Does Diversification Create Value for JSE Listed Companies in the Presence of External Financing Constraints? Evidence from the 2008-2009 Financial Crisis A Research Report presented to The Graduate School of Business University of Cape Town in partial fulfilment of the requirements for the Master of Business Administration Degree by Gareth Edwards December 2010 Supervisor: Professor Enrico Uliana
PLAGIARISM DECLARATION This thesis is not confidential. It may be used freely by the University of Cape Town s Graduate School of Business. Declaration 1. I know that plagiarism is wrong. Plagiarism is to use another s work and pretend that it is one s own. 2. I have used a recognised convention for citation and referencing. Each significant contribution and quotation from the works of other people has been attributed, cited and referenced. 3. I certify that this submission is all my own work. 4. I have not allowed and will not allow anyone to copy this essay with the intention of passing it off as his or her own work. Signature: Name: Gareth Edwards Exam Number: MOD258 Date: 10 th December 2010 I
ACKNOWLEDGEMENTS I would firstly like to acknowledge and thank Professor Enrico Uliana for his help and support as my supervisor. His guidance kept me focussed on the problem and research question at hand. I hope I have done his faith justice. A heartfelt thanks goes to my family and friends who had to endure many stressed days with me and for their continued support I will be forever grateful. I want to extend this gratitude to the MBA Modular Class of 2009/2010 who shared the wonderful experience that is the MBA with me. II
ABSTRACT Does diversification reduce shareholder value? Even though results from international studies in the past are mixed, this report finds that a diversification discount does exist on the Johannesburg Securities Exchange (JSE). This finding is consistent for 2005 when the JSE was in a bull market and capital was easily accessible, and during the 2008-2009 Financial Crisis when external financing was scarce. Due to changes in the internal capital market created by a diversified firm and the external capital market, the diversification discount deepened during the crisis. These findings were gathered through the use of an international recognized methodology of applying industry multipliers to segment data of diversified firms where diversification is defined as diversity of product segments. This paper also finds that the more diversified a firm is, the more value is destroyed and it suggests that diversification has a significant effect on wealth. KEYWORDS: Diversification, diversification discount, internal capital market, external capital market, financial crisis. III
Contents PLAGIARISM DECLARATION...I ACKNOWLEDGEMENTS... II ABSTRACT... III TABLE OF FIGURES...VI TABLE OF TABLES...VI 1 INTRODUCTION... 1 2 LITERATURE REVIEW... 4 2.1 Diversification types... 4 2.1.1 Product Diversification... 5 2.1.2 Geographical diversification... 6 2.2 Studies documenting evidence in favour of a diversification discount... 7 2.3 Studies documenting evidence against a diversification discount... 8 2.4 Internal versus external capital markets... 9 2.5 Agency theory... 10 2.6 Conclusion... 11 3 RESEARCH METHODOLOGY... 12 3.1 Research approach and strategy... 12 3.1.1 Level of diversification... 12 3.1.2 Value of the firm and the impact of the 2008-2009 crisis... 14 3.1.3 The role of corporate finance... 14 3.2 Research design, data collection, methods and research instruments... 15 3.2.1 Data collection... 15 3.2.2 Dependent variables... 18 3.2.3 Sampling... 19 4 RESEARCH FINDINGS, ANALYSIS AND DISCUSSION... 21 4.1 Does a diversification discount exist on the JSE?... 21 IV
4.1.1 Testing for diversification using the market-to-sales multiplier... 22 4.1.2 Testing for diversification using the market-to-assets multiplier... 23 4.2 Does the level of diversification have an impact on the value of a firm?... 25 4.3 Did the value of diversification increase during the 2008-2009 Financial Crisis?.. 26 4.4 The impact of corporate finance on the diversification discount... 28 4.4.1 The more money effect the debt coinsurance hypothesis... 28 4.4.2 The smarter money effect the role of the internal capital market... 29 4.5 Limitations of the study... 30 5 CONCLUSION... 32 6 FUTURE RESEARCH DIRECTION... 34 7 BIBLIOGRAPHY... 35 APPENDIX A Diversification performance link in the literature... 40 APPENDIX B List of firms used in the study... 41 APPENDIX C Rumelt s categories of diversification... 44 V
TABLE OF FIGURES Figure 1: Curvilinear relationship between diversification and performance... 5 Figure 2: Evolution of the ALSI and the SATRIX SAVI from 1 January 2004 to 31 December 2009... 16 Figure 3: Excess value for different levels of diversification using market-to-sales multipliers... 25 Figure 4: Excess value for different levels of diversification using market-to-assets multipliers... 26 Figure 5: Excess value using market-to-sales multipliers... 27 Figure 6: Excess value using market-to-asset multipliers... 27 TABLE OF TABLES Table 1: Primary segments and number of firms matching the segment... 22 Table 2: Market-to-sales multipliers for single-segment firms over five sectors on the JSE.. 22 Table 3: Excess value for single-segment and diversified firms using market-to-sales multipliers... 23 Table 4: Market-to-assets multipliers for single-segment firms over five sectors on the JSE 24 Table 5: Excess value for single-segment and diversified firms using market-to-assets multipliers... 24 Table 6: Assets-to-debt multipliers for single-segment firms over five sectors on the JSE... 28 Table 7: Measure of excess debt values for 2005 and 2009 for single-segment and diversified firms... 29 Table 8: Size of internal capital market for diversified firms... 30 Table 9: Rumelt s major categories of diversification... 44 VI
1 INTRODUCTION The 2008-2009 financial crisis was the worst of its kind since the 1930s and it was the first time since World War II that the financial markets have seen such turmoil (Speidell, 2008). The crisis originated in consumer markets (consumer credit) and not in corporate finance (credit markets or equity markets) or demand-side factors (business or economic fundamentals). Campello, Graham and Harvey (2010) suggest that this crisis creates the perfect environment to study the effects of corporate finance on investment as the original shock was outside of the system even though it eventually spilled over to the corporate domain. Firms that choose to diversify can cause their values to be discounted by the market if the costs associated with diversification outweigh the benefits, but the literature on the effects of corporate diversification on firm performance presents a puzzle. Recently, financial economists have been actively debating on whether diversified firms trade at a discount to single-segment firms and if so, is it the level of diversification of the firm that causes this discount? For example, Servaes (1996) found that diversified firms during the 1960s traded at a discount relative to single-segment firms and later Klein (1997) found exactly the opposite result for the same period. The change in firm value can originate through two channels. The first channel is through external capital markets where diversified firms can enjoy the benefits of debt coinsurance. The argument is that the external capital market will prefer to allocate capital to low risk conglomerates rather than to high risk single-segment firms. This enables the conglomerates to achieve their optimal capital structure more easily than single-segment firms. As a result the value of conglomerates will increase relative to their single-segment counterparts. However, disadvantages of external capital markets include frictions such as transaction costs and taxes, and agency costs where there is information asymmetry between the manager and the funder (Stein, 2003). These costs can lead to lower firm valuations. The second channel through which diversified firms can change their value relative to singlesegment firms is through the internal capital market it creates. This ability to benefit from an internal capital market is a defining characteristic of diversified firms. If the internal capital market allocates capital more efficiently than the external capital market, diversified firms would increase in value relative to single-segment firms. On the other hand, Bhide (1993) (in 1
Blount & Davidson, 1996) argues that internal capital markets have a number of disadvantages. These include slow reaction times, politicised decision making and misaligned incentives to managers. It is acknowledged that these two channels are not mutually exclusive and that diversified firms can benefit or be at a disadvantage due to a combination of both channels. The composition of diversified firms in South Africa changed considerably during the late 1980s and early 1990s. Near the end of the Apartheid era, the Johannesburg Securities Exchange (JSE) was dominated by six large diversified companies (Barr & Kantor, 1994). These firms were structured as pyramid holding companies which allow dominant shareholders to retain the majority of the voting rights while holding only a small equity stake (Blount & Davidson, 1996). Following the fall of Apartheid, The African National Congress (ANC) pressured these conglomerates to unbundle to aid balanced economic development. Through political pressure and capital market conditions many conglomerates did unbundle during the 1990s. Currently only a few true conglomerates still exist on the JSE with Bidvest Limited and Imperial Holdings Limited being two examples. There are two schools of thought on the impact of diversification on the value of a firm. The first school of thought argues that diversification destroys value, whereas the second school of thought argues that diversification does not destroy value. This contradiction creates a problem for researchers, managers and investors. If diversification has a direct impact on the value of a firm which impacts the markets which in turn impacts wealth, what implication does the valuation of diversified firms have on wealth? Not only will academics have an interest in this study, but also investors, corporate managers, venture capitalists and equity analysts. Investors might use the new insight to fashion new incentive contracts with the corporate managers that manage their businesses. Venture capitalists on the other hand position themselves as either a single-segment player or a diversified conglomerate through their cumulative portfolios and would benefit from the new insights. Increased diversification increases the forecast error for equity analysts trying to forecast earnings for conglomerates (Dunn & Nathan, 2009) and equity analysts can benefit from more clarification on the diversification-performance relationship in South Africa. The remainder of this research report contains five sections. The second section explores the literature on the effects of diversification on firm value and possible sources that could cause a valuation discount or premium. The third section provides a description of the research 2
methodology and data collection methods used for the study. In the fourth section the research analysis and findings are discussed. The fifth section serves as a conclusion and the last section suggests some future research directions. 3
2 LITERATURE REVIEW The literature on the diversification-performance relationship presents a puzzle. Some researchers argue that diversification does not destroy value whereas other researchers argue that diversification does destroy value. Some studies have gone further and researched the cause of this diversification discount or premium. There are three prominent schools of thought on the cause of a diversification discount or premium. The first is that diversified firms have either an advantage or disadvantage as a result of the efficiency, or lack of efficiency, of the internal capital market it creates. The second school of thought focuses on the impact the external capital market has on the value of the diversified firms. The last school of thought focuses on the role that Agency Theory plays in the valuation of diversified firms. This section is divided into six sub-sections. The first sub-section reviews the literature on the different types of diversification product diversification and geographical diversification. The next two subsections explore the literature on arguments for and against a diversification discount. The third and fourth sub-sections discuss the role of the internal capital market versus the role of the external capital market and the role of Agency Theory as a cause for a diversification discount or premium. conclusion to the literature review. The final sub-section serves as a 2.1 Diversification types Until 1 January 2009, the accounting rule IAS 14 1 (Segmental Reporting) defined a segment as a distinguishable component of the company that is engaged in providing products or services within different geographical areas which are subject to risks and returns which are different from those of other segments. The basis of segment reporting is representative of the internal structure used for management reporting. Managers of listed firms indicate if they are using product diversification or geographical diversification as the primary segmentation of their business units in the Annual Reports. At the turn of the century research shifted focus from the effects of diversification on performance to more in-depth studies of the performance of unrelated diversifiers and the performance of related diversifiers (Palich, Cardinal and Miller (2000). Palich et al. suggested that in the long run, related or moderate diversifiers will outperform singlesegment companies. However, as companies diversified more and more, the cost associated 1 IFRS 8 superseded IAS 14 on 1 January 2009 4
with diversification also increased especially where management needed to manage businesses with little in common. Management were unlikely to have the same level of knowledge for each of the unrelated businesses which further impeded coordination efforts. As a result, the incremental cost of diversification increases as the level of diversification increases. This leads to an inverted U-shaped relationship (see Figure 1 below) between firm performance and the level of firm diversification (Palich et al., 2000). Figure 1: Curvilinear relationship between diversification and performance This study focussed on Product Diversification and Geographical Diversification as defined in section 2.1.1. and section 2.1.2. and not related or unrelated diversification. This enabled the author to use the management s definition of a segment being either Product Diversification or Geographical Diversification as their primary basis for segment reporting. These definitions can be observed directly from the Annual Reports of the company under review. 2.1.1 Product Diversification Product diversification is defined as the expansion into product markets new to a firm (Hitt, Hoskinson & Kim, 1997, p 768). Hitt et al. (1997) defined the level of diversification as the percentage of total sales represented by the sales of each segment. 5
Firms engaging in product diversification are able to exploit synergies across product lines by consolidating operational activities and thus achieve economies of scale (Amit & Livnat, 1988). For this reason it is expected that moderate diversifiers will outperform their single business competitors over the long term (Ravichindral, 2009). However, as diversification escalates, costs also increase. These costs can be related to agency problems, coordination costs and inefficient resource allocation (Pearce & Robinson, 2004). Mixed empirical evidence on the impact of product diversification on firm performance suggests that the relationship is not a cause-effect relationship (Kuppuswamy and Villalonga, 2010). 2.1.2 Geographical diversification Hitt et al. (1997) defined geographical diversification as expansion across the borders of regions and countries into different geographic locations or markets. Buckley (1988) argued that firms can enjoy above-normal returns by exploiting its assets in global markets. Buckley found that this was especially true for intangible assets. Delios and Beamish (1999) supported this view and suggested that market imperfections created further opportunities for exploitation of these assets. However, geographical diversification comes at a cost. Denis, Denis and Yost (2002) argued that global diversification could lead to cross-subsidisation of less profitable or even unprofitable businesses. Christophe and Pfeiffer (2002) showed that the capital market values the equity of multinational conglomerates lower and that this result was consistent through the 1980s and 1990s. Hitt, Hoskisson and Ireland (1994) argued that the costs associated with geographical diversification outweighed the benefits and that this form of diversification will impact a firm s performance negatively. There are similar effects of both geographic diversification and product diversification on the performance of a firm. Lu and Beamish (2004) argued that coordination costs, information asymmetry costs and incentive misalignment costs are applicable to both product diversification and geographic diversification. Palich et al. (2000) suggested that a possible optimal point of diversification exists. Palich et al. observed that this indicates increasing advantages as both product and global diversification rise, but it also demonstrates the negative utility of these activities beyond some optimal level of diversity (Palich et al., 2000, p. 169) 6
2.2 Studies documenting evidence in favour of a diversification discount Lang and Stulz (1994) argued that diversified firms were consistently valued less than singlesegment firms. They estimated Tobin s q for American firms using the CIS Compustat Industry Segment files and found that diversified firms had lower average and median q values than their single-segment counterparts. They also found that the sample firms performed poorly before they decided to diversify and concluded that diversifying firms do not necessarily become poor performers as a result of diversifying. Berger and Ofek (1995) compared the sum of imputed segment values for a firm to the firm s total value and found that diversified firms were worth 15% less than the sum of the imp uted segment values of the firms individual segments. This methodology is based on industry mean multipliers. Berger and Ofek (1995) concluded that the diversification discount was either caused by management overinvesting in segments with limited investment opportunities or by performing segments that subsidised under-performing segments. Servaes (1996) supported the arguments made by Lang and Stulz (1994) and Berger and Ofek (1995) and suggested that even though diversification has not been beneficial to American firms over the 1960s and 1970s, the market valued the cost of diversification very differently over these two periods. The 1960s and 1970s in the US were characterised by large merger and acquisitions activity (Servaes, 1996) and Servaes found that diversified US firms were valued at a discount in both decades, but much less so in the 1970s. Servaes (1996) also argued that inside ownership had a negative effect on the value of a diversified firm. Berger and Ofek (1999) studied 107 diversified firms over the time period 1984 to 1993 and analysed the effects of refocusing announcements. Berger and Ofek (1999) argued that the results supported their 1995 study in that refocusing represents management s efforts to reverse the value destruction associated with previous diversification attempts. They further suggested that the narrowing diversification discount could be attributed to a reduction in agency conflicts rather that the benefits from internal capital markets. In two separate studies Lamont and Polk found evidence in favour of the diversification discount. Lamont and Polk (2001) studied the long-run returns and cash flows of singlesegment and diversified firms whereas their 2002 paper studied the impact of industry shocks on the value of diversified firms (Lamont and Polk, 2002). Gomes and Livdan (2004) argued that firms only diversify when current activities become unproductive and that this endogenous selection mechanism results in the diversification discount. Kuppuswamy and 7
Villalonga (2010) examined whether the diversification discount changed during the 2008-2009 financial crisis. They argued that even though a diversification discount persisted throughout the 2008-2009 crisis, the diversification discount narrowed due to the diversified firms ability to take advantage from the internal and external capital markets. 2.3 Studies documenting evidence against a diversification discount The literature is rich with studies that highlight the difficulties involved when researchers attempt to link diversification to value destruction. Some researchers suggest that the correlation between diversification and a firm s value is not causal. Campa and Kedia (2002) argued that researchers have ignored the endogeneity of a firm s diversification policy. They argue that the very attributes that lead management to the decision to diversify, are the attributes that the market discounts and which in turn lead to a lower value. By controlling for endogeneity, Campa and Kedia (2002) empirically showed that the diversification discount drops significantly and in some cases disappears completely. Graham, Lemmon and Wolf (2002) showed that firms acquired in a diversifying merger have already been discounted by the market prior to the announcement of the transaction. They argued that valuing the firm post-merger will produce a false diversification discount as the acquired firm has already been discounted pre-merger. Billett and Mauer (2000) showed by tracking diversifying merger announcements, that there are benefits to diversification. This result was consistent with the findings of Hyland and Diltz (2002) who argued that there is a positive impact on diversifying merger announcements and that the firms who choose to diversify are discounted before the diversifying transaction. Villalonga (2004) argued that diversified firms trade at a large and statistically significant premium relative to single-segment firms. Villalonga used establishment data rather than segment data and showed that the premium is robust across different research methods, samples and measures for the diversification discount. Hyland (2008) found evidence of the impact of a firm s size on diversification. Hyland argued that smaller firms that diversify mostly destroyed value, because smaller firms diversify to expand opportunities that might not add shareholder value. However, when Hyland looked at larger firms he found that diversification mostly had a neutral effect on the long-run performance of a firm and in some cases the effect was positive. 8
2.4 Internal versus external capital markets Perhaps the most defining characteristic of diversified firms relative to single-segment firms is the ability to create an internal capital market. Managers of diversified firms can allocate capital for investments internally while members of the capital market can allocate capital to single-segment firms directly. There are mixed results coming from research conducted on the corporate diversification discount and the relative efficiency of internal versus external capital markets. Stein (2003) argued that there are two financing related ways to create value through diversification, given that value will not be created through operating synergies. Firstly, bringing together multiple businesses allows the conglomerate access to more external funding than the sum of external financing that can be raised by the individual business units. Secondly, an internal capital market allocates capital more successfully to individual business units than the external capital markets. Stein (2003) called the first effect a more-money effect and the second effect a smarter-money effect. The smarter-money effect has been discussed over the last five decades. Alchian (1969), Williamson (1975), Donaldson (1984), Gertner, Scharfstein and Stein (1994) and Matsusaka and Nanda (2002) have discussed the theory broadly referred to as winner-picking (Stein, 1997). These researchers argued that through stronger control rights and better information quality, managers are in a position to make better capital allocation decisions. However, internal capital markets also have costs associated with it. Rajan, Servaes and Zingales (2000), Scharfstein and Stein (2000) and Wulf (2002) argued that managers are in a position to misallocate capital by acting in their self-interest and thus act as rent-seekers. The more-money effect was researched by Lewellen (1971) who argued that debt coinsurance creates an increased debt capacity for conglomerates. This is true for firms with imperfectly correlated divisions. However, some researchers have questioned this argument showing that diversified firms do not borrow substantially more than single-segment firms (Berger and Ofek (1995) and Comment and Jarrel (1995)). Studies on the capital structure of firms have shown that the optimal capital structure of a firm largely depends on the industry in which it operates and the maturity of the business (Frelinghaus, Mostert, & Firer, 2005). Transaction-cost economists argue that firms should turn to internal markets when transaction costs are higher in external markets compared to the agency cost of internal markets (Williamson, 2000). These transaction costs can be high due to information asymmetry and 9
due to lack of control rights. Therefore, internal capital markets are beneficial to firms in emergent industries with high information asymmetry and where control rights are needed to shift resources quickly between businesses within the conglomerate (Aggarwal & Zhao, 2009). Aggarwal & Zhao (2009) argued that by accessing internal capital markets, emergent companies can perform better across multiple businesses which will result in a diversification premium. In contrast, Matsusaka and Nanda (2002) showed that internal capital markets are costly where low information asymmetry exists and where there is little need to shift resources between different businesses. Mature industries have these attributes and these firms will benefit from accessing external markets where the financing costs are lower due to the presence of high free cash flows. In most cases, diversification will be value destroying in mature industries (Aggarwal & Zhao, 2009). 2.5 Agency theory The effects of agency theory were strongly represented in the financial literature in the 1970s. Jensen and Meckling (1976) argued that because managers are not full residual claimants, they make decisions that will benefit them personally even though these decisions might destroy shareholder value. The literature suggests two reasons embedded in agency theory on why managers choose to diversify their firms. The first type of agency explanation involved the level of equity ownership of managers in the firms that they manage. May (1995) found that CEOs that have high equity stakes in their businesses acquire more diversifying businesses than those who do not have a large equity stake in the businesses they manage. The undiversified position in their own firms faces higher idiosyncratic risk and therefore managers will seek to diversify their position to mitigate this risk. May (1995) argued that the positive correlation between managerial equity ownership and diversification supported this argument. The second type of agency explanation involved private benefits that managers enjoy from managing a conglomerate firm. Jensen (1986), Stulz (1990) and Denis, Denis and Sarin (1997) argued that these private benefits included higher salaries due to the complexity of the business that they manage and it made the managers more valuable to the firm, essentially entrenching them in the firm. Aggarwal and Samwick (2003) argued that both of these explanations regarding agency theory are misleading. Once incentives are set, managers choose the level of diversification 10
to reduce the idiosyncratic risk of their undiversified holdings. Aggarwal and Samwick (2003) conclude that, because the positive effects of incentives do not enter the risk reduction explanation nor does it enter the private benefits explanation, diversification of firms cannot be fully explained by agency behaviour. 2.6 Conclusion The effect of diversification on the performance of firms has been discussed extensively in the strategic, financial and economic literature (see Appendix A). The results from research on the impact of diversification on firm performance have been mixed. Research has shown that the diversification-performance relationship is not a causal relationship. Some studies have shown that firm performance, and usually below par performance, encourages managers to diversify. The size of the firm has an impact on whether a diversification discount or premium will materialise post-merger. Other studies have shown that diversification has a negative impact on firm performance. Research on the causes of the diversification discount usually focuses on either the behavioural issues around rent-seeking managers that do not act in the interest of the shareholders or on the effect of internal versus external capital markets. Researchers showed that firm maturity and the economy in which the firm operates have an influence on the efficiency of the external market. An inefficient external market has higher friction costs which translate into higher financing costs to the firm. It is argued that diversified firms with access to internal capital markets have an advantage as they are not dependent on external markets to fund investment. Therefore, it could be argued that more expensive or unavailable external funding during the 2008-2009 financial crisis might have increased the relative value of internal capital markets versus external capital markets. This in turn will increase the relative value of diversified firms versus single-segment firms. 11
3 RESEARCH METHODOLOGY The literature has shown that there is no clear evidence of a diversification discount for diversified firms versus their single-segment counterparts. The objective of this research is to study the diversification-performance relationship for South African firms listed on the JSE. The research explores whether a diversification discount exists in a South African context and if so, why? The 2008-2009 financial crisis will be used as a natural experiment to test whether any changes to the diversification discount or premium can be attributed to changes in corporate finance (internal capital markets or external capital markets) or whether it can be attributed to changes in investor perception. 3.1 Research approach and strategy The research methodology will be deductive in nature and will be a quantitative observation study. Bryman & Bell (2007) define deductive theory as the commonest view of the nature of the relationship between theory and research. Leedy and Ormrod (2010) define a quantitative observation study as a study with a particular and pre-specified focus. Leedy and Ormrod (2010) suggest that by using this method the researcher needs to strive to be as objective as possible in the study. The design of the research methodology to ensure objectivity is discussed in section 3.1.1. The research will be conducted in five phases. Firstly, the level of diversification of firms listed on the JSE will be determined and secondly, a diversification discount or premium for diversified firms will be measured. The third phase will explore the impact of the level of diversification on firm performance. In phase four the change in diversification discount during the 2008-2009 financial crisis is examined. The last phase will explore whether changes in corporate finance (internal capital markets and external capital markets) lead to the diversification discount or premium. The impact of agency theory is not explored, as this is beyond the scope for this study by design. 3.1.1 Level of diversification Two methods to measure the level of diversification of a firm exist and both methods have been used in many studies before. These two models are the product count measure method and the categorisation method. The product count measure method, first suggested by Montgomery (1982), measures the level of a firm s diversification based on Standard Industrial Classification (SIC) codes. This 12
method was used to determine the level of firm diversification in studies by Berger and Ofek (1995) and Delios and Beamish (1999). The South African Companies and Intellectual Property Registration Office (CIPRO) developed an economic activity classification model which provides a framework for the collection and analysis of data. CIPRO s SIC classification consists of a five digit number with each digit having its own attached description. Sambhaya (2000) suggested various strengths and weaknesses associated with the SIC-based, product count measure method. The main strength is the simplicity of the measurement. In a South African context, this measurement proves to be too simplistic. The CIPRO SIC codes are very broad and as a result it groups firms together that have nothing in common. For example, under Code 88140 CIPRO has listed Anglo Platinum (JSE Ticker: AMS), Allied Electronics (JSE Ticker: ATN), Astral Foods (JSE Ticker: ARL) and Aveng (JSE Ticker: AEG). The focus of these organisations ranges from electronics and mining to foods and construction. This paper uses the categorisation method to ensure greater validity and reliability of the results. The categorisation method was first suggested by Rumelt (1982) who developed a method where diversification was measured by comparing divisional revenues to the total revenue of the firm. Rumelt developed a scale for the level of diversification of a firm ranging from least diversified or single-segment firm to most diversified or unrelated businesses. By measuring the specialisation ratio, a level of diversification can be assigned to the firm. The Specialisation Ratio (SR) measures the proportion of an organisation s revenue derived from its largest single business. Rumelt s model was used in studies by Markides (1995), Pandaya and Rao (1998) and Harper and Viguerie (2002). Sambhaya (2000) assessed the strengths and weaknesses associated with this method and found that its conceptual rigour was a strength. However, Sambhaya (2000) found that this method is time consuming and leaves the door open to subjectivity. Sambhaya s review is based on research carried out in the US where thousands of firms need to be studied, however, the pool of companies on the JSE that can be selected for this research is significantly smaller. This will require fewer companies to be analysed which will be less time consuming. 13
3.1.2 Value of the firm and the impact of the 2008-2009 crisis The author followed Berger and Ofek s (1995) method of measuring excess value for diversified firms relative to single-segment firms. They define excess value as the natural logarithm of the ratio of a firm s imputed value and market value at the end of each reporting period. A firm s imputed value is defined as the sum of its divisions imputed values. Divisional imputed values are obtained by multiplying the division s most recent annual sales (or assets) by the mean market-to-sales (or market-to-assets) multiplier of single-segment firms in the same sector (Kuppuswamy & Villalonga, 2010). Kuppuswamy and Villalonga (2010) suggest a three-pronged approach to assess if the value of diversified firms increased during a certain period: A: Univariate Analysis of Excess Value B. Multivariate Ordinary Least Squares Regression C. Controlling for Self-Selection Copyright However, the author s sample size is very small as 98% of the JSE UCT is made up of only 150 firms as ranked by market value. The firms and segments are clustered into broad sectors as defined by the Profile s Stock Exchange Handbook (2008) and the difference in excess value between diversified firms and single-segment firms will be observed. 3.1.3 The role of corporate finance To test the effects of the external capital market on firm performance, the methodology used by Kuppuswamy and Villalonga (2010) that used Lewellen s (1971) debt coinsurance hypothesis will be followed. To test Lewellen s (1971) debt coinsurance hypothesis, a measure of excess debt of diversified firms relative to single-segment firms will be constructed. As suggested by Kuppuswamy and Villalonga (2010) excess debt is defined as the natural log of the ratio of its net debt (short-term debt plus long-term debt minus cash and marketable securities) to its imputed net debt. The firm s imputed net debt is the sum of its segments imputed net debt values, which are obtained by multiplying the segment s most recent annual assets by the mean ratio of net debt to book value of assets for single-segment firms in the same industry (Kuppuswamy & Villalonga, 2010). The excess debt of the diversified firms relative to the excess debt of the single-segment firms will then be compared. 14
However, Comment and Jarrell (1995) argued that the absence of a strong positive correlation between firm diversification and leverage cannot be interpreted as evidence that diversification does not increase debt capacity. Managers of diversified firms may choose not to exploit their increased debt capacity. Kuppuswamy and Villalonga (2010) suggest a more definitive test of Lewellen s theory which will be used in this study. This paper compares how diversified and single-segment firms change their debt levels in response to external financing constraints such as during the 2008 2009 financial crisis. Following the methodology of Kuppuswamy and Villalonga (2010) a proxy will be used for the size of a diversified firm s internal capital market. The measure developed by Rajan et al. (2000) makes use of segment investment rates derived from annual segment data and will form the basis of this proxy. The investment rate of a segment is calculated as the ratio of segment capital expenditures to total segment assets. The author will calculate the industryadjusted investment rate for each segment as the difference between its investment rate and the average investment rate of single-segment firms in the same industry. The size of a conglomerate s internal capital market is the sum of the absolute values of its segments industry investment rates. Thus, larger values indicate a higher level of capital reallocation facilitated by the firm s internal capital market (Kuppuswamy & Villalonga, 2010). 3.2 Research design, data collection, methods and research instruments Bryman & Bell (2007) define a research design as the criteria that are employed when evaluating business research and that it serves as a framework for the generation of evidence that is appropriate to the research question. This section will serve as the framework for the author s research design with three sub-sections. Sub-section one will describe the data collection methods, sub-section two explains how to calculate the dependent variable used in the analysis and the third sub-section justifies the sampling method used. 3.2.1 Data collection The 2008-2009 financial crisis encompassed both the last quarter of 2008 and the first quarter of 2009. On the other hand, the JSE was in the middle of a bull market with the JSE growing 70.3% as can be seen from the Figure 2. Figure 2 also shows the South African Volatility Index (SAVI) that indicates the volatility of the market that is calculated by using current option price data. Equity traders refer to the SAVI as a fear gauge of where prices will move to and as can be seen by Figure 2, fear was at its peak in the middle of the 2008-2009 financial crisis. This paper compares the diversification discount in the 2005 bull market to 15
the 2008-2009 financial crisis and determines if the discount narrowed or expanded during the crisis. Figure 2: Evolution of the ALSI and the SATRIX SAVI from 1 January 2004 to 31 December 2009 Data for the study was collected from a number of different sources. The data collection was initiated by ranking JSE listed firms by market capitalisation using data from the McGregor s database. The sample was reduced by selecting only the top 150 firms ranked by market capitalisation. These top 150 firms make up 98% of the total market capitalisation of the JSE. Firms with sales of less than R100 million in either 2005 or 2009 were eliminated. In the Kuppuswamy and Villalonga (2010) study, they decided to eliminate firms with turnover less that USD10 million. Moreover, the firms needed to be listed before 2005 and remain listed until the end of 2009. The annual turnover data was collected from the annual financial statements as reported by the Inet database. The resulting sample of 106 firms represents 81.2% of the total market capitalisation of the JSE in 2009 and represents 85.8% of the total market capitalisation of the JSE in 2005. South Africa lacks a database that records segmental data in the same manner as the Compustat Industry Segment database in the United States of America (USA). In the USA public traded firms are required to report segmental financial information for segments where the assets, sales, or profits exceed 10% of the consolidated totals (Kuppuswamy &Villalonga, 2010). For segmental data the Annual Reports for the 106 firms from the firms individual websites were downloaded. Where Annual Reports were not present, the author wrote to the 16
firms in question and requested copies of the Annual Report. Where the 2005 annual reports were not available, the 2006 annual report was obtained as it contains comparative data to 2005. This, however, can lead to small differences in the data as financial numbers can be restated in subsequent years. Twelve firms had to be disqualified due to lack of financial results for 2005, 2005, 2009 or the combination of these Annual Reports (see Appendix B for a detailed list of the firms in the sample). Similar to the study by Panday and Rao (1998) single-segment firms are defined as firms with a SR of greater than 0.95 and diversified firms are defined as firms with a SR less than 0.7. For this study another segmentation was added. Highly Diversified firms were defined as firms with a SR of less than 0.5. The resulting sample contains 94 firms that represent 74.6% of the total market capitalisation of the JSE in 2009 and 75.5% of the market capitalisation of the JSE in 2005. Of these firms 29 are found to be diversified (SR < 0.7) and 35 are found to be single-segment firms (SR > 0.95) using Rumelt s (1982) Specialisation Ratio. In South Africa segmental reporting was regulated under IAS 14 until the 1 st of February 2009 when IFRS 8 superseded IAS 14. Under IAS 14, which was in effect for the observation period of this study, a segment was defined as a distinguishable component of the Group that is engaged in providing products or services within different geographical areas which are subject to risks and returns which are different from those of other segments. The basis of segment reporting is representative of the internal structure used for management reporting. Segment results, assets and liabilities include items directly attributable to a segment as well as those that can be allocated on a reasonable basis. To ensure objectivity, segments were selected as per the definition in the Annual Report of the company under investigation. For example, Distell (JSE ticker: DST) trades under one segment as defined in their 2009 Annual Report (page 114): The Group is engaged in the manufacturing, marketing and distribution of alcoholic beverages. As these activities comprise an integrated operation, the Group regards this as a single primary business segment, on which all information is disclosed in the annual financial statements. On the other hand, Dimension Data PLC (DDT) report on three business segments and defined their segments in their 2009 Annual Report as (page 89): The Group also offers a full life cycle of IT Services to clients including planning, building, support and management. This is reported as three 17
streams of revenue: product (the resale of non-proprietary product), managed services (of annuity or recurring nature) and professional services (project-based engagements). Segmental data was captured manually from the Annual Reports. Where segment results were quoted in US Dollars, the ratio of US Dollar segment sales to total US Dollar sales was calculated and multiplied by the total Rand sales value as per the annual financial results. 3.2.2 Dependent variables To measure the diversification discount, this paper uses Berger and Ofek s (1995) measures of excess value as was done in Kuppuswamy and Villalonga s (2010) study. The excess value for diversified firms is measured relative to the excess value of single-segment firms. Berger and Ofek (1995) specifically defined excess value for diversified firms and singlesegment firms as the natural logarithm of the ratio between a firm s market value and its imputed value at the end of the firm s financial year (Kuppuswamy and Villalonga, 2010, p.10). They further define a firm s imputed value as the sum of all its segment s imputed values. A segment s imputed value is obtained by multiplying the segment s annual sales or assets by the mean market-to-sales multiplier or mean market-to-assets multiplier of single- segment firms in the same industry. The market-to-sales multiplier from single-segment firms is calculated by dividing the average market capitalisation over the year by the annual sales for that year. The market-to-assets multiplier from single-segment firms is calculated by dividing the average market capitalisation over the year by the total assets reported at the end of that year. The sum of the imputed values of a firm s individual segments estimates the firm s value if the individual segments operated as stand-alone businesses. Positive excess value shows a positive effect of diversification on firm value and negative excess value shows that diversification destroys value. There are many advantages of using industry multipliers to examine diversification over other methods used in diversification studies. One such method is to use an event study that requires a clearly identified and defined event date. However, it is difficult to identify and pin point a date that unambiguously provides information about diversification (Berger and Ofek, 1995). A second method used in examining diversification is to examine stock price responses to takeover announcements. It is difficult to identify investors attitudes about diversification using this method as the announcement might convey a signal about the terms, probability of success and future opportunities of the offer (Berger and Ofek, 1995). Tobin s 18
q-ratio is widely used in diversification studies as highlighted in chapter 2. This method requires the researcher to make assumptions about future inflation rates, replacement value of the firm and depreciation rates. Also, q-ratios are not industry adjusted even though the q- ratio differs significantly over different industries. Researchers who have attempted to industry adjust q-ratios have found it to be problematic as they could not calculate the ratio s from the available data (Berger and Ofek, 1995). The industry multiplier approach has two distinct advantages. Firstly, it directly estimates segment excess value as a result of diversification. Secondly, it allows for further analysis of the overall value effect that individual segments have on the overall value of the firm. However, management s disclosure policies impact the validity of using industry multipliers to examine the effect of diversification on firm performance. Managers have the ability and may have the incentive to mis-state segmental sales numbers. Managers also have greater discretion to allocate expenses between segments and for this reason, this paper does not use a market value-to-earnings multiplier to calculate the imputed value of individual segments of diversified firms. To test the debt coinsurance hypothesis as first suggested by Lewellen (1971) the author uses a measure of excess debt of diversified firms relative to single-segment firms. This measure is constructed in a similar fashion as that of Berger and Ofek s (1995) measure of excess value. Excess debt is specifically defined in line with the Kuppuswamy and Villalonga (2010) study as the natural log of the ratio of net debt (short-term plus long-term debt minus cash and cash equivalents) to its imputed net debt. The firm s imputed net debt is the sum of all its segment s imputed net debt values. A segment s imputed net debt is obtained by multiplying the segment s annual assets by the mean ratio of net debt to total assets for single-segment firms in the same industry (Kuppuswamy & Villalonga, 2010). In line with Kuppuswamy and Villalonga (2010) the researcher chose net debt over gross debt to minimise the effect of out of the ordinary liquidity management by firms during the 2008-2009 Financial crisis. 3.2.3 Sampling The sampling method that is most appropriate for this study given the number of observations that are available, is that of non-probability convenient sampling. Leedy and Ormrod (2010) 19