Investor Recognition of Corporate International Diversification
Tamir Agmon; Donald R. Lessard
The Journal of Finance, Vol. 32, No. 4. (Sep., 1977), pp. 1049-1055.
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Mon Mar 27 10:15:32 2006INVESTOR RECOGNITION OF CORPORATE INTERNATIONAL
DIVERSIFICATION
TAMIR AGMON AND DONALD R. LESSARD*
IN THE PRESENCE OF BARRIERS to portfolio capital flows, multinational firms
(MNCS) have an advantage relative to single-country firms because of their ability
to diversify internationally. This financial advantage—the result of financial mar-
ket imperfections—compliments the advantages MNCs derive from imperfections
in real goods and factor markets and represents an additional motive for multina-
tional expansion.' This paper argues that such barriers do exist and provides
empirical support for the diversification motive by showing that investors appear to
recognize the extent of multinational diversification of a sample of U.S. firms lisied
‘on the New York Stock Exchange.
L._ RELEVANCE OF INTERNATIONAL DIVERSIFICATION
AT THE CORPORATE LEVEL
The benefits of international diversification at the investor level are well docu-
mented (e.g. 3} [8], and (16). However, the mere presence of less than perfect
correlations among company earnings and/or asset values in various countries is,
insufficient to establish that international diversification is relevant at the corporate
level. Two further conditions must be satisfied: 1) there must exist greater barriers
or costs to portfolio capital flows than to capital flows forming part of the direct,
investment package; and 2) investors must recognize that MNCS provide a diver-
sification opportunity which otherwise is not available,
If there were no barriers to international capital flows, and if capital markets,
vere uniformly well developed, investors would diversify their portfolio holdings
internationally and required rates of return on securities (projects) would reflect
only their contributions to the risk of a fully diversified world portfolio. Under
such circumstances, diversification at the firm level would be of no consequence
‘Senior Lecturer, Tel Aviv Universiy, and Associate Profesor, Sloan School of Management, M.LT.
‘This paper was written while Dr. Agmon was a Visiting Profesor atthe Sloan School. We would like to
thank Michael Adler, Fischer Black, Dennis Logue, James Paddock, Robert Pindyek, Alan Rugmaa,
and Marshall Blume, «reviewer for this Journal, for helpfl comments and Alex Henry for computa
‘ional assistance.
1. Weis generally acknowledged that in order to justify foreign investment, the multinational
corporation must have some advantage relative to local firms inthe countries in which it invests which
allows it to overcome the costs imposed by cultural and geographical distance not borne by lea firms.
‘Most economists have argued that the primary sources of advantages of MNCs relative to local frm
face imperfections in markels for products and factors of production, generally excluding capital
Reviews of the theory of foreign investment are provided by Dunning [2}. Kindleberger [7], Ragaza (13)
and Stevens [17]. The benefits of international diversification were introduced into the iterature by
Grube! (3) Ragazzi 13] and Rugman (14) extend them to FDI.
10491050 The Journal of Finance
and the required rate of return on a particular project would be the same whether it
‘was undertaken by an MNC or a local firm?
II, VERIFYING THE DiveRsiFicaTION Morive
In order to verify the existence of a diversification motive for multinational
expansion by corporations, we seek to determine if the two conditions cited above
are true. In the case of the first condition, we observe that there are numerous
examples of barriers to portfolio flows which are or have been more stringent than,
those applying to direct investment flows.’ Further, the flexibility of the MNC in.
shifting revenue-producing resources among its operating units suggests that even,
when barriers are nominally the same, direct investment flows will be freer than,
portfolio flows.* Although these observations are not conclusive, they lend substan-
tial support to the first condition, We concentrate on the second condition, whether
investors appear to recognize the diversification opportunities provided by MNC
shares. We do this by investigating the share price behavior of a sample of
US-based MNCs.
Direct measures of the existence and magnitude of the diversification motive
based on the pattern of MNC expansion are avoided since the diversification
motive coexists with motives resulting from imperfections in product and real
factor markets. As a result, in many cases it is consistent with the same patterns of
expansion explained by alternative hypotheses and cannot be isolated empirically.*
For example, the foreign investment “balance sheet” of the United States,
characterized by a preponderance of outward FDI and inward foreign portfolio
investment (FPI), has been explained in terms of real goods and factor market,
relationships, but the same pattern is consistent with the argument outlined above.
The US. investor, seeking diversification but facing relatively less efficient capital
markets abroad and barriers imposed by legal restrictions as well as by a lack of
previous foreign investment experience, would prefer to diversify by purchasing,
shares of U.S.-based MNCs which include claims on foreign operations while
2. Myers {12] provides a clear argument for this case in reference to the domestic conglomerates
Others, including Lewellyn [10] and Hughes, Logue and Sweeney [S] have argued that diversification at
the corporate level is advantageous since st increases a firm's debt capacity, However, this conclusion
‘hasbeen questioned on the grounds that when a frm which has outstanding debt diversities, it increases
the value of the debt and thus reduces the value of equity. See fr example Higgins and Schall 4)
3, These may include formal “border” barriers such as the U.S, 1ET, formal internal barriers suchas
SEC registration requirements, informal border barriers resulting fom investor tradition and/or lack of
information, and informal internal bariers which would include relatively undeveloped or inefficient
domestic capital markets
4. Foreign direct investment often involves transfers of intangible factors of production such as
technology or managerial skis. To the extent that these real transfers are nat pai fo in cat, they are
accompanied by financial transers, usually of a risk-beaing nature since the eventual payment for the
factors involved is contingent on future outcomes. Clearly, such inward tansfers are not captured by
‘contol over financial flows. Remittances of profits from these transferred resources often will not be
restrcied and even if they are, the MNC has a number of options for bypassing such restrictions,
‘especially tanser pricing of goods and factors of production.
5. This problem has plagued mott empirical research on the motivation for multinational expansion
Fora critical review of these stuies, see Stevens (17.Investor Recognition of Corporate International Diversification 1051
non-U‘S. investors, to whom the U.S. market appears quite open and efficient,
would diversify by purchasing shares in U.S. firms. Direct measures based on the
risk adjusted performance of the shares of multinational firms relative to single-
county firms suffer from similar drawbacks*
III. Invesor RECOGNITION oF MNC Diversiric
Since the shares of U.S.-based MNCs represent claims on foreign as well as
domestic activities, one would expect share price movements to reflect this fact. If
prices behave as if the market does not distinguish between firms with different
degrees of international involvement, one would have to conclude that as far as the
American equity market is concerned, international diversification of activities
does not matter. On the other hand, if the movements of share prices indicate that
the market perceives international corporations as different than those less interna-
tionally inclined, this evidence, in combination with evidence of barriers to capital
flows, lends support to the view that the MNC’s ability to diversify internationally
is an advantage.
The Relationship Between Share-Price Behavior and the Extent of International
Incotcement
Fluctuations in share prices reflect events (i.¢., new information) which change
expectations of the future cas flows of conporations or the mechanism by which
these future cash flows are capitalized by investors in the market, For purposes of
exposition, itis useful to clasify fluctuations within a single economy as those
resulting from three arbitrarily defined types of effects—those which affect virtu-
ally all stocks (although perhaps to a different degree), those which affect certain
soups of stocks such as industries, and those specific to sinale stocks. The fist
type of effect is the main component of the systematic risk which cannot be
eliminated by diversification, Thus the most important relationships between
Felurns on securities can be described in terms of “market model”
yma t Bayi ®
where &, is the return on security j (a random variable) in period 1. Rj, is the
feturn of the market index. and f, are parameters for security), and’, is a
random variable with a 270 mean, and Cow(,4)=0, Cow(ya)=0
Internationally, the structure of returns appears to be more complex. Returns on
securities within each domestic market appear to be reasonably well described by
the market model, but they are related internationally through a world factor.” In
6. This approach faces the same empirical dificultes as tess of the capital astet pricing model inthe
domestic context as well as the as yet unresolved issue of specifying an appropriate international capital
asset pricing model. For a review of the frst set of issues, see Jensen (6 forthe second Agmon (1), and
Solnik [15] Hughes, Logue, and Sweeney [5] rise a series of interesting ites i this regard
7, Agmon {1}, Lessard [8], and Sonik [15] explore the international structure of returns. All conclude
that country elements are very stong and industry elements of litle importance. However, they do not
aceept a common definition of the world market factor nor do they resolve whether price changes of
individual stocks are directly related to the world factor or are flated only direc through the
respective domestic market factors.1052 The Journal of Finance
this case the interdependence of changes in the prices of securities in the interna-
tional market can be summarized in terms of an “international market model”
Ryn ay+ By Ret yh. +e, ®
where iy is the return on security j from country k, and where time subscripts
were dropped for simplicity, R, is the return on the country & market factor. and
Fi is the return on the world market excluding country k (.. the rest ofthe world).
if we view an international firm as a collection of activities in different counties,
then the return on its traded shares can be described as:
nat Sm Akt y at °
where the i represent the market factors for each of the N countries in which firm
{j generates proportion w, of its revenues (S,w,= 1). Equation (3) implies a direct
relationship between the international composition of the firm’s activities and the
pattern of the price changes of its shares. Unfortunately such a complex re-
lationship would be difficult to test due to the lack of necessary data and the need
for a more specific and explicit international valuation model.
In this section we take a more modest and preliminary step. We test the
proposition that securities of firms with relatively large international operations are
more closely related to the rest of the world market factor and less to their home
country factor than shares of firms which are essentially domestic. We expect this
since non-U.S. activities should be reflected by a dependence on the rest of the
world factor and the appropriate country factors. but not by dependence on the
US. country factor. Therefore, the higher the proportion of non-U'S. activities, the
lower the dependence on the U.S. country factor. Further, since the rest of the
world factor by construction does not reflect U.S. activities. it should become more
important as non-U.S. activities increase. Thus an examination of the relationship
between security price changes and the domestic and the rest of the world factors,
controlling for the degree of international involvement, provides a partial and
indirect test of whether the international composition of a firm’s operations is
reflected in the market behavior of its securities” Thus the return on the shares of
US-based MNC may be thought of as arising from the following relationship:
Rem 04+ By Rect YR * o
where A =return on the share of the jth corporation with a proportion + of
non-US sales, R, the return of the NYSE index, and R, the return of the rest of
the world index, defined to be orthogonal to R,,
4, It should be emphasized that our analysis is restricted to determining the impact of degree of a
firm's international involvement on the flatonship ofits stock's movements with general domestic and
‘world market effets. t does not encompass tests ofthe relationship between the stock’s riskiness and
{verage return overtime. Hughes, Logue, and Sweeney [5] interpret similar results as showing that
Stockeare pried internationally rather than domestically. While this i an atractive hypothesis, this
‘interpretation can be questioned on several groundsInvestor Recognition of Corporate International Diversification 1os3
‘We test the hypothesis that f, is a decreasing function of s, and that y,, is an
increasing function of s,
Enpirical Results
In order to test the hypothesis that security returns reflect the international
‘composition of a firm's activities, monthly returns (ending stock price plus cash
dividend, divided by the previous price) for 168 months from January 1959 to
October 1972, and an estimate of the proportion of a firm’s revenue from non-U.S.
sources were obtained for a sample of 217 U.S. firms. The firms were then ranked
according to the degree of international activity and grouped in deciles in order to
reduce the influence of differences other than the extent of international activity.
The composite return series for the resultant portfolios (about 20 stocks were
included in each one) were regressed on the indexes for the U.S. stock market and
the rest of the world.” To obtain the latter, the Capital International world index
was regressed on to the New York Stock Exchange index and the residuals of this
regression were defined as the “rest of the world” stock market index. The results
of this regression are presented in Table | below.
The data presented in Table | shows that those portfolios with a high degree of
international involvement, measured by proportion of sales outside the U.S., have
TABLE!
Derexnence oF Mosity RETURNS ON U.S. Ax WoRLD Isnexes|
Rr at Bhat yh ty
Proportion of Sales
Portfolio Outside the US. Std Er. y SiLER Rot
No. (US) of 8 (world) ofty regression
T os i 8
2 Los -u 10 es
3 3 1B 8 894
4 2 o5 56 08 61
5 % 8 18 10 865
6 8 8 20 10 336
1 258 BS 30 % 853
8 29.35 2 8 30 10 an
9 33-0 a 8 39 10 820
10 Be a 8 «0 ~ 64
9. The monthly holding period returns fo individual stocks are from the CRSP monthly file, the US.
index is a market-value weighted index for the New York Stock Exchange aso fcom the CRSP file, and
the world market inde i the Capital International World index, a marketvalue weighted index ofthe
major securities listed on the 18 most important national stock markets, The foreign activity measures,
proportion of sales generated outside of the USS, were taken from Standard and Poor's The Outlook
‘(August 13, 1973). The ideal measure of foreign activity would be proportion of total market value
represented by non-US. operations, sales, ete. However, for obvious reasons this number is aot
Aavailable—noris it known bythe firms in question. Other measures such a asses, employees, or profi
appear to be even further from the ideal than sales. The international distribution of profits,
‘example, is arbitrary since it depends on tansfr price, overhead allocations, and various accounting
conventions regarding recognition of foreign activites, However the grouping procedure employed
should alleviate some of the problems associated withthe foreign activity measure.1054 The Journal of Finance
relatively high y's, the coefficient relating the changes in the share price to the rest
cof the world index (not including the U.S). Moreover, the higher the level of
international involvement, the more statistically significant is the y coefficient.
‘Similarly, the B coefficient relating the returns on each of the portfolios to the U:S.
index are much higher for those portfolios with litle international involvement.!°
This evidence supports the hypothesis that the market recognizes the geographi-
cally diversified nature of the US-based international corporations as well as the
‘extent of their international involvement,
These results, however, are only indicative since they do not show whether the
observed differences in f"s and 's are statistically significant. Further, although
the grouping of stocks into portfolios is useful for isolating the impact of the extent
of international activity, it does not lend itself easily to such a test. Therefore, we
performed a two-stage regression on individual stock data to test the relationship
between firm's national dependence (f,) and international dependence (1) on its
degree of international involvement.
Tn the frst stage, f, and yy were determined for each of the 217 securities using
equation (4). In the second stage the fs and 7's were related to IS, the interna
tional sales ratio in two separate equations:
Boma + blS+u, (Sa)
yng + oS+u, (56)
The evidence presented in Table | suggests that 5, will be negative and that bj
will be positive.'” A summary of the two-stage regression is presented in Table 2
below:
TABLE?
US. ano Wort DEPENDENCE As A FUNCTION oF
Inetenxaniosal INVOLVEMENT
(US. dependence) bj (world dependence)
— 010 or
T satistc Tati
3.98 4a
F statistic (1,215) F statistic (1,218)
1391 932
Resquared Resquared
069. 083
Both 5, and b; have the expected sign and are statistically significant at a 5
percent level
Similar relationships hold when the 4-year period was split into two seven-year periods
1. fy and y, are regression coefficients themselves and hence are measured with error. However, 0
the extent that this eror i uncorrelated with /S, twill not bias the estimates of band 8 but wil reduce
the tatatistis,Investor Recognition of Corporate International Diversification 1055
IV. CoveLusions
The results support the hypothesis that U.S. investors recognize the international
composition of the activities of U.S.-based corporations. This is only a first step
towards a specification of the relationship between real corporate variables, such as
the international distribution of operations, and capital market variables, such as
changes in share prices. However, when coupled with the observation that MNCs
often can diversify internationally at a lower cost than portfolio investors, it
suggests that the diversification motive should be given more serious consideration
than has been the case to date.
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1968),
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