Qian, 1994, 1995).~: There are two different measurements (i.e. performance and entropy) to define a firm's foreign operations. The question is whether these different measurement approaches affect the empirical results differently. Nothing however has been done to deal with this important issue. The purpose of this study is therefore two-fold: to test for the differences in this relationship by using these two measurements (the first test is concerned with the performance measure and the second with entropy); to provide additional insight into whether firms with a varying degree of foreign operations perform differently. The performance measure is most commonly used in the empirical study of foreign direct investment (FDI) by international business. It is simple and easy to compute. This is because it recognizes only two different geographic market units (i.e. domestic and foreign ones). Comparatively, the entropy (Continued from p. 247) MNEs as the latter have both higher return and lower risk. In addition, they also differ in terms of home government's tax policy, foreign exchange translation, accounting practice, company experience, working relationship with host-countries, organizational structure, socio-cultural distance (i.e. between home and host cultures), scope of product diversification and legal restrictiveness. Because of these differences in business firms from different countries, relevant problems may arise when such direct comparisons among MNEs from different countries are made. For this reason, there has therefore been a considerable amount of empirical research into the distinguishing characteristics of the very largest firms in any single domestic economy. To capture the effects of state ownership of MNEs on risk-return performance, however, an indirect way of comparison can be made by constructing a dummy variable to represent state ownership (i.e. the national dummy). The statistical test is through regression analysis. The inclusion of the national dummy indicates if the observed differences in mean profit rates of risk of return between, say the European and US MNEs are significant when other plausible explanatory variables are also present. Another strength of comparing the risk-return performance of MNEs and DMCs within the same country directly is for a policy perspective; it can address the growing criticism of MNEs' supposed adverse impact on domestic°investment, employment and exports. For this consideration, it is of interest to examine whether their performance has been inferior compared to that of DMCs. ~:Causality between multinationality and profitability may plausibly run in both directions. This is simply because firms with either higher profits in the past or a good profit prospect in future may have, on the whole, more resources to increase their firm size. Such firms may also have resources at their disposal to allow them to bear risks and operate optimally and to monitor significant production activities in foreign countries by diversifying in both market and product dimensions. More importantly, firms which can always achieve a better risk-return performance generally have enjoyed certain "ownership" advantages over other firms and enabled them to set up international operations. Almost all of the research in this area, however, has focused on the possible effect of multinationality upon a firm's profitability. A further international business study will surely deal with this important issue by empirically examining how the potential growth of profitability can affect a firm's foreign involvement.
249 measure is relatively complicated but more comprehensive. It considers both the number of geographic regions in which a firm is involved and the number of its subsidiaries in each region. The firm sample is reorganized respectively according to both measurement approaches. The first firm sample includes only MNEs and domestic firms while the second firm sample contains not only MNEs and DMCs but also firms which lie between MNEs and DMCs (hereafter referred as the middle firms). This is intended to serve as a further comparison with the previous studies when the middle firms are included. This study uses the theories of foreign direct investment (FDI) and international real asset diversification to explain the effect of a firm's overseas activities upon its risk-return performance.
Firm-specific Advantages and Foreign Direct Investment (FDI) The fundamental assumption associated with FDI is that firms engaging in international production are at a disadvantage compared to local firms. This is because of their unfamiliarity with local market conditions. Operating a subsidiary in a foreign market requires the commitment of resources and attention to both the supply and demand sides of the market. Additional costs (e.g. communication, administration and transportation) are incurred. For FDI to be successful, MNEs must therefore possess certain advantages not available to existing or potential local competitors (Hymer, 1960, 1976; Kindleberger, 1969; Caves, 1971, 1982; Dunning, 1973, 1979; Buckley and Casson, 1976; Hood and Young, 1979; Errunza and Senbet, 1981; Cho, 1985; Yu and Ito, 1988; Kim et al., 1989; Markides and Ittner, 1994). FDI is m o t i v a t e d by m a r k e t i m p e r f e c t i o n s which p e r m i t MNEs to exploit monopolistic advantages in foreign markets. MNEs must have ownership advantages vis-a-vis other firms wishing to supply a similar market. These ownership advantages, largely in the form of intangible assets, represent a range of competitive strengths which are essential to their continued growth and ultimately to their survival (Dunning, 1993; Dunning et al., 1986). Market imperfections may be one or more of several types: in goods markets, including product differentiation; volume economies; marketing skills and administered prices; in factor markets, including proprietary technology, managerial skills, intelligence gathering, operational flexibility and stability, tax arbitrage and discriminatory access to capital; economies of scale internal and external to a firm; and government-imposed market distortions (Leibenstein, 1966; Hirsch and Lev, 1971; Lessard, 1979; Teece, 1980; Chakravarthy and Lorange, 1984; Kogut, 1985; Amit, 1986; Kim et al., 1989; Morck and Yeung, 1991; Mitchell et al., 1993). Such advantages give MNEs an edge over their competitors in similar locations and thus serve to compensate for the additional costs of operating across national boundaries. This discussion suggests that FDI takes place once an MNE has secured internally transferable advantages. These enable it to overcome its lack of knowledge of local conditions and to compete successfully with local firms in host-countries and foreign firms from Third countries. Market imperfections
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250 International Business Review 5,3
created by the existence of an oligopolistic advantage should prevail to motivate MNEs to make FDI. MNEs can exploit market imperfections by minimizing the additional costs and appropriating the full return from their utilization.
International Real Asset Diversification The concept of international corporate diversification has often been linked with risk reduction. It has therefore been argued that the most important function of international diversification is to reduce total risk at the firm level. Risk reduction cannot exceed a certain level within an economy. Corporate diversification within a particular economy is still subject to fluctuations in that economy. Diversification across national boundaries increases the stabilization of profits (see Hughes et al., 1975; Lloyd, 1975; Agmon and Lessard, 1977; Rugman, 1977, 1979; Miller and Pras, 1980; Geyikdagi, 1981; Bettis and Hall, 1982; Fatemi, 1984; Lessard, 1985; Shaked, 1986; Buhner, 1987; Grant, 1987; Amit and Livnat, 1988; Barton, 1988; Geringer et al., 1989; Geyikdagi and Geyikdagi, 1989; Amit and Wernerfelt, 1990; Madura and Whyte, 1990; Morck and Yeung, 1991). International real asset diversification occurs in both product and market dimensions. It allows the application of firm-specific know-how to penetrate prospective foreign markets and facilitates the extension of the business and/or products which the firm knows best. The power of international market diversification lies in the differences (in goods markets) which arise from demand and supply variations between geographical markets. The potential for risk reduction from the diversification of real assets may be significant compared with that of financial asset diversification. This is because there is a relatively low correlation between national industrial production indices relative to financial variables such as interest rates and equity prices (Rugman, 1977). Because product markets are less correlated than financial markets, this suggests that both foreign and home markets may be mutually complementary. MNEs benefit from the low correlation observed in international goods and factor markets and therefore achieve a more stable stream of profits. Consequently, MNEs are viewed as being more able to reduce the risk of their profits relative to DMCs selling most of their products in a single economy. International activities in any one country may be more risky than a comparable investment in a home county. The riskiness of international activities as a whole, however, may not be any higher and may even be lower than the riskiness of domestic investment. MNEs should therefore exhibit a m o r e stable stream o f profits than c o m p a r a b l e firms w h i c h are not internationally diversified. The overall variance of a firm's cash flow will be reduced if the income streams from its various international activities are less than positively correlated. If there were no barriers to international capital flows and if capital markets were fully integrated, investors could diversify their portfolio holdings internationally by themselves and thus eliminate unsystematic risk
251 on a global basis. In such circumstances, there is no need for diversification at the firm level. No systematic advantage could therefore be achieved by owning the shares of an MNE rather than those of a number of DMCs in different countries. Perfect information with no impediments to financial market transactions, however, does not occur in the real world. International capital markets are neither segmented nor integrated but lie somewhere between these two extremes (Aliber, 1970, 1971; Agmon, 1972; Buckley and Casson, 1976; Lessard, 1976; Stehle, 1977; Senback and Beedles, 1980; Caves, 1988; Froot and Stein, 1991; Brewer, 1993). This suggests that there is room for MNEs in the integration of partially-segmented capital markets. The MNE is thus likely to provide diversification opportunities not otherwise available to individual investors or available only at higher costs. Because of the behaviour of business cycles across different countries, MNEs should provide a valuable service through diversified FDI and offer shareholders risk-return opportunities superior to those available to the shareholders of purely DMCs. Because of barriers facing investors in the choice of international portfolio diversification, flows of FDI will be freer than portfolio flows. This means that investors cannot diversify as freely as MNEs. The MNE can therefore be regarded as a vehicle for international diversification. Market performance can be regarded as an effective means of identifying whether the diversification opportunities provided by MNE shares is great. The market should therefore treat the MNE differently from the DMC. This suggests that investors will therefore reward the MNE for going overseas because of the opportunity for earning excess risk-adjusted returns.
Sample Size This study uses a sample of 169 largest US industrial firms on the "Fortune 500 listing". For a firm to be included in the sample, there needs to be performance data for the 10-year period (1981-90).* The time period 1981-90 is employed because this allows short-term influences on firm risk-return to average out. The initial base sample consists of all firms in the "Fortune 500" listing in independent existence over this period. Because the composition of the top *There are two main reasons for the selection of the time period 1981-90 in this study. One is that this research started in late 1990 such that the data were therefore most update at that time. The other is that the time period under study is inversely correlated with the sample size since the longer time period is at the cost of a small sample size. For this reason, both time period and sample size are treated equally. The previous study (Qian, 1994) therefore consists of two parts. In the first part: the 20-year period (1971-90) and 121 finns (including the finns whose shares of foreign involvement lie between MNEs and DMCs) are used; and the 10-year period (1981-90) and 169 finns are used. The two periods of time and their related sample size are employed to prevent unnecessary biases. The present article is based upon the second part of this study. The sample size increased by 40% compared with the first part. From today's point of view, however, the data for 1991-94 are available. The data availability will permit further study in future.
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252 International Business Review 5,3
500 firms has changed a great deal over this 10-year period and there were some missing data on many firms, the original sample size was reduced substantially, leaving the present sample of 169 industrial finns (including 57 MNEs and 69 DMCs), for which all of the requisite data for 1981-90 was available.*
The Description of the Variables The two profitability measures employed are return on assets (ROA) and return on equity (ROE). ROA and ROE are often used by managers and external analysts as a measure of the effectiveness and efficiency of top management. The impact of FDI on a firm's performance is more directly reflected in accounting profit than in stock price which measures investor's expectations about future profits. Risk is measured by the standard deviations of both ROA and ROE figures across the 10-year time period. The SD of ROA and SD of ROE are used to measure the extent to which returns vary about the mean over time. They represent a finn's earnings stability or total risk.
Statistical Design Two kinds of statistical tests can generally be used to analyse the risk-return performance of business finns engaging in a varying degree of international activities: paired-difference and regression tests. The differences depend largely upon the object of study.t This study examines the risk-return performance of US MNEs and DMCs by using a paired difference test. It is
*The relationship between sample size and time period is inversely related. This is because with more years included, the composition of the firms surveyed varied. Originally, 258 firms were selected which satisfied the conditions of multinationality and domesticity. This sample, however, is based upon a simple calculation from discrete time periods. The data for many firms in the study are not continuous so that the longer time period reduces the sample size. It is necessary therefore, to make some adjustments to the original data base. This involves the exclusion of several MNEs and DMCs from the original sample base because of the unavailability of data needed to construct the relevant variables. 57 MNEs and 69 DMCs were the final sampled firms in this study. These firms were in independent existence over 10-year time period (1981-90), The principal reasons for their adjustments are as follows: -- Changed foreign involvement for both MNEs and DMCs; -- Figures no longer published; -- Merged into another firm; -- No longer classified as an industrial; -- Acquired by another firm; -- Liquidated after business failures; -- No published figures in certain years. After careful examination of these problems, the original sample size was reduced to the present sample of 126. t F o r comparing the risk-return performance for different types of firms, paired-difference tests are the most effective. This is because the variable of interest is the difference between the values of the observations rather than the degree of relationship between the observations themselves. Paired-difference tests are therefore most applicable to the present study. By contrast, statistical regression is the most desirable method to test the relationship between the (Footnote continued on p. 253)
253 employed to find statistically significant differences between two population means (i.e. MNEs and DMCs) when the data are obtained from related samples. Since market measures (e.g. ROA and ROE) are the chief concern, a value in one sample (e.g. the MNE sample) is paired with a corresponding value in the other (e.g. the DMC sample) according to these c o m m o n denominators (market measures). To establish whether any differences exist between the two related samples, the individual values for each example must be obtained. The significance of this difference can be tested using t-statistics to derive a confidence interval for paired samples. The t-test stresses the average (or mean) of the two (or more) samples. Because the size of the sample is not small (size > 15), parametric assumptions underlying the test hold.
The Performance Measure of Foreign Involvement The performance measure has an accounting/financial appeal because it defines a firm as multinational according to performance characteristics. Much of the research on MNEs focuses upon their share of foreign sales, o p e r a t i n g p r o f i t s , n u m b e r of e m p l o y e e s a b r o a d , f o r e i g n assets or combinations of these variables. For example, the ratio of foreign sales to multinational total sales is used as the measure of international geographic diversification (e.g. Kumar, 1984; Grant et al., 1988). Performance indicators of foreign involvement, however, require thresholds in the extent or size of sales, earnings, assets and e m p l o y m e n t overseas to be established for definitional purposes. The multinational content of all firms varies so that any threshold is likely to be somewhat arbitrary. A firm's foreign sales as a percentage of its total sales, for example, is widely used to determine MNEs and DMCs. The thresholds for MNEs in the empirical literature range from 20% (Shaked, 1986), 25% (Stich, 971), 28% (Kohers, 1975) and 35% (Geyikdagi and Geyikdagi, 1989). It is evident that there is no common ground for defining the measurement threshold for multinationality. The distinction between MNEs and DMCs is based upon their degree of foreign involvement. This is because DMCs are also likely to engage in foreign operations, including those with little previous foreign involvement. Because any threshold is likely to be arbitrary, it can be argued that the above measures are either too high or too low and are therefore not ideal choices. If the threshold of foreign involvement is set too low, the classification of firms becomes difficult and, consequently, most firms can become MNEs. It is (Continued from p. 252) risk-return performance of business firms (taken as the dependent variables) and their determinants (i.e. independent variables). The number of independent variables, however, depend chiefly upon a multiplicity of explanatory factors affecting the respective dependent variable. One of the chief concerns in the previous study (Qian, 1994), for example, is whether there is any effect of a firm's foreign activities upon risk-return performance. The first regression model is mainly concerned with the factors affecting the return performance in profits while the second is concerned with the factors affecting the risk performance.
Risk-Return Performance of US Firms
254 International Business
Review 5,3
also important to avoid eliminating a large number of "genuine" MNEs because the threshold of foreign involvement is set too high. The sample size of MNEs is reduced and the test results are biased. To prevent the occurrence of these two extremes therefore, a threshold of 30% or more of foreign sales is selected as a representative of MNEs (Qian, 1994, 1995). A criterion must also be established for measuring DMCs. Most studies regard d o m e s t i c - o r i e n t e d firms as those with 10% or less of foreign involvement (e.g. sales, earnings, assets and employment). This is rather low because most of the largest "Fortune 500" firms are in the process of internationalization. If the threshold for measuring foreign involvement is set too low, this process may not be fully reflected. The differences in measuring f o r e i g n i n v o l v e m e n t of M N E s and D M C s are s m a l l e r than b e f o r e . Accordingly, any firm which has 15% or less of its foreign operations during a certain year is defined as a DMC (Qian, 1994, 1995). The m i n i m u m difference between MNEs and DMCs is therefore 15% points.
Results of the Return and Risk by the Performance Measure The main concern here is whether any difference exists over the whole time period when the complete sample of MNEs and DMCs is considered. The null hypothesis is that MNEs and DMCs have equal risk-return performance and the alternative hypothesis is that their risk-return performance is significantly different. The results on the risk-return performance between MNEs and DMCs for the 1981-90 period are shown in Table 1. MNEs appear to have a better risk-return performance than DMCs for each measure. The difference between the two groups is statistically significant at the 5% level and, in some sub-periods, at the 1% level. The null hypothesis that MNEs and DMCs have equal risk-return performance can therefore be rejected. The results indicate that the MNE sample outperforms the DMC sample in
Variable
Table 1. Differencebetween MNEs and DMCs 1981-1990. All Industries
ROA MNEs DMCs SD of ROA MNEs DMCs ROE MNEs DMCs SD of ROE MNEs DMCs
Mean
df
t-values
Probabilities
95% Confidence Intervalfor Mean
110
5.20
0.0000
1-89 to 4.21
87
-2.95
0.0040
-2.00 to ~).39
121
4.93
0.0000
3.23 to 7-55
87
-3.04
0.0031
-5.40 to -1.1
8.15 5-10 2-47 3.66 16.51 11.10 5.33 8.59
Note: all t-values are significantat 5% or higher.
255 terms of a higher rate of return while simultaneously incurring less risk. Because the findings are derived from activities over the last 10 years, economic fluctuations during this period are likely to have a minimal effect upon the MNE performance. The results suggest that MNEs may possess certain competitive advantages or assets (tangible or intangible) unavailable to rivals without incurring substantial cost and uncertainty (Kogut, 1985; Porter, 1985). If this is the case, the higher levels of profitability for MNEs can be explained by their being a monopolistic response to international market imperfections. Furthermore, while activities in any one country are risky, the risk of international operations as a whole may not be any higher (and may be even lower) than that of domestic investment.
Risk-Return Performance of US Firms
Results of the Return and Risk with Time Segments MNEs and DMCs may also perform differently in different time periods. It is therefore important to examine the impact of economic cycles or other economic factors on their risk-return performance. The complete time period (1981-90) is divided into six segments. These data are continuous and therefore prevent information loss. The results of the risk-return performance between MNEs and DMCs for six time intervals are shown in Table 2. A superior risk-return performance is still found to exist for MNEs. The only exceptions are several insignificant differences in the SD of ROA and SD of ROE for three of the six time Variable ROA MNEs DMCs t-values probabilities
1981-85
1982-86
1983-87
1984-88
1985-89
1986-90
7"82 5'20 4'35 0.0000
7"67 4-90 4-52 0.0000
7"87 4'97 5'00 0.0000
8' 10 5"01 4"84 0.0000
8"26 4"85 5"29 0'0000
8-48 4'65 5'48 0'0000
SD of ROA MNEs DMCs t-values probabilities
1.86 2.34 -1-81 0-073
1.79 2.09 -1'16" 0.25
1.98 2-29 -1-17" 0-24
2.15 3.32 -2'18 0.032
2.21 3.34 -2"09 0-039
2.15 3"47 -2-38 0.020
ROE MNEs DMCs t-values probabilities
14-55 11-17 3" 15 0-0021
14.61 10.29 3.66 0-0004
15-06 10-80 4-13 0-0001
16-94 11.47 4.25 0"0000
17.69 11-52 4-78 0.0000
18 "48 11-24 4-90 0"0000
SD of ROE MNEs DMCs t-values probabilities
3"75 5-37 -2"30 0.023
3.81 4.51 -1'12" 0.26
4-42 5-07 -1-03" 0.30
4'72 7"60 -2"21 0.030
4.92 7"34 -2-02 0.047
4"45 8'60 -2'89 0'0050
*Insignificant.
Table 2. Difference Between MNEs & DMCs by Time Segments
256 International Business Review 5,3
intervals. When the time factor is considered therefore, MNEs are still likely to achieve a higher return and a lower overall risk than DMCs. The results continue to suggest a better risk-return performance for the MNE sample in spite of the differences for some of the risk measures being insignificant. There is therefore considerable support for the general conclusions of earlier cross-sectional studies. MNEs enjoy locational advantages derived from d i f f e r e n c e s in goods markets in relation to international demand and supply variations. Geographic variations in factor markets result in differences in the rates of return on foreign capital. International operations offer the opportunity to exhaust economies of scale more fully in a large overseas market.
The Entropy Measures of Foreign Involvement In the performance approach, the ratio of a firm's foreign sales, including e x p o r t sales, to its total sales is used to r e p r e s e n t a f i r m ' s f o r e i g n involvement. This is most commonly used in the measurement of a firm's multinationality (e.g. Wolf, 1975, 1977; Rugman, 1979). Even though these studies have recognized two different geographic market units, domestic (usually the US) and foreign (Rest of World), their measures do not truly reflect the extent of international market diversification. This is because they fail to reflect the multiplicity of foreign markets served by firms (Buhner, 1987; Kim et al., 1989; Vachani, 1991). A bias is likely to occur because the measures do not distinguish between firms having 30% of their sales in one country and a similar amount in several countries. According to the previous definitions, any firm that has 30% of foreign involvement is classified as a MNE. A significant difference in the risk-return performance of two firms may be expected because of their differential involvement in particular countries or geographic areas. Several studies attempt to correct for this deficiency. The number of foreign countries in which a firm operates can be counted to capture the multiplicity of foreign markets (Cohen, 1972; Kim, 1989; Vachani, 1991). This is based upon the relative shares of sales in each foreign market. Entropy measures can be used (Hirsch and Lev, 1971; Miller and Pras, 1980; Kim, 1989; Vachani, 1991). These are based upon the ratio of a firm's holdings (the number of subsidiaries) in a region to its global holdings (the total number of its foreign subsidiaries). Accordingly, entropy measures reflect, not only the multiplicity of foreign markets, but also the equality or inequality of the size of foreign operations. More importantly, entropy measures not only quantify the dispersion of a firm's activities across dissimilar geographic regions but also measure the extent to which a firm's activities are spread across similar foreign countries within regions (Vachani, 1991). The similarities include physical and cultural proximity and level of economic development across the countries in which it operates. An increased geographic scope of operation may increase a firm's ability to share or coordinate its international activities. Such benefits include economies of scale, scope and experience (Kogut, 1985; Porter, 1985, 1987).
257 There is a growing similarity of countries in terms of infrastructure, distribution channels and marketing. At the same time, technology is playing an integrating role by permitting easier coordination of activities in different countries. International market diversification also offers the opportunity to exhaust economies of scale within a firm. A broad area of operations, however, entails costs. It is suggested that institutional and cultural factors erect formidable barriers to the transfer of competitive advantage between countries (Kogut, 1985). Geographically diverse operations may limit a firm's efforts to tailor its activities to serve a particular target segment, geographic area or industry. This may frustrate attempts to achieve lower costs or a differentiated position in the market (Porter, 1985). The possible influence of regional differences and increased costs of geographical coordination may reduce the potential benefits associated with increased scope. For the entropy measure, the scope of FDI is determined by reference to the Directory of American Firms Operating in Foreign Countries. In addition, Who Owns Whom (North America) and Moody's International Directory of Corporate Affiliations also provide useful information on the countries in which US firms are involved. These manuals have been consulted to establish the extent of overseas operations by the sampled firms.
Results of the Return and Risk by the Entropy Measure Diversification through FDI across national boundaries should improve investors' risk-return opportunities when economic activity in different countries is less than perfectly correlated. International market diversification is a vehicle for realizing a better risk-return performance. This is based upon the explanation of international real asset diversification theory. This conclusion is fully supported by the previous empirical results. These results are, h o w e v e r , o b t a i n e d w i t h o u t r e g a r d i n g the possible g e o g r a p h i c diversification effect. Index of International Market Diversification International diversification is calculated as the entropy of each firm's relative country (or regional) holdings: D = Silog¢ (1/Si)
(1)
Where Si is the ratio of a firm's holdings (number of subsidiaries) in country or region i to the total number of foreign subsidiaries. According to the theories of market imperfections and transaction costs, a firm's ability to earn profits from its intangible assets and to minimize its costs of managing is affected by similarities and differences between the countries in which it operates (Vachani, 1991). The relevant geographic unit is one in which patterns of general economic conditions, fluctuations in demand and external restrictions have close similarities. Six g e o g r a p h i c r e g i o n s are used to m e a s u r e i n t e r n a t i o n a l m a r k e t
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258 International Business Review 5,3
diversification by a large number of "Fortune 500" firms. These market areas are the EU; EFTA; North America; Other Developed Countries; Eastern Europe, China and Common Market Associates; and other LDCs (see Worm Bank, 1987). More pronounced differences are expected to occur between rather than within each geographic region. These six international regions provide the basis for geographic specification. Each firm is assigned a value in terms of both the number of geographic regions in which it is involved and the number of its subsidiaries in each region.
The International Market Diversification Hypotheses The criteria for defining high and low international market diversification are based upon entropy measure (Miller and Pras, 1980). If the composite index (D) is not less than 1"3, a firm is regarded as a high international market diversifier (HI). Comparatively, if the composite index is not more than 0.7, it is treated as a low international market diversifier (LI). In addition, the group between high and low global diversification are also included; "medium international market diversifier" (MI) with a composite index (D) is between 0.7-1.3. The theoretical arguments lead to the proposition that the higher the international market diversification of a firm, the better its chances of obtaining a superior risk-return performance. It is possible therefore to make the following hypotheses:
Hypothesis la: On average, the profitability of HI is greater than that of both MI and LI diversification. Hypothesis lb: On average, the profitability of MI is greater than that of LI. Hypothesis 2a: On average, the profit stability of HI is greater than that of both MI and LI. Hypothesis 2b: On average, the profit stability of MI is greater than that of LI.
The Extent of Global Diversification by MNEs A firm may be classified as an MNE even if it is not as diversified as another MNE which has the same ratio of multinationality. It is therefore imprecise to depend solely upon such a ratio to differentiate between MNEs and DMCs. Furthermore, two firms, although belonging to the MNE category, are still influenced by their actual geographic diversification.To investigate these influences further, it is necessary to compare the risk-return performance between MNEs. Again, all MNEs in the sample are divided into three subgroups below: Group 1: The Group 2: The and Group 3: The 1.3.
ratio of international market diversification is less than 1.0. ratio of international market diversification is between 1.0 1-3. ratio of international market diversification is greater than
259 The t h e o r e t i c a l a r g u m e n t s lead to the p r o p o s i t i o n that the h i g h e r international market diversification an MNE, the better its chance of obtaining a superior risk-return performance.
Hypothesis 3:
Risk-Return Performance of US Firms
It is hypothesized that the risk-return performance of Group 3 is greater than that of both Group 1 and Group 2.
Results of the Return and Risk by Entropy Measure The empirical tests are performed on the basis of the entropy measure. The principal results and their implications are discussed below. The Extent of Global Diversification This is concerned with a comparison of the risk-return performance for finns with a varying degree of international market diversification. Table 3 reports the results of such comparison. Hypotheses la, lb, 2a and 2b are fully supported by the empirical tests. Both the profitability and risk measures are statistically significant at the 10% level. The results also indicate that the difference between any MI-LI pair is not statistically significant except for ROA. This clearly suggests that a firm must meet minimum requirements of international market diversification before it is able to perform differently from its counterparts. Global Diversification by MNEs This is concerned with a comparison of risk-return performance between MNEs which have differing extents of international market diversification (i.e. testing Hypothesis 3). Table 4 provides the results of such comparison.
Pairwise comparison
Difference
t-statistic
Significance
ROA
HI-LI HI-MI MI-LI
2.36 0.98 1.38
3.74 1'65 2.30
0.0003 0" 1000 0-0240
SD of ROA
HI-LI HI-MI MI-LI
-0.87 -0.45 -0.42
1.68 1.26 0-73
0-0990 0-2100 0.4700
ROE
HI-LI HI-MI MI-LI
2.36 0'95 1'41
1.91 0.84 1"04
0.0600 0.4000 0'3000
SD of ROE
HI-LI HI-MI MI-LI
-2.06 ~3-56 -1.50
1"66 0-53 1-09
0" 1000 0-6000 0-2800
Variable
Notes: HI: high international market diversification. MI: medium international diversification. LI: low international diversification.
Table 3. Risk-Return Performance and Global Diversification
260 International Business Review 5,3
Table 4. Risk-Return Performance and MNE Global Diversification
Pairwise comparison
Difference
t-statistic
Significance
ROA
HMD-LMD HMD-MMD MMD-LMD
1"57 0"58 0"99
1"64 0'51 0"96
0' 1100 0"6200 0"3500
SD of ROA
HMD-LMD HMD-MMD MMD-LMD
0'289 0"390 ~). 101
0"69 1"22 0"25
0"5000 0"2300 0'8100
ROE
HMD-LMD HMD-MMD MMD-LMD
0"53 -1 "58 2"11
0"32 0"75 1"01
0"7500 0"4600 0'3300
SD of ROE
HMD-LMD HMD-MMD MMD-LMD
1"01 0'92 0'09
0'96 1' 10 0'09
0"3600 0.2800 0"9300
Variable
Notes: HMD: high international market diversification by MNEs. MMD: medium international market diversification by MNEs. LMD: low international market diversification by MNEs.
As indicated in Table 4, none of the differences in the r i s k - r e t u r n performance is observed for any of the three pairs. Hypothesis 3 can therefore be rejected. This implies that any firm which belongs to the multinational category based upon the criterion of multinationality (the ratio of foreign sales to its total sales) can provide a similar r i s k - r e t u r n p e r f o r m a n c e independent of the number of countries or geographic areas in which it operates. The multinationality variable therefore can still be used to measure a firm's international diversification. This result provides strong support for the previous empirical results.
Summary and Conclusions MNEs are believed to have ownership advantages. The advantages to firms from international activities include cost savings, access to technical and other resources, tax deferment or reduction, sales expansion and the extension of products' life cycles. They have exploited proprietary intangible assets by selecting those foreign locations which minimize transaction costs. A broad g e o g r a p h i c scope of international operations may yield c o m p e t i t i v e advantages by permitting a firm to exploit the benefits of performing more activities internally (Rugman, 1981). On a priori grounds, international market diversification enables the use of firm-specific know-how to penetrate prospective foreign markets in a firm's main lines of business. Increased geographic scope of operations may increase a firm's ability to share or coordinate activities of different geographic areas. Such benefits include economies of scale, scope and experience. The growing similarity of countries and the integrating role of technology are extremely important for international market diversification (Porter, 1987). This is because of the
261 availability of infrastructure, distribution channels and marketing. Information technology already permits easier coordination of activities in different countries. Corporate diversification within a particular e c o n o m y is subject to fluctuations in that economy. FDI is therefore an important means for a firm to maximize its value by reducing its risk through diversifying its portfolio of investments. Because of the behaviour of business cycles across different countries, MNEs are able to provide a valuable service through diversified FDI. The superior r i s k - r e t u r n p e r f o r m a n c e of a firm can therefore be explained by its international activities. The results have indicated that the use of different measurement approaches do not alter the conclusion that firms with a greater share of overseas activities have a greater opportunity to achieve a better risk-return performance than those with little foreign involvement. It is reasonable to conclude that the increasing extent of foreign operations is associated with higher profits and lower risks. In other words, multinationality is positively related to profitability and inversely to risk. Because FDI by MNEs help to diversify risks, investors (existing and potential) expect a more stable rate of return. Investors should therefore reward MNEs for engaging in international activity by paying a premium for MNE shares (Qian, 1994, 1995). For MNEs as a whole, no significant difference in risk-return performance is found to exist. This suggests that for a firm which meets the basic requirements of multinationality (foreign sales as percentage of its total sales), the number of foreign markets served has a minimal influence on its economic performance. In other words, there is no difference in the risk-return performance whenever the performance or the entropy measures have been used to define MNEs. The use of both the measures cannot change the fact that MNEs are able to achieve a better risk-return performance. The results do not necessarily mean that a firm, by increasing the extent of foreign involvement, can achieve the possible highest rates of return. From a t h e o r e t i c a l point o f view, there s h o u l d be an o p t i m a l level o f internationalization. The advantages of "more is better" should hold only until a firm reaches some optimum combination of domestic to foreign operations. Otherwise firms would continue to improve their performance until they have no domestic operations at all. This is unrealistic. The main reasons have already been explained. Firms which exceeded this optimum would be expected to show evidence of declining performance and a probable resultant downturn in their portion of foreign to total operations (Daniels and Bracker, 1989). Different industries may also have different optimum domestic to foreign combination of business. In other words, some industries will continue to increase profit performance to higher dependence levels than others. This is because of specific industry or entry barrier conditions (Daniels and Bracket, 1989). According to industrial organization theory, the growth potential of product market in which a firm has business operations exerts a great i n f l u e n c e upon the p e r f o r m a n c e of that firm. Also, elements such as
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262 International Business Review 5,3
competitive structure (degree of market concentration, product differentiation, etc), level of research and development (i.e. technical product differentiation), advertising expenditures (product differentiation due to marketing) and firm size, are given great i m p o r t a n c e as factors d e t e r m i n i n g industries' profitability. Aggregate comparisons may therefore obscure industry-byindustry differences in foreign operating advantages. It is therefore extremely important to go a step further by examining the relationship between multinationality and profitability for sub-groups by industry. However there is not any single firm whose shares of foreign sales were over 60% of its total sales in this study. It may imply that the sample of companies does not overstep the boundary separating optimum from declining returns. From a policy perspective, it is also very important to ascertain the optimum domestic to foreign combination of business. This is because firms have limited resources and managers must take many allocation decisions. Yet managers at present have little empirical and theoretical information to guide them in terms of what is the best ratio of domestic to foreign operations. It is possible, however, to narrow the estimation range of where the optimum ratio lies. In this respect, industry-specific differences must be taken into consideration when deciding the extent to which international operations are appropriate (Daniels and Bracker, 1989). It should be acknowledged, however, that there may be several weaknesses in the methodology and possible biases in the test results because of subjective classification and data pooling. Despite these limitations, the findings lend empirical credence to findings reported in previous studies and provide additional insights. Acknowledgements -- The author is grateful to Dr Robert Read for his many constructive comments. The helpful advice of the editor and two anonymous referees are also gratefully acknowledged.
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The Effect of Multinationality Measures upon the Risk-Return Performance of US Firms Gongming Qian Department of International Business, Faculty of Business Administration, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong Abstract -- This study analyses the effect of a firm's overseas activities upon its risk-return performance for a sample of US firms (including multinational enterprises and domestic firms) by using different multinationality measures. The test results indicate that firms with a greater share of overseas activities have a greater opportunity to achieve a better risk-return performance than those with little foreign involvement. More importantly, for a firm which meets the basic requirement of multinationality (for MNEs as a whole), the number of foreign markets served has a minimal influence on its performance. Copyright © 1996 Elsevier Science Ltd Key Words -- Multinationality, Risk-Return Performance, US Firms.
Introduction There has been an increasing trend in business involvement in overseas markets of the largest industrial firms, especially multinational enterprises (MNEs), from developed countries post World War II. They have been a major and increasingly important influence upon the shape of the international economy. One of the most important focuses in the study of MNEs is the relationship between multinationality (i.e. foreign operations) and its risk-return performance.t It is widely suggested that multinationality has played a Gongming Qian received his Ph.D. from the Management School of Lancaster University, UK, in 1994. He is currently assistant professor in the Department of International Business, Faculty of Business Administration, The Chinese University of Hong Kong, Hong Kong. He has published widely in both national and international journals. tThe study of the financial performance of MNEs can be made either from the same country or from different ones. The former is however, more comparable than the latter. This is because, when the risk-return performance of US MNEs and European counterparts is compared, for example, the results may turn out to be biased. This is because a significant proportion of the European-based MNEs are state-owned. State ownership is often associated with a multiplicity of objectives beyond profit making, such as reaction and maintenance of employment, regional development and the enhancement of the image of state (Haar, 1989). These state-owned MNEs must respond to the social and political goals of the government leaders. They are likely therefore to become an arm of government and vehicle for its current policy objectives ( R u g m a n , 1983). C l e a r l y , these p o l i t i c a l and social goals i n e v i t a b l y c o n f l i c t with considerations of efficiency. The implication is that European MNEs are less efficient than US (Footnote continued on p. 248)
247
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248 International Business Review 5,3
significant role in influencing this performance (Hirsch and Lev, 1971; Cohen, 1972; Hughes, et al., 1975; Wolf, 1977; Buckley, et al., 1978, 1984; Rugman, 1979; 1983; Miller and Pras, 1980; Kumar, 1984; Michel and Shaked, 1986; Buhner, 1987; Grant et al., 1988; Geyikdagi and Geyikdagi, 1989; Morck and Yeung, 1991; Vachani, 1991; Qian, 1994, 1995).~: There are two different measurements (i.e. performance and entropy) to define a firm's foreign operations. The question is whether these different measurement approaches affect the empirical results differently. Nothing however has been done to deal with this important issue. The purpose of this study is therefore two-fold: to test for the differences in this relationship by using these two measurements (the first test is concerned with the performance measure and the second with entropy); to provide additional insight into whether firms with a varying degree of foreign operations perform differently. The performance measure is most commonly used in the empirical study of foreign direct investment (FDI) by international business. It is simple and easy to compute. This is because it recognizes only two different geographic market units (i.e. domestic and foreign ones). Comparatively, the entropy (Continued from p. 247) MNEs as the latter have both higher return and lower risk. In addition, they also differ in terms of home government's tax policy, foreign exchange translation, accounting practice, company experience, working relationship with host-countries, organizational structure, socio-cultural distance (i.e. between home and host cultures), scope of product diversification and legal restrictiveness. Because of these differences in business firms from different countries, relevant problems may arise when such direct comparisons among MNEs from different countries are made. For this reason, there has therefore been a considerable amount of empirical research into the distinguishing characteristics of the very largest firms in any single domestic economy. To capture the effects of state ownership of MNEs on risk-return performance, however, an indirect way of comparison can be made by constructing a dummy variable to represent state ownership (i.e. the national dummy). The statistical test is through regression analysis. The inclusion of the national dummy indicates if the observed differences in mean profit rates of risk of return between, say the European and US MNEs are significant when other plausible explanatory variables are also present. Another strength of comparing the risk-return performance of MNEs and DMCs within the same country directly is for a policy perspective; it can address the growing criticism of MNEs' supposed adverse impact on domestic°investment, employment and exports. For this consideration, it is of interest to examine whether their performance has been inferior compared to that of DMCs. ~:Causality between multinationality and profitability may plausibly run in both directions. This is simply because firms with either higher profits in the past or a good profit prospect in future may have, on the whole, more resources to increase their firm size. Such firms may also have resources at their disposal to allow them to bear risks and operate optimally and to monitor significant production activities in foreign countries by diversifying in both market and product dimensions. More importantly, firms which can always achieve a better risk-return performance generally have enjoyed certain "ownership" advantages over other firms and enabled them to set up international operations. Almost all of the research in this area, however, has focused on the possible effect of multinationality upon a firm's profitability. A further international business study will surely deal with this important issue by empirically examining how the potential growth of profitability can affect a firm's foreign involvement.
249 measure is relatively complicated but more comprehensive. It considers both the number of geographic regions in which a firm is involved and the number of its subsidiaries in each region. The firm sample is reorganized respectively according to both measurement approaches. The first firm sample includes only MNEs and domestic firms while the second firm sample contains not only MNEs and DMCs but also firms which lie between MNEs and DMCs (hereafter referred as the middle firms). This is intended to serve as a further comparison with the previous studies when the middle firms are included. This study uses the theories of foreign direct investment (FDI) and international real asset diversification to explain the effect of a firm's overseas activities upon its risk-return performance.
Firm-specific Advantages and Foreign Direct Investment (FDI) The fundamental assumption associated with FDI is that firms engaging in international production are at a disadvantage compared to local firms. This is because of their unfamiliarity with local market conditions. Operating a subsidiary in a foreign market requires the commitment of resources and attention to both the supply and demand sides of the market. Additional costs (e.g. communication, administration and transportation) are incurred. For FDI to be successful, MNEs must therefore possess certain advantages not available to existing or potential local competitors (Hymer, 1960, 1976; Kindleberger, 1969; Caves, 1971, 1982; Dunning, 1973, 1979; Buckley and Casson, 1976; Hood and Young, 1979; Errunza and Senbet, 1981; Cho, 1985; Yu and Ito, 1988; Kim et al., 1989; Markides and Ittner, 1994). FDI is m o t i v a t e d by m a r k e t i m p e r f e c t i o n s which p e r m i t MNEs to exploit monopolistic advantages in foreign markets. MNEs must have ownership advantages vis-a-vis other firms wishing to supply a similar market. These ownership advantages, largely in the form of intangible assets, represent a range of competitive strengths which are essential to their continued growth and ultimately to their survival (Dunning, 1993; Dunning et al., 1986). Market imperfections may be one or more of several types: in goods markets, including product differentiation; volume economies; marketing skills and administered prices; in factor markets, including proprietary technology, managerial skills, intelligence gathering, operational flexibility and stability, tax arbitrage and discriminatory access to capital; economies of scale internal and external to a firm; and government-imposed market distortions (Leibenstein, 1966; Hirsch and Lev, 1971; Lessard, 1979; Teece, 1980; Chakravarthy and Lorange, 1984; Kogut, 1985; Amit, 1986; Kim et al., 1989; Morck and Yeung, 1991; Mitchell et al., 1993). Such advantages give MNEs an edge over their competitors in similar locations and thus serve to compensate for the additional costs of operating across national boundaries. This discussion suggests that FDI takes place once an MNE has secured internally transferable advantages. These enable it to overcome its lack of knowledge of local conditions and to compete successfully with local firms in host-countries and foreign firms from Third countries. Market imperfections
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250 International Business Review 5,3
created by the existence of an oligopolistic advantage should prevail to motivate MNEs to make FDI. MNEs can exploit market imperfections by minimizing the additional costs and appropriating the full return from their utilization.
International Real Asset Diversification The concept of international corporate diversification has often been linked with risk reduction. It has therefore been argued that the most important function of international diversification is to reduce total risk at the firm level. Risk reduction cannot exceed a certain level within an economy. Corporate diversification within a particular economy is still subject to fluctuations in that economy. Diversification across national boundaries increases the stabilization of profits (see Hughes et al., 1975; Lloyd, 1975; Agmon and Lessard, 1977; Rugman, 1977, 1979; Miller and Pras, 1980; Geyikdagi, 1981; Bettis and Hall, 1982; Fatemi, 1984; Lessard, 1985; Shaked, 1986; Buhner, 1987; Grant, 1987; Amit and Livnat, 1988; Barton, 1988; Geringer et al., 1989; Geyikdagi and Geyikdagi, 1989; Amit and Wernerfelt, 1990; Madura and Whyte, 1990; Morck and Yeung, 1991). International real asset diversification occurs in both product and market dimensions. It allows the application of firm-specific know-how to penetrate prospective foreign markets and facilitates the extension of the business and/or products which the firm knows best. The power of international market diversification lies in the differences (in goods markets) which arise from demand and supply variations between geographical markets. The potential for risk reduction from the diversification of real assets may be significant compared with that of financial asset diversification. This is because there is a relatively low correlation between national industrial production indices relative to financial variables such as interest rates and equity prices (Rugman, 1977). Because product markets are less correlated than financial markets, this suggests that both foreign and home markets may be mutually complementary. MNEs benefit from the low correlation observed in international goods and factor markets and therefore achieve a more stable stream of profits. Consequently, MNEs are viewed as being more able to reduce the risk of their profits relative to DMCs selling most of their products in a single economy. International activities in any one country may be more risky than a comparable investment in a home county. The riskiness of international activities as a whole, however, may not be any higher and may even be lower than the riskiness of domestic investment. MNEs should therefore exhibit a m o r e stable stream o f profits than c o m p a r a b l e firms w h i c h are not internationally diversified. The overall variance of a firm's cash flow will be reduced if the income streams from its various international activities are less than positively correlated. If there were no barriers to international capital flows and if capital markets were fully integrated, investors could diversify their portfolio holdings internationally by themselves and thus eliminate unsystematic risk
251 on a global basis. In such circumstances, there is no need for diversification at the firm level. No systematic advantage could therefore be achieved by owning the shares of an MNE rather than those of a number of DMCs in different countries. Perfect information with no impediments to financial market transactions, however, does not occur in the real world. International capital markets are neither segmented nor integrated but lie somewhere between these two extremes (Aliber, 1970, 1971; Agmon, 1972; Buckley and Casson, 1976; Lessard, 1976; Stehle, 1977; Senback and Beedles, 1980; Caves, 1988; Froot and Stein, 1991; Brewer, 1993). This suggests that there is room for MNEs in the integration of partially-segmented capital markets. The MNE is thus likely to provide diversification opportunities not otherwise available to individual investors or available only at higher costs. Because of the behaviour of business cycles across different countries, MNEs should provide a valuable service through diversified FDI and offer shareholders risk-return opportunities superior to those available to the shareholders of purely DMCs. Because of barriers facing investors in the choice of international portfolio diversification, flows of FDI will be freer than portfolio flows. This means that investors cannot diversify as freely as MNEs. The MNE can therefore be regarded as a vehicle for international diversification. Market performance can be regarded as an effective means of identifying whether the diversification opportunities provided by MNE shares is great. The market should therefore treat the MNE differently from the DMC. This suggests that investors will therefore reward the MNE for going overseas because of the opportunity for earning excess risk-adjusted returns.
Sample Size This study uses a sample of 169 largest US industrial firms on the "Fortune 500 listing". For a firm to be included in the sample, there needs to be performance data for the 10-year period (1981-90).* The time period 1981-90 is employed because this allows short-term influences on firm risk-return to average out. The initial base sample consists of all firms in the "Fortune 500" listing in independent existence over this period. Because the composition of the top *There are two main reasons for the selection of the time period 1981-90 in this study. One is that this research started in late 1990 such that the data were therefore most update at that time. The other is that the time period under study is inversely correlated with the sample size since the longer time period is at the cost of a small sample size. For this reason, both time period and sample size are treated equally. The previous study (Qian, 1994) therefore consists of two parts. In the first part: the 20-year period (1971-90) and 121 finns (including the finns whose shares of foreign involvement lie between MNEs and DMCs) are used; and the 10-year period (1981-90) and 169 finns are used. The two periods of time and their related sample size are employed to prevent unnecessary biases. The present article is based upon the second part of this study. The sample size increased by 40% compared with the first part. From today's point of view, however, the data for 1991-94 are available. The data availability will permit further study in future.
Risk-Return Performance of US Firms
252 International Business Review 5,3
500 firms has changed a great deal over this 10-year period and there were some missing data on many firms, the original sample size was reduced substantially, leaving the present sample of 169 industrial finns (including 57 MNEs and 69 DMCs), for which all of the requisite data for 1981-90 was available.*
The Description of the Variables The two profitability measures employed are return on assets (ROA) and return on equity (ROE). ROA and ROE are often used by managers and external analysts as a measure of the effectiveness and efficiency of top management. The impact of FDI on a firm's performance is more directly reflected in accounting profit than in stock price which measures investor's expectations about future profits. Risk is measured by the standard deviations of both ROA and ROE figures across the 10-year time period. The SD of ROA and SD of ROE are used to measure the extent to which returns vary about the mean over time. They represent a finn's earnings stability or total risk.
Statistical Design Two kinds of statistical tests can generally be used to analyse the risk-return performance of business finns engaging in a varying degree of international activities: paired-difference and regression tests. The differences depend largely upon the object of study.t This study examines the risk-return performance of US MNEs and DMCs by using a paired difference test. It is
*The relationship between sample size and time period is inversely related. This is because with more years included, the composition of the firms surveyed varied. Originally, 258 firms were selected which satisfied the conditions of multinationality and domesticity. This sample, however, is based upon a simple calculation from discrete time periods. The data for many firms in the study are not continuous so that the longer time period reduces the sample size. It is necessary therefore, to make some adjustments to the original data base. This involves the exclusion of several MNEs and DMCs from the original sample base because of the unavailability of data needed to construct the relevant variables. 57 MNEs and 69 DMCs were the final sampled firms in this study. These firms were in independent existence over 10-year time period (1981-90), The principal reasons for their adjustments are as follows: -- Changed foreign involvement for both MNEs and DMCs; -- Figures no longer published; -- Merged into another firm; -- No longer classified as an industrial; -- Acquired by another firm; -- Liquidated after business failures; -- No published figures in certain years. After careful examination of these problems, the original sample size was reduced to the present sample of 126. t F o r comparing the risk-return performance for different types of firms, paired-difference tests are the most effective. This is because the variable of interest is the difference between the values of the observations rather than the degree of relationship between the observations themselves. Paired-difference tests are therefore most applicable to the present study. By contrast, statistical regression is the most desirable method to test the relationship between the (Footnote continued on p. 253)
253 employed to find statistically significant differences between two population means (i.e. MNEs and DMCs) when the data are obtained from related samples. Since market measures (e.g. ROA and ROE) are the chief concern, a value in one sample (e.g. the MNE sample) is paired with a corresponding value in the other (e.g. the DMC sample) according to these c o m m o n denominators (market measures). To establish whether any differences exist between the two related samples, the individual values for each example must be obtained. The significance of this difference can be tested using t-statistics to derive a confidence interval for paired samples. The t-test stresses the average (or mean) of the two (or more) samples. Because the size of the sample is not small (size > 15), parametric assumptions underlying the test hold.
The Performance Measure of Foreign Involvement The performance measure has an accounting/financial appeal because it defines a firm as multinational according to performance characteristics. Much of the research on MNEs focuses upon their share of foreign sales, o p e r a t i n g p r o f i t s , n u m b e r of e m p l o y e e s a b r o a d , f o r e i g n assets or combinations of these variables. For example, the ratio of foreign sales to multinational total sales is used as the measure of international geographic diversification (e.g. Kumar, 1984; Grant et al., 1988). Performance indicators of foreign involvement, however, require thresholds in the extent or size of sales, earnings, assets and e m p l o y m e n t overseas to be established for definitional purposes. The multinational content of all firms varies so that any threshold is likely to be somewhat arbitrary. A firm's foreign sales as a percentage of its total sales, for example, is widely used to determine MNEs and DMCs. The thresholds for MNEs in the empirical literature range from 20% (Shaked, 1986), 25% (Stich, 971), 28% (Kohers, 1975) and 35% (Geyikdagi and Geyikdagi, 1989). It is evident that there is no common ground for defining the measurement threshold for multinationality. The distinction between MNEs and DMCs is based upon their degree of foreign involvement. This is because DMCs are also likely to engage in foreign operations, including those with little previous foreign involvement. Because any threshold is likely to be arbitrary, it can be argued that the above measures are either too high or too low and are therefore not ideal choices. If the threshold of foreign involvement is set too low, the classification of firms becomes difficult and, consequently, most firms can become MNEs. It is (Continued from p. 252) risk-return performance of business firms (taken as the dependent variables) and their determinants (i.e. independent variables). The number of independent variables, however, depend chiefly upon a multiplicity of explanatory factors affecting the respective dependent variable. One of the chief concerns in the previous study (Qian, 1994), for example, is whether there is any effect of a firm's foreign activities upon risk-return performance. The first regression model is mainly concerned with the factors affecting the return performance in profits while the second is concerned with the factors affecting the risk performance.
Risk-Return Performance of US Firms
254 International Business
Review 5,3
also important to avoid eliminating a large number of "genuine" MNEs because the threshold of foreign involvement is set too high. The sample size of MNEs is reduced and the test results are biased. To prevent the occurrence of these two extremes therefore, a threshold of 30% or more of foreign sales is selected as a representative of MNEs (Qian, 1994, 1995). A criterion must also be established for measuring DMCs. Most studies regard d o m e s t i c - o r i e n t e d firms as those with 10% or less of foreign involvement (e.g. sales, earnings, assets and employment). This is rather low because most of the largest "Fortune 500" firms are in the process of internationalization. If the threshold for measuring foreign involvement is set too low, this process may not be fully reflected. The differences in measuring f o r e i g n i n v o l v e m e n t of M N E s and D M C s are s m a l l e r than b e f o r e . Accordingly, any firm which has 15% or less of its foreign operations during a certain year is defined as a DMC (Qian, 1994, 1995). The m i n i m u m difference between MNEs and DMCs is therefore 15% points.
Results of the Return and Risk by the Performance Measure The main concern here is whether any difference exists over the whole time period when the complete sample of MNEs and DMCs is considered. The null hypothesis is that MNEs and DMCs have equal risk-return performance and the alternative hypothesis is that their risk-return performance is significantly different. The results on the risk-return performance between MNEs and DMCs for the 1981-90 period are shown in Table 1. MNEs appear to have a better risk-return performance than DMCs for each measure. The difference between the two groups is statistically significant at the 5% level and, in some sub-periods, at the 1% level. The null hypothesis that MNEs and DMCs have equal risk-return performance can therefore be rejected. The results indicate that the MNE sample outperforms the DMC sample in
Variable
Table 1. Differencebetween MNEs and DMCs 1981-1990. All Industries
ROA MNEs DMCs SD of ROA MNEs DMCs ROE MNEs DMCs SD of ROE MNEs DMCs
Mean
df
t-values
Probabilities
95% Confidence Intervalfor Mean
110
5.20
0.0000
1-89 to 4.21
87
-2.95
0.0040
-2.00 to ~).39
121
4.93
0.0000
3.23 to 7-55
87
-3.04
0.0031
-5.40 to -1.1
8.15 5-10 2-47 3.66 16.51 11.10 5.33 8.59
Note: all t-values are significantat 5% or higher.
255 terms of a higher rate of return while simultaneously incurring less risk. Because the findings are derived from activities over the last 10 years, economic fluctuations during this period are likely to have a minimal effect upon the MNE performance. The results suggest that MNEs may possess certain competitive advantages or assets (tangible or intangible) unavailable to rivals without incurring substantial cost and uncertainty (Kogut, 1985; Porter, 1985). If this is the case, the higher levels of profitability for MNEs can be explained by their being a monopolistic response to international market imperfections. Furthermore, while activities in any one country are risky, the risk of international operations as a whole may not be any higher (and may be even lower) than that of domestic investment.
Risk-Return Performance of US Firms
Results of the Return and Risk with Time Segments MNEs and DMCs may also perform differently in different time periods. It is therefore important to examine the impact of economic cycles or other economic factors on their risk-return performance. The complete time period (1981-90) is divided into six segments. These data are continuous and therefore prevent information loss. The results of the risk-return performance between MNEs and DMCs for six time intervals are shown in Table 2. A superior risk-return performance is still found to exist for MNEs. The only exceptions are several insignificant differences in the SD of ROA and SD of ROE for three of the six time Variable ROA MNEs DMCs t-values probabilities
1981-85
1982-86
1983-87
1984-88
1985-89
1986-90
7"82 5'20 4'35 0.0000
7"67 4-90 4-52 0.0000
7"87 4'97 5'00 0.0000
8' 10 5"01 4"84 0.0000
8"26 4"85 5"29 0'0000
8-48 4'65 5'48 0'0000
SD of ROA MNEs DMCs t-values probabilities
1.86 2.34 -1-81 0-073
1.79 2.09 -1'16" 0.25
1.98 2-29 -1-17" 0-24
2.15 3.32 -2'18 0.032
2.21 3.34 -2"09 0-039
2.15 3"47 -2-38 0.020
ROE MNEs DMCs t-values probabilities
14-55 11-17 3" 15 0-0021
14.61 10.29 3.66 0-0004
15-06 10-80 4-13 0-0001
16-94 11.47 4.25 0"0000
17.69 11-52 4-78 0.0000
18 "48 11-24 4-90 0"0000
SD of ROE MNEs DMCs t-values probabilities
3"75 5-37 -2"30 0.023
3.81 4.51 -1'12" 0.26
4-42 5-07 -1-03" 0.30
4'72 7"60 -2"21 0.030
4.92 7"34 -2-02 0.047
4"45 8'60 -2'89 0'0050
*Insignificant.
Table 2. Difference Between MNEs & DMCs by Time Segments
256 International Business Review 5,3
intervals. When the time factor is considered therefore, MNEs are still likely to achieve a higher return and a lower overall risk than DMCs. The results continue to suggest a better risk-return performance for the MNE sample in spite of the differences for some of the risk measures being insignificant. There is therefore considerable support for the general conclusions of earlier cross-sectional studies. MNEs enjoy locational advantages derived from d i f f e r e n c e s in goods markets in relation to international demand and supply variations. Geographic variations in factor markets result in differences in the rates of return on foreign capital. International operations offer the opportunity to exhaust economies of scale more fully in a large overseas market.
The Entropy Measures of Foreign Involvement In the performance approach, the ratio of a firm's foreign sales, including e x p o r t sales, to its total sales is used to r e p r e s e n t a f i r m ' s f o r e i g n involvement. This is most commonly used in the measurement of a firm's multinationality (e.g. Wolf, 1975, 1977; Rugman, 1979). Even though these studies have recognized two different geographic market units, domestic (usually the US) and foreign (Rest of World), their measures do not truly reflect the extent of international market diversification. This is because they fail to reflect the multiplicity of foreign markets served by firms (Buhner, 1987; Kim et al., 1989; Vachani, 1991). A bias is likely to occur because the measures do not distinguish between firms having 30% of their sales in one country and a similar amount in several countries. According to the previous definitions, any firm that has 30% of foreign involvement is classified as a MNE. A significant difference in the risk-return performance of two firms may be expected because of their differential involvement in particular countries or geographic areas. Several studies attempt to correct for this deficiency. The number of foreign countries in which a firm operates can be counted to capture the multiplicity of foreign markets (Cohen, 1972; Kim, 1989; Vachani, 1991). This is based upon the relative shares of sales in each foreign market. Entropy measures can be used (Hirsch and Lev, 1971; Miller and Pras, 1980; Kim, 1989; Vachani, 1991). These are based upon the ratio of a firm's holdings (the number of subsidiaries) in a region to its global holdings (the total number of its foreign subsidiaries). Accordingly, entropy measures reflect, not only the multiplicity of foreign markets, but also the equality or inequality of the size of foreign operations. More importantly, entropy measures not only quantify the dispersion of a firm's activities across dissimilar geographic regions but also measure the extent to which a firm's activities are spread across similar foreign countries within regions (Vachani, 1991). The similarities include physical and cultural proximity and level of economic development across the countries in which it operates. An increased geographic scope of operation may increase a firm's ability to share or coordinate its international activities. Such benefits include economies of scale, scope and experience (Kogut, 1985; Porter, 1985, 1987).
257 There is a growing similarity of countries in terms of infrastructure, distribution channels and marketing. At the same time, technology is playing an integrating role by permitting easier coordination of activities in different countries. International market diversification also offers the opportunity to exhaust economies of scale within a firm. A broad area of operations, however, entails costs. It is suggested that institutional and cultural factors erect formidable barriers to the transfer of competitive advantage between countries (Kogut, 1985). Geographically diverse operations may limit a firm's efforts to tailor its activities to serve a particular target segment, geographic area or industry. This may frustrate attempts to achieve lower costs or a differentiated position in the market (Porter, 1985). The possible influence of regional differences and increased costs of geographical coordination may reduce the potential benefits associated with increased scope. For the entropy measure, the scope of FDI is determined by reference to the Directory of American Firms Operating in Foreign Countries. In addition, Who Owns Whom (North America) and Moody's International Directory of Corporate Affiliations also provide useful information on the countries in which US firms are involved. These manuals have been consulted to establish the extent of overseas operations by the sampled firms.
Results of the Return and Risk by the Entropy Measure Diversification through FDI across national boundaries should improve investors' risk-return opportunities when economic activity in different countries is less than perfectly correlated. International market diversification is a vehicle for realizing a better risk-return performance. This is based upon the explanation of international real asset diversification theory. This conclusion is fully supported by the previous empirical results. These results are, h o w e v e r , o b t a i n e d w i t h o u t r e g a r d i n g the possible g e o g r a p h i c diversification effect. Index of International Market Diversification International diversification is calculated as the entropy of each firm's relative country (or regional) holdings: D = Silog¢ (1/Si)
(1)
Where Si is the ratio of a firm's holdings (number of subsidiaries) in country or region i to the total number of foreign subsidiaries. According to the theories of market imperfections and transaction costs, a firm's ability to earn profits from its intangible assets and to minimize its costs of managing is affected by similarities and differences between the countries in which it operates (Vachani, 1991). The relevant geographic unit is one in which patterns of general economic conditions, fluctuations in demand and external restrictions have close similarities. Six g e o g r a p h i c r e g i o n s are used to m e a s u r e i n t e r n a t i o n a l m a r k e t
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258 International Business Review 5,3
diversification by a large number of "Fortune 500" firms. These market areas are the EU; EFTA; North America; Other Developed Countries; Eastern Europe, China and Common Market Associates; and other LDCs (see Worm Bank, 1987). More pronounced differences are expected to occur between rather than within each geographic region. These six international regions provide the basis for geographic specification. Each firm is assigned a value in terms of both the number of geographic regions in which it is involved and the number of its subsidiaries in each region.
The International Market Diversification Hypotheses The criteria for defining high and low international market diversification are based upon entropy measure (Miller and Pras, 1980). If the composite index (D) is not less than 1"3, a firm is regarded as a high international market diversifier (HI). Comparatively, if the composite index is not more than 0.7, it is treated as a low international market diversifier (LI). In addition, the group between high and low global diversification are also included; "medium international market diversifier" (MI) with a composite index (D) is between 0.7-1.3. The theoretical arguments lead to the proposition that the higher the international market diversification of a firm, the better its chances of obtaining a superior risk-return performance. It is possible therefore to make the following hypotheses:
Hypothesis la: On average, the profitability of HI is greater than that of both MI and LI diversification. Hypothesis lb: On average, the profitability of MI is greater than that of LI. Hypothesis 2a: On average, the profit stability of HI is greater than that of both MI and LI. Hypothesis 2b: On average, the profit stability of MI is greater than that of LI.
The Extent of Global Diversification by MNEs A firm may be classified as an MNE even if it is not as diversified as another MNE which has the same ratio of multinationality. It is therefore imprecise to depend solely upon such a ratio to differentiate between MNEs and DMCs. Furthermore, two firms, although belonging to the MNE category, are still influenced by their actual geographic diversification.To investigate these influences further, it is necessary to compare the risk-return performance between MNEs. Again, all MNEs in the sample are divided into three subgroups below: Group 1: The Group 2: The and Group 3: The 1.3.
ratio of international market diversification is less than 1.0. ratio of international market diversification is between 1.0 1-3. ratio of international market diversification is greater than
259 The t h e o r e t i c a l a r g u m e n t s lead to the p r o p o s i t i o n that the h i g h e r international market diversification an MNE, the better its chance of obtaining a superior risk-return performance.
Hypothesis 3:
Risk-Return Performance of US Firms
It is hypothesized that the risk-return performance of Group 3 is greater than that of both Group 1 and Group 2.
Results of the Return and Risk by Entropy Measure The empirical tests are performed on the basis of the entropy measure. The principal results and their implications are discussed below. The Extent of Global Diversification This is concerned with a comparison of the risk-return performance for finns with a varying degree of international market diversification. Table 3 reports the results of such comparison. Hypotheses la, lb, 2a and 2b are fully supported by the empirical tests. Both the profitability and risk measures are statistically significant at the 10% level. The results also indicate that the difference between any MI-LI pair is not statistically significant except for ROA. This clearly suggests that a firm must meet minimum requirements of international market diversification before it is able to perform differently from its counterparts. Global Diversification by MNEs This is concerned with a comparison of risk-return performance between MNEs which have differing extents of international market diversification (i.e. testing Hypothesis 3). Table 4 provides the results of such comparison.
Pairwise comparison
Difference
t-statistic
Significance
ROA
HI-LI HI-MI MI-LI
2.36 0.98 1.38
3.74 1'65 2.30
0.0003 0" 1000 0-0240
SD of ROA
HI-LI HI-MI MI-LI
-0.87 -0.45 -0.42
1.68 1.26 0-73
0-0990 0-2100 0.4700
ROE
HI-LI HI-MI MI-LI
2.36 0'95 1'41
1.91 0.84 1"04
0.0600 0.4000 0'3000
SD of ROE
HI-LI HI-MI MI-LI
-2.06 ~3-56 -1.50
1"66 0-53 1-09
0" 1000 0-6000 0-2800
Variable
Notes: HI: high international market diversification. MI: medium international diversification. LI: low international diversification.
Table 3. Risk-Return Performance and Global Diversification
260 International Business Review 5,3
Table 4. Risk-Return Performance and MNE Global Diversification
Pairwise comparison
Difference
t-statistic
Significance
ROA
HMD-LMD HMD-MMD MMD-LMD
1"57 0"58 0"99
1"64 0'51 0"96
0' 1100 0"6200 0"3500
SD of ROA
HMD-LMD HMD-MMD MMD-LMD
0'289 0"390 ~). 101
0"69 1"22 0"25
0"5000 0"2300 0'8100
ROE
HMD-LMD HMD-MMD MMD-LMD
0"53 -1 "58 2"11
0"32 0"75 1"01
0"7500 0"4600 0'3300
SD of ROE
HMD-LMD HMD-MMD MMD-LMD
1"01 0'92 0'09
0'96 1' 10 0'09
0"3600 0.2800 0"9300
Variable
Notes: HMD: high international market diversification by MNEs. MMD: medium international market diversification by MNEs. LMD: low international market diversification by MNEs.
As indicated in Table 4, none of the differences in the r i s k - r e t u r n performance is observed for any of the three pairs. Hypothesis 3 can therefore be rejected. This implies that any firm which belongs to the multinational category based upon the criterion of multinationality (the ratio of foreign sales to its total sales) can provide a similar r i s k - r e t u r n p e r f o r m a n c e independent of the number of countries or geographic areas in which it operates. The multinationality variable therefore can still be used to measure a firm's international diversification. This result provides strong support for the previous empirical results.
Summary and Conclusions MNEs are believed to have ownership advantages. The advantages to firms from international activities include cost savings, access to technical and other resources, tax deferment or reduction, sales expansion and the extension of products' life cycles. They have exploited proprietary intangible assets by selecting those foreign locations which minimize transaction costs. A broad g e o g r a p h i c scope of international operations may yield c o m p e t i t i v e advantages by permitting a firm to exploit the benefits of performing more activities internally (Rugman, 1981). On a priori grounds, international market diversification enables the use of firm-specific know-how to penetrate prospective foreign markets in a firm's main lines of business. Increased geographic scope of operations may increase a firm's ability to share or coordinate activities of different geographic areas. Such benefits include economies of scale, scope and experience. The growing similarity of countries and the integrating role of technology are extremely important for international market diversification (Porter, 1987). This is because of the
261 availability of infrastructure, distribution channels and marketing. Information technology already permits easier coordination of activities in different countries. Corporate diversification within a particular e c o n o m y is subject to fluctuations in that economy. FDI is therefore an important means for a firm to maximize its value by reducing its risk through diversifying its portfolio of investments. Because of the behaviour of business cycles across different countries, MNEs are able to provide a valuable service through diversified FDI. The superior r i s k - r e t u r n p e r f o r m a n c e of a firm can therefore be explained by its international activities. The results have indicated that the use of different measurement approaches do not alter the conclusion that firms with a greater share of overseas activities have a greater opportunity to achieve a better risk-return performance than those with little foreign involvement. It is reasonable to conclude that the increasing extent of foreign operations is associated with higher profits and lower risks. In other words, multinationality is positively related to profitability and inversely to risk. Because FDI by MNEs help to diversify risks, investors (existing and potential) expect a more stable rate of return. Investors should therefore reward MNEs for engaging in international activity by paying a premium for MNE shares (Qian, 1994, 1995). For MNEs as a whole, no significant difference in risk-return performance is found to exist. This suggests that for a firm which meets the basic requirements of multinationality (foreign sales as percentage of its total sales), the number of foreign markets served has a minimal influence on its economic performance. In other words, there is no difference in the risk-return performance whenever the performance or the entropy measures have been used to define MNEs. The use of both the measures cannot change the fact that MNEs are able to achieve a better risk-return performance. The results do not necessarily mean that a firm, by increasing the extent of foreign involvement, can achieve the possible highest rates of return. From a t h e o r e t i c a l point o f view, there s h o u l d be an o p t i m a l level o f internationalization. The advantages of "more is better" should hold only until a firm reaches some optimum combination of domestic to foreign operations. Otherwise firms would continue to improve their performance until they have no domestic operations at all. This is unrealistic. The main reasons have already been explained. Firms which exceeded this optimum would be expected to show evidence of declining performance and a probable resultant downturn in their portion of foreign to total operations (Daniels and Bracker, 1989). Different industries may also have different optimum domestic to foreign combination of business. In other words, some industries will continue to increase profit performance to higher dependence levels than others. This is because of specific industry or entry barrier conditions (Daniels and Bracket, 1989). According to industrial organization theory, the growth potential of product market in which a firm has business operations exerts a great i n f l u e n c e upon the p e r f o r m a n c e of that firm. Also, elements such as
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262 International Business Review 5,3
competitive structure (degree of market concentration, product differentiation, etc), level of research and development (i.e. technical product differentiation), advertising expenditures (product differentiation due to marketing) and firm size, are given great i m p o r t a n c e as factors d e t e r m i n i n g industries' profitability. Aggregate comparisons may therefore obscure industry-byindustry differences in foreign operating advantages. It is therefore extremely important to go a step further by examining the relationship between multinationality and profitability for sub-groups by industry. However there is not any single firm whose shares of foreign sales were over 60% of its total sales in this study. It may imply that the sample of companies does not overstep the boundary separating optimum from declining returns. From a policy perspective, it is also very important to ascertain the optimum domestic to foreign combination of business. This is because firms have limited resources and managers must take many allocation decisions. Yet managers at present have little empirical and theoretical information to guide them in terms of what is the best ratio of domestic to foreign operations. It is possible, however, to narrow the estimation range of where the optimum ratio lies. In this respect, industry-specific differences must be taken into consideration when deciding the extent to which international operations are appropriate (Daniels and Bracker, 1989). It should be acknowledged, however, that there may be several weaknesses in the methodology and possible biases in the test results because of subjective classification and data pooling. Despite these limitations, the findings lend empirical credence to findings reported in previous studies and provide additional insights. Acknowledgements -- The author is grateful to Dr Robert Read for his many constructive comments. The helpful advice of the editor and two anonymous referees are also gratefully acknowledged.
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