The effect of product diversification strategies on the relationship between international diversification and firm performance

Journal of World Business 42 (2007) 61–79 www.socscinet.com/bam/jwb

The effect of product diversification strategies on the relationship between international diversification and firm performance Shao-Chi Chang a,*, Chi-Feng Wang a,b a

Institute of International Business, National Cheng Kung University, No. 1, University Road, 701 Tainan, Taiwan b Department of International Trade, Cheng Shiu University, Taiwan

Abstract Previous studies have provided mixed evidence on the interaction effect of product and international diversification on firm performance. This study extends this stream of research by investigating the differential impacts of product diversification strategies on the relationship between international diversification and firm performance. We find that while related product diversification positively influences the performance of multinational firms, unrelated product diversification negatively moderates the international diversification–performance relationship. The evidence is robust for different models of international diversification and firm performance, and holds for firms in both the service and manufacturing industries. Our findings highlight the importance of distinguishing different product diversification strategies, and provide a potential explanation for prior mixed evidence. # 2006 Elsevier Inc. All rights reserved.

1. Introduction As an increasing number of firms expand into global markets, the impact of international diversification has generated quite an interest among researchers (e.g., Capar & Kotabe, 2003; Contractor, Kundu, & Hsu, 2003; Gomes & Ramaswamy, 1999; Hitt, Hoskinsson, & Kim, 1997; Lu & Beamish, 2004). Since global diversification encompasses dimensions of geographic as well as product markets (Kim, Hwang, & Burgers, 1989), many multinational firms have also diversified their products. Prior literatures have argued that the strategy of product diversification has important influences on the performance of multinational firms (Geringer, Beamish, & da Costa, 1989; Hitt et al., 1997; Kim et al., 1989). For example, the experience of

* Corresponding author. Tel.: +886 6 2757575 53506. E-mail addresses: [email protected] (S.-C. Chang), [email protected] (C.-F. Wang). 1090-9516/$ – see front matter # 2006 Elsevier Inc. All rights reserved. doi:10.1016/j.jwb.2006.11.002

product diversification enables managers to better handle the diversity and complexity created from international diversification. Diversified firms may replicate the structures and capabilities established in their existing operations to cross-border expansion in order to reduce potential transaction costs. Furthermore, economies of scale and scope arising from the interdependencies across divisions bring firms greater opportunities to achieve synergy of product diversity as they expand into global markets. Nevertheless, the empirical evidence on the interaction effect between product and international diversification has been mixed. Hitt et al. (1997) found that product diversification positively enhances the performance of internationally diversified firms. In contrast, Geringer, Tallman, and Olsen (2000) and Tallman and Li (1996) found no significant evidence for an interactive effect between international and product diversification. Furthermore, Kim et al. (1989) found that the effect of product diversification is contingent upon the extent of international diversification. They

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found that product diversification matters only for firms with a low degree of international diversification, but has no effect on the performance of those with a high degree of international diversification. This study is motivated by these conflicting results, which could be due to two causes. First, although the importance of product diversification strategy on corporate performance has been well documented, most studies on the interaction effect of product and international diversity did not consider the differential effects of product diversification strategies. Two distinct types of product diversification strategy have been identified in the literature. Related product diversification refers to the involvement into product markets which are related to a firm’s core resource, and unrelated product diversification involves expansion into product markets that are not related to a firm’s core resource (Rumelt, 1974). Prior evidence on the performance of product diversification strategies generally found that the economies of scale and scope from leveraging strategic resources across related products contribute to superior performance. Extensive diversification into unrelated areas that do not capitalize on strategic resources does not necessarily add to rent (Geringer et al., 2000; Grant, Jammine, & Thomas, 1988; Tallman & Li, 1996). Kim et al. (1989) argued that the strategies of resource deployment related to the scope and relatedness of products sold are critical for the performance of multinational corporations. To the extent that diversifications into related products have different performance impacts from those into unrelated products, failure to take product diversification strategies into consideration could lead to biased inferences about the moderating effect of product diversification on the performance of internationality. Second, the conflicting findings may be related to the model specifications on the relationship between internationality and firm performance. A review of the literature shows that various models of international diversity and performance have been proposed, ranging from a linear relationship (Delios & Beamish, 1999; Grant et al., 1988; Kim & Lyn, 1987), curvilinear relationship (Gomes & Ramaswamy, 1999; Hitt et al., 1997) to horizontal-S relationship (Contractor et al., 2003; Lu & Beamish, 2004). Conflicting results may occur if the empirical results are sensitive to the underlying international diversity–performance models. For example, different results may occur when the sample clusters on parts of the underlying relationship between international diversification and firm performance. Compounding this issue, Capar and Kotabe (2003) suggested that the relationship between international

diversification and performance might be industryspecific. They argued that the model for manufacturing firms is not necessarily appropriate for service firms. This study attempts to examine the moderating effect of product diversification on the relationship between international diversification and firm performance by taking product diversification strategies into account. To address this issue, we start by synthesizing prior theories of product diversification and explore how related product diversification differs from unrelated diversification in its influence on the performance of multinational firms. We argue that the moderating effect of product diversification is related to the costs and benefits that vary depending on the contents of product diversification. By analyzing five key effects through which the product diversification strategy is suggested to impact firm performance, we provide the hypothesis that diversification into related business segments is expected to have a more favorable effect on the relationship between international diversification and performance than diversification into unrelated segments. We test this hypothesis based on a sample of U.S. firms during the period of 1996–2002. The hypothesis is tested against models of linear, inverted-U and horizontal-S relationships between internationality and performance to see if our hypothesis holds under different specifications. Furthermore, to test if the results are sensitive to the industry-specific effect, we test the hypothesis against sub-samples of firms in service and manufacturing industries. The results show that the product diversification strategy plays an important role in moderating the relationship between international diversification and performance. We find that when different product diversification strategies are not distinguished in the analysis, the interaction effect of overall product diversity is statistically insignificant. When considering the strategy of product diversification, we find related product diversification has a strong positive moderating effect on the performance of internationally diversified firms. In a sharp contrast, the interaction effect of unrelated product is significantly negative. The results hold for different models of international diversification and firm performance, and are robust in both manufacturing and service sub-samples. The empirical findings strongly indicate that different types of product diversification lead to a systematically different impact on corporate performance when firms expand into global markets. Our evidence suggests that failing to take account of the product diversification strategy (e.g., Kim et al., 1989) could have contributed to prior inconsistent empirical findings.

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The remainder of this paper is organized as follows. Section 2 provides the theoretical background and the hypothesis. Section 3 introduces the sample and methodology. The empirical results are in Section 4. Finally, Section 5 provides a review of this study along with a discussion of its limitations and possible further directions of inquiry. 2. Theoretical background and the hypothesis In this section, we review various theoretical domains to identify the benefits and costs of product diversification on the performance of multinational firms. Based on the arguments derived from various theoretical bases, we then explore how the joint effect of product and international diversification depends on the product diversification strategy. 2.1. Interaction effects of product and international diversification The literature suggests that product diversification impacts the performance of multinational firms through various channels. First, experience learned from managing product diversification helps build capabilities in managing international diversification activities (Hitt et al., 1997). For example, in order to achieve a higher performance, product diversifiers often use sophisticated policies and mechanisms to promote cooperation or produce competition among divisions (Hill, Hitt, & Hoskisson, 1992). Firms learn from the success and mistakes of past collective experience (Teece, Pisano, & Shuen, 1997), and they can apply these structural mechanisms in dealing with diversified activities to facilitate transactions across geographic markets and reduce costs and time in the decisionmaking process (Kogut & Zander, 1992). Second, there are greater opportunities to achieve synergies as product-diversified firms expand into multiple regional markets. For instance, prospective markets offered by foreign operations provide product diversifiers with better opportunities to gain from the economies of scope and scale when they are also internationally diversified (Buhner, 1987). In addition, enhanced efficiency in resources allocation through multinational networks gives product-diversified firms opportunities to exploit the imperfection in factor markets (Porter, 1985). The global network also provides product-diversified firms with greater bargaining power and competitive advantages because of the greater sources of input and increased quantity of output (Kogut, 1984).

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Despite the potential advantages, implementing both dimensions of diversification may be detrimental to firm performance. One of the potential costs comes from the impact on the internal control mechanism. As firms increase their level of international diversification, it takes a greater amount of integration for top managers to understand the information that each subsidiary confronts in their diverse markets. When these firms are diversified in product markets as well, the problem of information asymmetry can be greatly magnified to the extent that it becomes too costly for executives to have an adequate understanding of varied subunits. In response, corporate managers may shift the performance evaluation criteria from the execution of strategic goals to the summary of financial measures. Consequently, the internal control mechanism shifts away from strategic controls to financial controls (Hoskisson & Hitt, 1988). This in turn results in suboptimal compensation contracts, which encourage activities with more certain and immediate contributions to earnings. Prior studies demonstrated that longterm investments, which facilitate innovation and productivity growth of a firm, such as R&D expenditures, are, therefore, likely to be sacrificed (Baysinger & Hoskisson, 1989; Delios & Beamish, 1999). Second, diversification may be costly for firms to adjust the unfitness between corporate internal settings and external environment. As firms diversify, their existing structures, systems, and internal resource schemes may at some point fail to fit the new competitive environment (Ruigrok & Wagner, 2003). When product-diversified firms also expand internationally, differences in government regulations, infrastructures, and currency fluctuations across countries heighten this discord between internal resources and external contexts. To avoid the disadvantages of overexpansion, firms are compelled to reconfigure their internal systems. Nevertheless, over-commitment of time and resources to frequent organizational restructurings may put an additional workload on management that diverts attention from the core business. The final cost of diversification comes from the increasing need for coordination and governance created by diversity. Hitt et al. (1997) argued that as the number of foreign transactions increases, difficulties in communication and coordination between headquarters and divisional managers could increase. When these firms are also engaged in manufacturing different types of products, the amount of task interdependence between differentiated subunits becomes greater, and the organizational structures tend to be more complex. This implies that both the information processing

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demand and costs of coordination will rise rapidly to such an extent that it may exceed the managerial capability (Franko, 2004; Tallman & Li, 1996). 2.2. Product diversification strategy: related versus unrelated diversification Previous studies have suggested that diversification strategy matters in corporate performance. From various theoretical perspectives, related diversification is found to be fundamentally different from unrelated diversification (e.g., Jones & Hill, 1988; Kim et al., 1989; Palepu, 1985; Rumelt, 1974). Building on the theories related to product diversification, we identify five key factors through which the product diversification strategy has important impacts on the performance of international diversification. These five effects are inter-division knowledge learning, synergy, internal control mechanism, adjustment of internal settings with external environments and governance costs. We argue that although internationally diversified firms may be affected by product diversification, the influences on the above five factors may not be the same for different product diversification strategies. Inter-division knowledge learning Researchers of the knowledge-based view (Grant, 1996; Simonin, 1999) and organizational learning theory (Ghoshal, 1987; Kogut & Zander, 1992) emphasize the importance of knowledge relatedness in successful learning. They argue that significant differences in basic knowledge and skills among business units greatly impede learning. If they have a similar background, it is less costly for units in related diversified firms to establish shared understanding about the skills and capabilities possessed by other divisions. This common knowledge in turn permits effective learning across business units (Grant, 1996). In addition, according to Simonin (1999), a well-developed core competence serves as a good launch point for new services, since cumulative experience facilitates familiarity and comfort with new information. Therefore, when related diversifiers implement international expansion, they are expected to be in a better position to rapidly replicate the capabilities built through interdivisional knowledge sharing to global markets. Despite the importance of business relatedness in knowledge sharing advocated in prior studies, an alternative argument suggests that diversity among business units can create greater value of learning (Inkpen, 2000). This is because unrelated businesses

usually have potential new knowledge that is outside the scope of a specific unit, and thus the learning opportunity is enhanced. However, other studies have shown that differences among individual segments may not guarantee successful learning (Bowman & Helfat, 2001; Chang & Singh, 2000; Szulanski & Winter, 2002). For example, technological knowledge and skills are often tacit in nature and are highly embedded in the organizational structure. To fully acquire the knowledge, the receiving units not only need to have similar technological backgrounds, they also have to possess the same structures of communication channels, information transactions and application routines as the transferring units. As a result, knowledge sharing can be difficult when the divisions are technologically and organizationally dissimilar (Bowman & Helfat, 2001; Chang & Singh, 2000). Similarly, Zahra and George (2002) distinguished between potential and realized absorptive capacity. They argued that while knowledge diversity may increase a firm’s potential absorptive capacity by providing enhanced learning opportunities, knowledge similarity could increase a firm’s realized absorptive capacity by increasing the likelihood that learning will actually occur (Cohen & Levinthal, 1990; Lane & Lubatkin, 1998).1 Once the product-diversified firms expand into global markets, the diverse markets accompanied by international diversification will only add to the difficulty of transferring knowledge and cross-unit learning. Therefore, we expect that related diversifiers stand in better positions to leverage their capabilities for foreign expansion and to create greater gains than unrelated diversifiers. Synergy Synergy means that for two outputs, X1 and X2, the value created by their joint production is greater than the value created if they are produced separately (Hill et al., 1992). We expect that synergy is likely to arise in multinational firms accompanied by both related and unrelated product diversification strategies. From the resource-based view, as firms diversify within the scope of their resources and capabilities, they obtain economies of scale and scope by leveraging their current strategic resources across business units in utilizing common production facilities, distribution channels, or even brand names (Pennings, Barkema, & Douma, 1994). In this way, related diversifiers create 1

We thank the anonymous reviewer for this comment.

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synergy from utilizing the same amounts of inputs to a higher quantity of outputs, and improving their operating efficiency by lowering their average costs. When these firms are also internationally diversified, the enlarged geographic scope provides greater opportunities to extend the reach of their competencies to gain synergy from shared fixed assets (Hitt et al., 1997). Firms integrating international diversification and unrelated product diversification strategies may also obtain unique and inimitable synergy. Unrelated diversifiers may achieve synergy of economies of scope by sharing marketing and technological information, or transferring managerial competencies between units (Markides & Williamson, 1996; Robins & Wiersema, 1995). For example, economic benefits are derived by the Citizen Watch Company Ltd. by utilizing a common set of advanced technologies to produce diversified products, which include watches, printers, floppy disk drives, liquid crystal color TVs, small portable PCs, and robots (Markides & Williamson, 1996). As unrelated diversified firms simultaneously become internationally diversified, a broader customer base brings them scale economies. Furthermore, the ability to offer differentiated products at competitive prices helps them place intense pressure on competitors and maintain sustainable competitive advantage (Hitt et al., 1997). Therefore, to the extent that diversification enables firms to leverage resources across divisions, we expect both related and unrelated product diversification to produce synergies and positively moderate the relationship between international diversification and performance.

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asymmetric business prospects among unrelated divisions make it more difficult to implement strategic controls in integrating various strategic goals of each division. Compounding this problem, the greater amount of information processing associated with unrelated business segments may prevent corporate executives from adequately understanding the resources needed and the competitiveness of each unit, further increasing the difficulty of strategic controls. When these firms also expand into global markets, implementing strategic controls becomes even more difficult. In response, firms use financial controls for evaluating the divisional contribution to company performance. The reliance on the financial control system could motivate divisional managers to pursue activities that focus on short-run earnings at the expense of long-term investments, and ultimately damage innovation and firm performance. Prior research documented a negative relationship between relative R&D investment and the tendency toward the adoption of financial control (Baysinger & Hoskisson, 1989; Delios & Beamish, 1999; Eisenman, 2002; Hoskisson & Hitt, 1988). In contrast, related diversified firms tend to have fewer problems resulting from asymmetric business operations. It is less costly for them to implement strategic controls and to focus on effective integration of strategic goals at the divisional level, and long-run activities and risk-taking investments are more easily allowed in these firms (Baysinger & Hoskisson, 1989). Therefore, from the perspective of internal control mechanisms, unrelated product diversification is expected to be more hostile to internationally diversified firms than related product diversification.

Internal control mechanism Internal control systems are utilized by diversified firms to manage and maintain the relations between corporate headquarters and business units (Chandler, 1962). Firms make trade-offs between strategic and financial controls according to the degree and relatedness of their diversification (Hoskisson & Hitt, 1988). While strategic controls refer to an emphasis on strategically relevant and subjective criteria, financial controls emphasize objective financial criteria for the top executives to evaluate the performance of divisional managers (Gupta, 1987). Problems arising from internal control mechanisms are expected to be more serious for multinationals undertaking unrelated product diversification. When firms engage in dissimilar business sectors, the technological background, manufacturing process and marketing competencies are expected to be more diverse than those in related businesses. The

Adjustment of internal settings with external environments The literature on organizational evolution theory suggests that as firms expand, changes in environmental conditions create an organizational complexity that poses new managerial problems (Chandler, 1962; Mintzberg & Water, 1982). To secure efficient control and avoid a decline in firm performance, changes must be implemented to find a new match between internal settings and external contexts. Divisional managers in related diversified firms tend to deal with relatively similar suppliers, customers, and competitors (Pennings et al., 1994). When these firms also implement geographic expansion, the new international markets may require changes to internal settings. However, due to the symmetry of business activities among divisions, the adjustment can be applied to all divisions without

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much difficulty, and the cost of adjustment will thus be minimal. On the contrary, when firms diversify into more complex arrays of products, they face diverse competitive environments, distribution systems and customer preferences. When such firms expand into global markets, the unfitness of the internal structure with the external environment can be greatly increased. Because of the dissimilar activities across business and geographic regions, more complex organizational restructuring may be needed to better fit the diverse global market (Ruigrok & Wagner, 2003; Sullivan, 1994). Time and resources devoted to the adjustment across divisions are likely to significantly increase the cost of organization. Thus, as firms expand into global markets, the cost of internal– external adjustments for firms with unrelated product diversification is expected to be greater than those with related product diversification. Governance costs According to the transaction cost theory, a high level of diversification increases the governance cost of firms (Williamson, 1985). Subsequent studies found that unrelated diversification enhances the transaction costs (Christensen & Montgomery, 1981; Geringer et al., 1989). Since divisions of unrelated business are often involved in dissimilar business settings, the resources needed for information processing and transaction coordination is more demanding than those for related diversification. When these firms are also international diversified, increasingly diverse information across businesses and borders raises the difficulty of internal administration. Governance costs may hence rise rapidly to a point at which the costs exceed benefits associated with diversification. Moreover, as firms diversify into unrelated businesses, divisions with specific tasks are created, and coordination across business units becomes more difficult. To handle diverse information in different product markets, complex structures to coordinate activities across multiple products and countries are often introduced. When these structures are applied, however, interdivision coordination costs and managerial interest conflicts may also increase (Franko, 2004). On the other hand, some researchers have argued that unrelated diversification may actually be associated with lower governance costs when each division functions as a self-contained unit. This is especially true when there exists a well-developed internal market for performance monitoring and resources allocation (e.g., Jones & Hill, 1988). Some empirical evidence, however, casts doubt on the effectiveness of the internal

capital market. Shin and Stulz (1998) found that internal capital markets tend to be socialist in nature, and the resulting resource allocation decisions have little to do with the growth opportunities of each segment. Scharfstein and Stein (2000) further suggested that this inefficiency grows when there is a greater divergence across divisions in investment prospects, which are a common characteristic of unrelated product diversification. In addition, decentralization in an unrelated diversified firm may impose other significant costs (Bethel & Liebeskind, 1998; Holmstrom & Ricart I Costa, 1986; Milgrom & Roberts, 1992). The potential governance cost involved in related diversification should not be ignored. In order to realize the benefits of business relatedness, a substantial degree of cooperation among units is required. Intense and continuous intra-firm communication often leads to administrative inefficiency (Porter, 1985). When divisions become increasingly interdependent, more resources invested in monitoring the performance of each division are required (Jones & Hill, 1988). Besides, the cooperative relationship established between divisions causes loss of independence and autonomy for business managers, which could result in slow and inelastic responses to demand in specific markets. Furthermore, to assure cooperation among businesses, firms often need to create new organizational mechanisms and change existing ones (Qian, 1997). The management cost arising from these organizational problems may reduce the positive contribution of related product diversity to the performance of multinational firms. Therefore, to the extent that diversification generates governing costs, both related and unrelated product diversifications are expected to create costs and negatively influence the performance of internationally diversified firms. 2.3. Research hypothesis By drawing on various theoretical perspectives, these discussions suggest that the performance impact of global diversification is influenced by the interaction effect of product and international diversification. Our arguments further highlight the importance of product diversification strategies in affecting the performance of multinational firms. The moderating effect of product diversification may differ depending on the costs and benefits related to the types of product diversification. On the one hand, the strategies of related and unrelated product diversification create similar impacts in several dimensions. For example, multinational firms accompanied by both related and unrelated product

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diversifications have the opportunities to achieve synergies of economies of scale or scope (Markides & Williamson, 1996; Pennings et al., 1994). It is difficult to identify which strategy generates greater gains. Likewise, from the perspective of governance, unrelated diversification generates additional governance costs to multinationals when the loads of processing diverse information increase (Christensen & Montgomery, 1981; Geringer et al., 1989). Related diversification also adds to the coordination costs of international diversification when the divisions have greater interdependence (Jones & Hill, 1988; Porter, 1985). On the other hand, the interaction effect of related and unrelated diversification on the performance of multinationals can be very different. Related business segments are more likely to share similarity in knowledge backgrounds, structures of communication and information transactions, which greatly facilitates inter-segment learning (Grant, 1996; Kogut & Zander, 1992). Consequently, internationally diversified firms who undertake related product diversification are expected to realize greater inter-divisional knowledge learning and resources sharing than those which embark on unrelated product diversification. In addition, since the internal control system of unrelated diversifiers tends to rely more on financial performance, managers have greater incentives to forgo long-term investments and pursue short-term earnings (Delios & Beamish, 1999; Eisenman, 2002; Hoskisson & Hitt, 1988). In contrast, the problem of internal control is expected to be less serious for multinationals with related products, because the implementation of strategic controls is more likely. Finally, relative to related diversification, the diversity in products, distribution channels and customers associated with unrelated product diversification adds significantly greater costs to the adjustment between the internal structure and external environments (e.g. Ruigrok & Wagner, 2003; Sullivan, 1994). In sum, even though related product diversification does not dominate unrelated diversification in every dimension, we expect that multinational firms with related product diversification benefit more from the advantages and suffer less from the disadvantages of diversification than those with unrelated product diversification. Therefore, we propose our hypothesis as Hypothesis. Product diversification moderates the relationship between international diversification and firm performance, such that the internationalization effect will be more favorable under related than unrelated product diversification.

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3. Sample and methodology The hypothesis is tested with a sample of U.S. firms. We collect the sample from the Industry Segment and Geographic Segment tapes in Standard & Poor’s COMPUSTAT database. The sample period is from 1996 to 2002. To be included, a firm has to demonstrate either product or international diversification. Firms lacking the information needed to measure primary variables, including firm performance, international diversification and product diversification, were excluded. In addition, because the information available for small firms is very limited, we include only firms with total annual sales greater than $10 million. Following these procedures, the final sample comprises 8,047 observations associated with 2,402 firms. Based on the classifications in Capar and Kotabe (2003) and Contractor et al. (2003), we classified the firms in our sample into sectors of manufacturing (SIC 20–39), service (SIC 15–17, 40–88) and others (SIC 01–14). Among this sample of firms, there are 936 firms in the service sector and 1,380 firms in the manufacturing sector. 3.1. Variables 3.1.1. Corporate performance Prior studies generally used the accounting-based measures of a firm’s profitability to analyse the diversification–performance relationship (e.g., Contractor et al., 2003; Hitt et al., 1997; Tallman & Li, 1996). It is widely acknowledged that accounting measures have serious limitations in measuring corporate performance (Benston, 1985). For example, the differences in accounting policies across firms and countries make performance comparison difficult. Furthermore, accounting measures do not consider business risks associated with individual firms in measuring performance. More importantly, accounting-based performance only reflects a historical record of the firm’s past financial situation. It does not include the expectation of future performance. In this study, we focus on Tobin’s Q ratio in measuring corporate performance. The theoretical Tobin’s Q is the ratio of the market value of a firm’s assets to their replacement value. Under the assumption of efficient markets, the market value of assets represents the unbiased present value of expected current and future profit discounted at the risk-adjusted cost of capital (Lang & Stulz, 1994). This measure thus provides information about the value of a firm as a going concern, and thus reflects investors’ valuation of both

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the tangible and intangible assets of the firm. Furthermore, by incorporating the capital market measure of firms’ rents, Tobin’s Q implicitly takes into account the business risk associated with a firm’s assets and minimizes distortions due to tax laws and accounting conventions (Wernerfelt & Montgomery, 1988). Moreover, since Tobin’s Q is the present value of future cash flows divided by the replacement cost of tangible assets, no risk adjustment or normalization is required to compare Tobin’s Q across firms (Lang & Stulz, 1994). Wernerfelt and Montgomery (1988) argued that Tobin’s Q is a more attractive measure in capturing corporate performance than the traditional accounting variables. Despite the above advantages, Tobin’s Q is not without limitations. First, the calculation of Tobin’s Q leaves intangible assets out of the denominator, thus overstating the relative performance of firms with large investments in intangibles (Lindenberg & Ross, 1981). This problem could be partially corrected by including a firm’s R&D intensity to control for the effect of intangible assets (Salinger, 1984). We followed this approach in the empirical analysis. Second, researchers have criticized the biased estimation of the investment opportunity of a firm arising from the measurement error of the Q value (Whited, 2001). However, such a potential measurement error is of less concern in studies such as ours, in which Tobin’s Q is used as a dependent variable (Lu & Beamish, 2004). Finally, since the market value of a firm varies with the strength of the general economy, the value of Tobin’s Q may fluctuate substantially from year to year (Sharpe, 1978). Because of the difficulty in estimating replacement costs, we estimate Tobin’s Q ratio as the ratio of the market to book value of the firm’s assets, where the market value of assets equals the book value of assets minus the book value of common equity plus the market value of common equity. This simple measure of Tobin’s Q for firm performance has been widely used in the literature of both finance and strategic management (e.g., Kim & Lyn, 1987; Shin & Stulz, 1998). 3.1.2. Product diversification Being able to directly compare our results with those in the literature, we used the entropy index to estimate product diversity. This measure has been widely used in measuring product diversification in the literature (e.g., Hitt et al., 1997; Jacquemin & Berry, 1979; Palepu, 1985). One of the most important advantages of the entropy approach in measuring product diversification is that it allows for the decomposition of total product diversification into the components of related and

unrelated diversification (Palepu, 1985). When one uses this index, total product diversification could be obtained by summing up its related and unrelated diversification components (Jacquemin & Berry, 1979). The entropy P measure of product diversification is defined as ½Pi lnð1=Pi Þ, where Pi is the percentage of firm sales in business segment i, and ln(1/Pi) is the weight of each segment. The component of related diversity is the weighted average of the firms’ degree of diversification within related business segments. Prior research (e.g., Hitt et al., 1997; Kim et al., 1989; Palepu, 1985) has used the Standard Industrial Classification (SIC) codes to distinguish related from unrelated product diversification. Following Hitt et al. (1997), we define related business segments as those having the same two-digit SIC codes. The business segment sales data are from the COMPUSTAT industry segment tapes. 3.1.3. International diversification Similar logic applies to our use of the entropy approach to measure international diversity. We use this measure to be able to directly compare our outcomes with those in prior studies (e.g., Hitt et al., 1997; Kim et al., 1989; Qian, 1997). The entropy measure of international diversification is defined as P ½Pi lnð1=Pi Þ, where Pi is the percentage of sales in geographic segment i, and ln(1/Pi) is the weight of each geographic segment. This measure thus considers both the number of geographic segments in which a firm operates and the relative importance in sales contributed by each geographic segment. Hitt et al. (1997) have argued that the entropy index is a more appropriate measure of international diversification. Due to data availability at the country level, we use sales of regional markets to measure international diversity (e.g., Hirsch & Lev, 1971; Miller & Pras, 1980). Following Hitt et al. (1997), we group foreign markets into four regions based on economic and political conditions: Africa, Asia and the Pacific, Europe, and the Americas. Although not perfect, this approach allows us to focus on between-market heterogeneity (Kim et al., 1989). The international market sales data are from the COMPUSTAT geographic segment tapes. In addition to the entropy measure, we also conduct the same analysis by measuring the degree of international diversification with the sales-based Herfindahl index. The Herfindahl index is computed as the sum of the squares of each segment’s sales as a proportion of total sales. We find high correlations between the entropy measure of international diversification and the Herfindahl index (r = .805, p < .01).

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3.1.4. Control variables We attempted to control other variables that are important to corporate performance. The first one is firm size (Geringer et al., 2000; Hitt et al., 1997; Tallman & Li, 1996). Firm size is related to the amount of resources under managerial control. Unlike large firms, small firms are more source-constrained and vulnerable to market competition (Doukas & Lang, 2003). In addition, small firms also have fewer resources to leverage when entering global markets, and may derive fewer benefits from international diversification. On the other hand, large firms may incur greater coordination costs, which could reduce the synergy of diversification. The effect of firm size on the performance of international diversification is ambiguous. We measure firm size by the natural logarithm of the book value of assets (Li & Greenwood, 2004; Mansi & Reeb, 2002, and others). Second, firm leverage has been argued to affect firm value (Buhner, 1987; Hitt & Smart, 1994). On the one hand, high-leveraged firms are expected to incur more unfavorable valuation because high debt may prevent a firm from raising funds to finance value-creating projects (Lang, Ofek, & Stulz, 1996). On the other hand, corporate debt disciplines managerial behavior, as the actions of management are closely monitored by creditors (Jensen, 1986), and such debt is, therefore, expected to be positively related to firm performance. We include leverage ratio to eliminate the variation in firm value owing to differences in capital structure. Leverage is measured as the ratio of long-term debt to total assets (Geringer et al., 2000; Tallman & Li, 1996, and others). Third, previous studies have found a positive relationship between R&D intensity and firm performance (e.g., Delios & Beamish, 1999; Franko, 1989; Kotabe, Srinivasan, & Aulakh, 2002). Companies with higher R&D intensity can achieve higher returns by innovating in product design and lower production costs by improving manufacturing processes (Hitt et al., 1997; Kotabe et al., 2002). Franko (1989) found a positive association between a firm’s R&D spending and its sales growth. We, therefore, include R&D intensity to control for the influence of intangible assets of a firm on performance. We measure R&D intensity as the ratio of R&D expenses to net sales (Delios & Beamish, 1999; Lu & Beamish, 2004). We also controlled for the effect of country scope, defined as the number of foreign countries in which a firm has operating subsidiaries (Delios & Beamish, 1999; Tallman & Li, 1996). We included this variable to avoid the over-emphasis on regionalization of our measure of international diversification (Hitt et al.,

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1997). The data of country scope are from the Corporate Affiliation PLUS database published by LexisNexis. Furthermore, changes in performance could be attributed to the mode of international diversification (Hitt et al., 1997). Thus, we include entry modes in the regression analysis by measuring the number of mergers and acquisitions and the number of strategic alliances undertaken by a firm during the study period, as documented in the Acquisitions and Alliances database of Securities Data Company. Finally, we controlled for the industry-specific effect in the analysis. Recent studies have argued that the effect of internationality on performance for manufacturing firms is different from that for service firms (Capar & Kotabe, 2003; Contractor et al., 2003). We use dummy variables to control for any industry-specific effect in the service and manufacturing industries. Additionally, we also include yearly dummies to capture the time-specific effects on corporate performance. 3.2. Methodology Most prior studies on diversification used variables averaged over a multi-year period. The advantage of this approach is it smoothes annual transient errors in the data. For example, averaging variables helps handle the potential problem that the value of Tobin’s Q in our study may fluctuate substantially from year to year. One important drawback of this approach is that it fails to catch changes of diversification and firm performance within the sample period. To overcome this difficulty, Geringer et al. (2000) suggested the Least Squares with dummy variables approach on a pooled cross-section/ time-series dataset. This approach avoids the danger of treating dissimilar data as homogeneous, by allowing for examination of variations among cross-sectional units simultaneously with variations within individual units over time (Bergh, 1993). In addition, the pooling technique increases the degrees of freedom, since more observations are available (Gomes & Ramaswamy, 1999). Since both approaches have their own merits, we conduct the empirical analysis following both approaches to check if our results are sensitive to the empirical frameworks. 4. Empirical analysis and results Table 1 presents descriptive statistics for the pooled data (N = 8,047), and seven-year averaged data (N = 2,402). The dependent variable, Tobin’s Q, is highly correlated with the independent variables. Table 1 also shows that many independent variables are significantly

0.015 0.172***

0.678*** 0.083***

0.034 *** 0.254 ***

0.676 ***

0.036 *** 0.315 *** 0.063 ***

0.351 0.233

p < .01, **p < .05. Firm size is measured by the natural logarithm of the book value of assets.

0.474 0.350 0.466 0.233

a

4.905 0.357 2.156 0.480

***

10

0.034 *** 0.228 *** 0.033 *** 0.101 *** 0.054 *** 0.132 *** 0.163 *** 0.359 *** 0.053 *** 0.203 *** 0.027 ** 0.207 ***

9

0.166 *** 0.092 *** 0.040 *** 0.155 *** 0.002 0.049 ***

8 7

0.072 *** 0.189 *** 0.004 0.004 0.311 *** 0.190 *** 0.041*** 0.435*** 0.037*** 0.103*** 0.316***

6 5

0.136*** 0.262*** 0.005 0.089*** 0.194*** 0.183*** 0.065*** 0.071***

4 3

0.080*** 0.091***

2

1.518 5.993 0.256 0.074 3.327 8.214

SD

1.139 1.885 1.099 0.172 8.200 9.145

Mean

1. 2. 3. 4. 5. 6.

Q ratio Firm size a Leverage R&D intensity Strategic alliances Mergers and acquisitions 7. Country scope 8. International diversification 9. Product diversification 10. Related product diversification 11. Unrelated product diversification

Variables

Table 1 Means, standard deviations, and correlations

0.186*** 0.258*** 0.040*** 0.174*** 0.017 0.148***

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11

70

correlated with each other. To assess the problem of multicollinearity, we computed the variance inflation factor in the regression analysis. Our analysis shows that multicollinearity does not appear to be a major problem, since most of the independent variables have variance inflation factors below the 5.0 criterion advocated by Marquardt and Snee (1975). The only exception occurs to the linear, squared, and cubed terms of international diversification, which is expected since any one of those three variables is the transformation of the others. Table 2 reports the regression results for the full sample. Panel A presents the results of the pooled sample, and Panel B presents the results of the 7-year averaged data. In each panel, we test the hypothesis based on three different functional relationships between international diversity and firm performance. Models 1–3 test the effect under a linear relationship. The results in model 1 show that international diversity significantly and positively improves firm valuation, but product diversity has a negative impact. The interaction effect of product and international diversification is positive but statistically insignificant. In models 2 and 3, product diversity is decomposed into components of related and unrelated diversification. Model 2 shows that the coefficient of the interaction term of related product diversification and international diversity is positive and significant at the 1 percent level, suggesting that diversification within related segments has a strong favorable impact on the performance of multinational firms. Conversely, the results in model 3 show that unrelated diversification not only has a less favorable influence, as predicted in our hypothesis, it actually dampens the performance of international diversity. The coefficient associated with the interaction effect of unrelated product diversity and international diversity is significantly negative at the 1 percent level. The opposite effects between related and unrelated product diversity explain the insignificant interaction effect when the product diversification strategy was not differentiated in model 1. To examine if this conclusion holds for other functional relationships, models 4–6 test the hypothesis under the framework of an inverted-U-shaped relationship. To fit the functional form of an inverted-U shape, we include both international diversity and its squared term in the regression analysis. As shown in models 4–6, the results in the inverted-U relationship are very similar to those in the linear model. We find that product diversity and international diversity have an insignificant interaction effect, although the sign becomes negative. Related product diversification has a strong positive effect, suggesting that the advantages of international diversification are enhanced so that the

Table 2 Regression analysis with full sample Independent variables

Linear-shaped relationship 1

Horizontal-S-shaped relationship

3

4

5

6

7

8

9

0.922*** (11.19) 0.335*** (7.68)

0.892*** (10.89) 0.497*** (11.48)

0.857*** (9.80) 0.968*** (7.22) 0.571*** (5.12)

0.835*** (9.98) 0.943*** (8.12) 0.606*** (5.65)

0.809*** (9.74) 1.090*** (9.69) 0.601*** (5.71)

0.903*** (10.17) 0.187 (0.63) 1.322** (2.03)

0.861*** (10.20) 0.350 (1.27) 0.885 (1.39)

0.838*** (10.02) 0.418 (1.54) 1.092* (1.73)

1.145*** (2.96) 0.151*** (2.89)

0.910** (2.38)

1.033*** (2.73)

0.120** (2.34) 0.060 (1.13)

0.007 (0.12)

0.007 (0.14) 0.218*** (3.94)

0.163*** (2.90) 0.111 (1.38)

0.445*** (4.58)

0.071 (0.87) 0.335*** (3.39)

0.475*** (5.04) 0.023*** (3.03) 0.060*** (5.48) 0.950*** (12.89) 0.014*** (8.48) 0.008*** (5.19) 0.007*** (2.69) Yes Yes 11.48 62.41*** 8047

0.353*** (3.56) 0.552*** (5.81)

0.026*** (3.38) 0.059*** (5.38) 0.983*** (13.26) 0.015*** (8.84) 0.007*** (5.10) 0.007*** (2.80) Yes Yes 10.48 53.35*** 8047

0.043*** (5.60) 0.060*** (5.47) 1.042*** (14.12) 0.015*** (9.37) 0.007*** (4.31) 0.007*** (2.81) Yes Yes 10.40 52.61*** 8047

0.021*** (2.70) 0.059*** (5.41) 0.930*** (12.63) 0.014*** (8.34) 0.008*** (5.31) 0.007*** (2.70) Yes Yes 11.80 60.99*** 8047

0.530*** (5.56) 0.026*** (3.39) 0.059*** (5.36) 0.986*** (13.30) 0.015*** (8.89) 0.007*** (4.94) 0.007*** (2.72) Yes Yes 10.57 51.05 *** 8047

0.043*** (5.67) 0.060*** (5.46) 1.045*** (14.16) 0.016*** (9.41) 0.006*** (4.16) 0.007*** (2.75) Yes Yes 10.40 50.17 *** 8047

0.021*** (2.78) 0.059*** (5.40) 0.933*** (12.68) 0.014*** (8.39) 0.008*** (5.15) 0.007*** (2.61) Yes Yes 11.90 58.21 *** 8047

71

0.045*** (5.93) 0.061*** (5.54) 1.061*** (14.36) 0.017*** (9.53) 0.006*** (4.14) 0.008*** (2.85) Yes Yes 10.01 53.62*** 8047

0.180*** (3.19)

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Panel A. Regression analysis on pooled data Intercept 0.969*** (11.44) International 0.344*** diversification (6.10) International diversification squared International diversification cubed Product 0.210*** diversification (4.38) Related product diversification Unrelated product diversification Product  international 0.016 diversification (0.22) Related product  international diversification Unrelated product  international diversification Firm size a 0.027*** (3.47) Leverage ratio 0.060*** (5.45) R&D intensity 0.999*** (13.46) Strategic alliances 0.015*** (8.98) Mergers and 0.008*** acquisitions (5.01) Country scope 0.008*** (2.85) Industry sector dummy Yes Yearly dummy Yes Adjusted R2 (percent) 10.20 F value 54.77 *** Number of observations 8047

Inverted-U-shaped relationship

2

72

Table 2 (Continued ) Independent variables

Linear-shaped relationship 1

2

a

Horizontal-S-shaped relationship

3

4

5

6

7

8

9

1.302*** (10.94) 0.557*** (7.66)

1.323*** (10.33) 0.839*** (3.56) 0.537*** (2.64)

1.312*** (10.82) 0.807*** (3.95) 0.557*** (2.85)

1.213*** (10.00) 1.203*** (6.18) 0.684*** (3.58)

1.399*** (10.78) 0.547 (1.15) 3.047*** (2.80) 2.310*** (3.35) 0.267*** (3.02)

1.371*** (11.20) 0.499 (1.11) 2.911*** (2.71) 2.247*** (3.28)

1.268*** (10.35) 0.030 (0.07) 2.438** (2.29) 2.025*** (2.98)

0.231*** (2.63) 0.175** (1.97) 0.153 (1.56)

0.195** (2.20) 0.095 (0.97)

0.056 (0.38)

0.113 (1.15) 0.114 (0.76)

0.683*** (3.81) 0.707*** (3.89) 0.042*** (3.65) 0.141*** (3.91) 0.856*** (8.43) 0.015*** (5.88) 0.007*** (2.74) 0.008* (1.84) Yes 14.30 37.46*** 2402

Firm size is measured by the natural logarithm of the book value of assets.

***

0.717*** (4.00) 0.793*** (4.34)

0.041*** (3.39) 0.145*** (4.00) 0.887*** (8.67) 0.016*** (6.02) 0.007*** (2.70) 0.008* (1.83) Yes 13.24 31.53*** 2402

p < 0.01,

**

0.056*** (4.80) 0.148*** (4.09) 0.944*** (9.29) 0.017*** (6.27) 0.005** (2.19) 0.009* (1.89) Yes 13.30 31.56*** 2402

0.040*** (3.49) 0.138*** (3.85) 0.834*** (8.22) 0.015*** (5.75) 0.007*** (2.83) 0.008* (1.82) Yes 14.70 35.57 *** 2402

0.759*** (4.15) 0.040*** (3.31) 0.148*** (4.09) 0.882*** (8.64) 0.016*** (6.15) 0.006** (2.49) 0.008* (1.83) Yes 13.61 30.10 *** 2402

p < 0.05, *p < 0.1. Values in parentheses are t-statistics.

0.056*** (4.76) 0.151*** (4.18) 0.938*** (9.26) 0.017*** (6.39) 0.005** (1.97) 0.009* (1.88) Yes 13.60 30.07 *** 2402

0.040*** (3.47) 0.141*** (3.93) 0.830*** (8.20) 0.015*** (5.86) 0.007*** (2.65) 0.008* (1.80) Yes 15.00 33.63 *** 2402

S.-C. Chang, C.-F. Wang / Journal of World Business 42 (2007) 61–79

Panel B. Regression analysis on seven-year averaged data 1.385*** Intercept 1.418*** (11.52) (11.66) International diversification 0.273*** 0.267*** (2.78) (3.48) International diversification squared International diversification cubed Product 0.312*** diversification (3.77) Related product 0.232*** diversification (2.67) Unrelated product diversification Product  international 0.180 diversification (1.26) Related product  0.788*** international (4.48) diversification Unrelated product  international diversification Firm size a 0.057*** 0.040*** (3.37) (4.89) Leverage ratio 0.147*** 0.15*** (4.06) (4.15) R&D intensity 0.901*** 0.961*** (8.81) (9.46) Strategic alliances 0.016*** 0.017*** (6.14) (6.38) Mergers and acquisitions 0.007*** 0.005** (2.63) (2.07) Country scope 0.009* 0.009* (1.88) (1.93) Industry sector dummy Yes Yes Adjusted R2 (percent) 13.02 13.00 F value 33.68*** 33.59*** Number of observations 2402 2402

Inverted-U-shaped relationship

S.-C. Chang, C.-F. Wang / Journal of World Business 42 (2007) 61–79

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Fig. 1. Moderating effect of related product diversification strategy on the relationship between internationalization and Tobin’s Q.

turning point of the functional form from a positive to a negative slope is delayed (model 5). Conversely, the interaction term of unrelated diversification is significantly negative (model 6), suggesting unrelated product diversification is harmful to the performance of international diversified firms. As in Contractor et al. (2003), and Lu and Beamish (2004), models 7–9 test the hypothesis in the framework of a horizontal-S relationship by additionally including a cubed term of international diversity in the regression. We find similar results with other models. Results in model 7 indicate that the moderating effect of product diversification is still insignificant. When product diversity is decomposed, the analyses in models 8 and 9 suggest that our hypothesis is still strongly supported in the horizontal-S relationship. Panel B tests the hypothesis using seven-year averaged data. Similar to Panel A, the hypothesis is tested against three different models of relationships. The results from each model are very similar to those in Panel A. We find strong evidence supporting the hypothesis that internationally diversified firms benefit from related product diversification, and that unrelated product diversification is detrimental to the performance of multinationals. To further test the robustness of the results, we redid the analysis using a sales-based Herfindahl index as the measure of international diversification.2 For our sample, the correlation

2 We do not use the Herfindahl index as the measure of product diversification as decomposing into related and unrelated diversification components is not possible for the Herfindahl index.

coefficient between the entropy measure and Herfindahl index is 0.805, significant at the p < .01 level. We find very similar results supporting the hypothesis for both the pooled and seven-year averaged samples. In sum, the findings generally suggest that the advantages of product diversification on the performance of multinational firms dominate the associated costs when diversification is within similar business segments. When firms expand into unrelated industries, the costs of coordination, governance and internal control suppress the benefits of product diversification to the performance of international diversity. To further examine the moderating effect of product diversity on the performance of multinational firms with different product diversification strategies, we constructed Figs. 1 and 2 by drawing on the results of models 5 and 6 in Panel A in the framework of an inverted-U-shape relationship. A comparison of Figs. 1 and 2 illustrates the different moderating impact associated with different product diversification strategy. In Fig. 1, a firm with a degree of internationalization of 0.3 and a degree of related product diversity of 1.6 has an expected Q value almost 9 percent higher than that for a firm at the same level internationalization but with half (0.8) the degree of related product diversity. This positive moderating effect of related product diversity becomes more prominent when a firm increases its degree of internationalization. When the degree of related product diversity increases from 0.8 to 1.6, there is an expected improvement in the Q value of 33 percent at an internationalization level of 1.2, in comparison with a 9 percent increase in the Q value at an internationalization level of 0.3. Fig. 1 also shows

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Fig. 2. Moderating effect of unrelated product diversification strategy on the relationship between internationalization and Tobin’s Q.

that the initially inverted-U-shaped internationality– performance relationship tends towards positively linear as an internationally diversified firm increases its degree of related product diversity. This suggests that related product diversification enhances the advantages of internationality so that the turning point of the inverted-U graph is greatly delayed. Fig. 2 presents the moderating effect of unrelated product diversification. This figure indicates that at the same level of internationalization, the Q value deteriorates when the degree of unrelated product diversification increases. Besides, the rate of performance deterioration becomes even greater with a higher degree of international diversity. For example, a firm with a degree of internationalization of 0.3 and a degree of unrelated product diversity of 1.6 has an expected Q value 26 percent lower than that for a firm at the same level of internationalization but with half (0.8) the degree of unrelated product diversity. As the internationalization level increases to 1.2, the deterioration of the Q value goes up to 66 percent when a firm increases its degree of unrelated product diversity from 0.8 to 1.6. The figure further suggests that this earlier curvilinear relationship between international diversification and firm performance becomes almost negatively linear with a high level of unrelated product diversification. This implies that unrelated product diversification magnifies the costs of internationality so that the advantages of international diversification are offset. Prior studies on the relationship between international diversification and performance documented inconsistent evidence for manufacturing (e.g., Gomes

& Ramaswamy, 1999; Hitt et al., 1997; Kim & Lyn, 1987) and service (e.g., Capar & Kotabe, 2003; Contractor et al., 2003) firms. To test if our conclusion is driven by industry effects, we conducted a separate analysis for services and manufacturing firms. Since the results are very similar under three different models, we report the results of the inverted-U relationship with the pooling data approach in Table 3. The findings for both service and manufacturing industries are consistent with the results in the full sample: related product diversification is more beneficial to the performance of international diversification than unrelated diversification. Our conclusion is not sensitive to industrial difference. We also use the 7-year averaged data approach to replicate Table 3. The findings are essentially the same, and thus are not reported here. As for the control variables, we find most of them have significant influences on corporate performance, suggesting the importance of considering their effects in the analysis. Specifically, we find that the leverage ratio is significantly negatively associated with corporate performance. This implies that firms with higher debt generally face greater financial constraints and have less flexibility in investments in new projects (Geringer et al., 2000; Hitt et al., 1997; Tallman & Li, 1996) than firms carrying less debt. R&D intensity is found to have a positive impact on firm performance. This finding is consistent with the resource-based view of the firm that returns are derived from a firm’s unique resources, which are usually represented by a firm’s possession of technological assets (Delios & Beamish, 1999; Kotabe et al., 2002). In addition, we find the number of mergers

Table 3 Regression analysis with sub-samples of service and manufacturing firms Independent variables

Service sectors

Intercept International diversification International diversification squared Product diversification Related product diversification Unrelated product diversification Product  international diversification Related product  international diversification Unrelated product  international diversification Firm sizea Leverage ratio R&D intensity Strategic alliances Mergers and acquisitions Country scope Yearly dummy Adjusted R2 (percent) F value Number of observations a

Manufacturing sectors 2

***

1.411 (11.45) 0.848*** (3.51) 0.582*** (2.79) 0.151* (1.77)

3 ***

1.360 (11.80) 0.958*** (4.60) 0.683*** (3.44)

4 ***

1.292 (11.25) 1.169*** (5.67) 0.738*** (3.72)

5 ***

0.811 (8.82) 1.056*** (5.96) 0.606*** (4.23) 0.147** (2.04)

0.028 (0.32)

6 ***

0.835 (9.75) 1.053*** (6.93) 0.663*** (4.81) 0.076 (0.99)

0.258*** (3.38)

0.141 (1.46) 0.236** (2.15)

0.189 (1.31) 0.528*** (3.19) ***

0.075 (5.79) 0.043*** (3.51) 1.015*** (6.48) 0.015*** (6.07) 0.007*** (3.36) 0.004 (0.91) Yes 12.39 25.77*** 2802

0.758*** (9.19) 1.132*** (7.81) 0.614*** (4.60)

0.231* (1.66)

***

0.083 (6.53) 0.043*** (3.54) 1.042*** (6.72) 0.016*** (6.32) 0.006*** (3.01) 0.005 (0.97) Yes 12.81 26.72 *** 2802

Firm size is measured by the natural logarithm of the book value of assets.

***

p < 0.01,

**

0.456** (2.39) 0.068*** (5.32) 0.044*** (3.58) 0.916*** (5.86) 0.015*** (5.80) 0.007*** (3.48) 0.003 (0.55) Yes 13.06 27.29*** 2802

0.016 (1.51) 0.184*** (5.27) 0.911*** (10.63) 0.015*** (6.25) 0.010*** (3.82) 0.006** (1.98) Yes 10.07 34.60 *** 4802

0.007 (0.69) 0.198*** (5.65) 0.992*** (11.58) 0.016*** (6.67) 0.007*** (2.78) 0.006* (1.93) Yes 9.29 31.72*** 4802

p < 0.05, *p < 0.1. Values in parentheses are t-statistics.

0.579*** (4.70) 0.02* (1.92) 0.175*** (5.06) 0.861*** (10.15) 0.013*** (5.72) 0.011*** (4.30) 0.006* (1.85) Yes 11.98 41.86 *** 4802

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and acquisitions and strategic alliances undertaken by sample firms are positively related to the performance. We also find a positive association between the country scope of foreign operations and firm performance. This finding is similar to those documented in previous research (Delios & Beamish, 1999; Kim et al., 1989). Firm size is negatively associated with performance for the overall sample, but the influence is different for service and manufacturing industries. The data shows that firm size is negatively associated with corporate performance for service firms, but not for manufacturing firms. In fact, in model 6 of Table 3, we even find a positive and marginally significant effect of firm size on performance in the manufacturing sector. This difference may be attributed to the industrial characteristics. Firms in the service sector tend to face greater demand for customer contact, customization, and cultural adaptation (Patterson & Cicic, 1995). To become more competitive, service firms must constantly differentiate their products and management systems in response to the local environment (Ghoshal, 1987). Small size allows for a more flexible structure and faster reaction to the market changes. Conversely, manufacturing firms have greater fixed assets investments, and have to rely more on the advantages of scale economies. Since large-scaled firms usually have more resources and capability to achieve economies of scope, firm size plays a positive role in influencing performance in manufacturing industries. Our findings are consistent with Capar and Kotabe (2003) for service firms, and with Geringer et al. (2000), and Tallman and Li (1996) for manufacturing firms. 5. Discussion Based on various theories, we develop the hypothesis that the interaction effect between product and international diversification is more favorable under related rather than unrelated product diversification. The empirical results not only provide a strong support for the hypothesis, but also suggest a positive interaction effect associated with related product diversification, and a negative interaction effect with unrelated product diversification. Thus, this study contributes to the literature by providing theoretical explanations and empirical evidence, which demonstrate the importance of product diversification strategies in affecting the relationship between international diversification and performance. Furthermore, the results of this paper provide one potential explanation for the mixed evidence documented in previous studies. Since the effect of related product diversity is opposite to that of unrelated product diversity, the results of the

interaction effect of overall product diversification will be dependent on the composition of the diversification strategy pursued by the sample firms. A positive interaction effect will be expected when the sample firms engage in relatively more related product diversification. On the other hand, when sample firms’ product diversification strategy is more evenly distributed, the interaction effect of product diversification effect becomes neutral. Furthermore, the evidence indicates that our conclusion is not affected by different specifications of the functional relationship. Our conclusion also holds for firms in both service and manufacturing industries. To further test the robustness of our findings, we conducted several supplementary analyses. First, we used Tobin’s Q ratio as the measure of corporate performance. To test if the conclusion is sensitive to different measures of corporate performance, we replicated the empirical analysis by replacing Tobin’s Q with return on assets, measured by the ratio of net income to total assets, as the dependent variable. We find that the evidence using the accounting-based performance measure generally supports our hypothesis. The coefficients of the interaction effects conform to the prediction of the hypothesis, and are statistically significant at the conventional level. We also tested if the results still hold when the threshold for distinguishing between related and unrelated product diversification changes to the threedigit SIC code. Using this criterion reduces the relative portion of related diversification. We find the evidence based on three-digit SIC codes is very similar to that based on two-digit SIC codes. Furthermore, the approximation of Tobin’s Q includes a firm’s total assets in the denominator. Two predictors, firm size and leverage ratio, also contain total assets. Thus, the total assets construct appears in two variables on the right side of the equation and also in the dependent variable. To test if this may jeopardize the validity of the regression results, we used alternative variables to measure firm size and leverage ratio. In the analysis, we measured a firm’s size by the natural logarithm of sales, and leverage by the ratio of total debt to shareholder equity. We find that the results of the product diversification strategies remain the same using the alternative measures of firm size and leverage. For the results of firm size and leverage, we find the results of firm size being generally consistent under the two different measures. For leverage, the effect under the new measure is statistically insignificant. In the regression models, some variables are constructed from other variables. Aiken and West

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(1991) suggested the approach of centering variables to reduce multicollinearity when multiple derivations of a variable are included in the analysis. To test if our conclusion is susceptive to this potential bias, we followed Aiken and West (1991) by subtracting each variable from its mean value in the sample. We constructed the interaction terms with the centered variables and re-ran the regression models. The results indicate that the centering approach does not change the conclusions. The coefficients of the interaction terms are consistent with the hypothesis, and are significant at the 1 percent level. We further applied the centering approach to the 7-year averaged sample, and to the subsamples for manufacturing and service firms, and the results remain unchanged. In addition, we find that centering does not change the results when the business relatedness is defined by three-digit SIC code, or when we use alternative variables for firm size and leverage. The overall evidence suggests our results are not sensitive to the potential problem of multicollinearity. 6. Conclusions This study investigates the impacts of product diversification strategies on the relationship between international diversification and firm performance. Prior research mainly focused on the moderating effect of the overall product diversification, and documented inconclusive evidence. This study re-examines this topic by exploring if prior conflicting evidence could be an outcome resulting from the failure of considering the potential different impacts of different product diversification strategies. Based on the costs and benefits associated with product diversity on the performance of internationally diversified firms, we provide arguments that diversifying into related products is expected to have more favorable impacts on the performance of multinationals than diversifying into unrelated products. The empirical results provide a strong support for the hypothesis. The findings indicate that related product diversification positively enhances the performance of internationality. Conversely, unrelated product diversification not only has a weaker influence than related product diversification, it actually damages the performance of multinational firms. The conclusion holds under different models of internationality and performance, and is robust for both service and manufacturing industries. The present study has important managerial implications. It sensitizes managers that in acknowledging the optimal level of investment in international diversification, firms may improve their performance

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by a series of appropriate strategies and processes (Lu & Beamish, 2004; Sullivan, 1994). One such strategy that advances the fixed relationship between internationality and performance is the product diversification strategy. Managers need to focus not just on the overseas expansion activities, but also on their product strategies to gain further benefits from overseas expansion. In the meanwhile, care must be taken in recognizing the threshold value of product diversity. Without paying attention to the potential downsides of excessive expansion, firms may not succeed in international diversification. By doing well in implementing both product and international diversification, firms can extend the peak of the internationalization and performance relationship and move the threshold of internationalization to a higher level. This study has several limitations. In developing the hypothesis, two implicit assumptions are embedded throughout this paper. First, we assume each of the aforementioned five effects occurs independently of the others. Second, we assumed each of these five effects contributes equally to firm performance. Future research could investigate the magnitude of these five factors and their interactions. For example, it is possible that in unrelated diversified firms, the positive effect from synergy could be so strong that it nullifies the negative effects associated with internal controls, governance, etc. Next, even though the SIC code was extensively used in prior studies, it may not fully capture the fundamental difference in product diversification strategies. Markides and Williamson (1996) and Robins and Wiersema (1995) have suggested that the ability to share resources and capabilities across business segments may occur within industries, across industries, or both. Future research could examine the validity of our conclusion using the resource-based approach in measuring relatedness, as advocated by Markides and Williamson (1996) and Robins and Wiersema (1995) (see footnote 1). Third, our empirical approach did not allow for the possible shifts and changes in relationships across time (Geringer et al., 2000). Future research is encouraged to accommodate this issue in the specification of empirical analysis. Furthermore, our sample was limited to publicly listed firms in the United States. Some studies have found that samples from other countries provide different evidence about the relationship between international diversification and firm performance. For example, Lu and Beamish (2004) studied Japanese firms. Capar and Kotabe (2003) focused on German enterprises. Both of them documented dissimilar results from those found for U.S. firms. Furthermore, Lu and Beamish (2001)

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found that the performance of international diversity for small-to-medium sized enterprises is different from that of large firms. Therefore, it would be interesting to see if the conclusions of this study can be generalized to other economies or small-to-medium-sized firms. Finally, due to data availability, we measured the degree of international diversification by grouping countries into four global regions. This approach, however, may not be satisfactory. Countries in each region may be fundamentally different in terms of their culture, political system, market environment and economic development status. Future research is encouraged to investigate detailed country-specific data on this topic. Acknowledgements The authors wish to thank two anonymous referees, Gregory G. Dess (the Editor), Eshghi, G.S., Meyer, K., the seminar participants at the 2005 Academy of International Business Annual Meeting and 2005 Research Workshop of the National Science Council for their helpful comments and suggestions. Shao-Chi Chang acknowledges funding from the National Science Council in Taiwan (94-2416-H-006-028). References Aiken, L. S., & West, S. G. (1991). Multiple regression: Testing and interpreting interactions. Newbury Park, CA: Sage. Baysinger, B., & Hoskisson, R. (1989). Diversification strategy and R&D intensity in multiproduct firms. Academy of Management Journal, 32(2): 310–332. Benston, G. J. (1985). The validity of profits-structure studies with particular reference to the FTC’s line of business data. American Economic Review, 75: 37–67. Bergh, D. D. (1993). Don’t ‘‘waste’’ your time! The effects of time series errors in management research: The case of ownership concentration and research and development spending Journal of Management, 19(4): 897–899. Bethel, J., & Liebeskind, J. P. (1998). Diversification and the legal organization of the firm. Organization Science, 9: 49–67. Bowman, E. H., & Helfat, C. E. (2001). Does corporate strategy matter? Strategic Management Journal, 22(1): 1–24. Buhner, R. (1987). Assessing international diversification of West German corporations. Strategic Management Journal, 8: 25–37. Capar, N., & Kotabe, M. (2003). The relationship between international diversification and performance in service firms. Journal of International Business Studies, 34: 345–355. Chandler, A. (1962). Strategy and structure: Chapters in the history of American industrial enterprise. Cambridge: MIT Press. Chang, S. L., & Singh, H. (2000). An evolutionary perspective on diversification and corporate restructuring: Entry, exit and economic performance during 1981–1989. Strategic Management Journal, 17(8): 587–611. Christensen, H. K., & Montgomery, C. A. (1981). Corporate economic performance: Diversification strategy versus market structure. Strategic Management Journal, 2(4): 327–343.

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