oy 47:58:25 Strategic Management Journal, Vol. Lo Diversification Strategy, Profit Performance and the Entropy Measure KRISHNA PALEPU Graduate School of Business Administration, Harvard \ University, Boston, Messachusetts, U.S.A. Summary Several industrial organization studies, usine diversification index measures, examined corporete diversification and economic performance and failed to ind any significant relationship between ‘hem. Rumelt and other siroieny researchers used a Semisudjective classification scheme ond uncovered a systematic relationship benswen diversifcction stratepies and performance. This study combines the sirengihs of the index approach. namely, simblict). objectivity and replcablity, with the exental richness of Ruelt’s ‘methodology. Using the Jacquemin-Berry entropy measure of ‘iversfication and the line-of-busines data, this swudy finds that ums with predominantly related diversification show signticantly beter profi growth thom firms with predominantly unrelated diverstication. INTRODUCTION A vast majority of U.S. firms are currently pursuing some form of diversification (Rumelt, 1974). Diversification strategy is thus an important component of strategic management of a firm, and the relationship between a firm’s diversification strategy and its economic performance is an issue of considerable interest to both academics and managers. ‘Two streams of research literature, industrial organization and strategic management, deal with the profit impact of corporate diversification. The industrial organization literature, including studies by Gort (1962), Arnould (1969) and Markham (1973), concludes that no significant relationship exists between diversification and firm performance. In contrast, the studies by Rumelt (1974, 1982), Montgomery (1982) and Christensen and Montgomery (1981) in the strategic management literature report a systematic relationship between a firm’s diversification strategy and economic performance. The fundamental difference between the two streams of research is the methodology used to measure corporate diversification. The industrial economics studies employed simple product-count indices that measure the total diversity of a firm's operations. The strategic management studies used a categorical measure based on the classification scheme proposed by Rumelt. In a recent study, Montgomery (1982) compared the product-count measures with Rumelt’s classification scheme and found that the two sets of measures exhibit a fair amount of correlation in terms of the total diversity of a firm's operations. As she pointed out, however, Rumelt’s categorical system taps an element of diversification that commonly (0143-2095/85/030239-17501.70 Received 22 Aprit 1983 (©1985 by John Wiley & Sons, Ltd. Revised 10-April 1984 BG240 ‘Krishna Palepu employed product-count indices have not: the distinction between related and unrelated diversification, Thus, the industrial organization studies failed to uncover the different profitability patterns of related and unrelated diversifiers. Montgomery comments, ‘Perhaps further work with continuous measures that distinguish between diversification within and between major industry groups will better address this issue” (p. 306). The study described in this paper attempts to accomplish this. This study re-examines the diversification-performance relationship using a diversification index that distinguishes between related and unrelated diversification. In so doing, it combines the advantages of using a product-count type measure with the essential richness of Rumelt’s classification scheme. It is hoped that this helps bridge the gap between the two streams of literature dealing with the profit impact of corporate diversification. This paper is organized as follows. The extant empirical literature on the diversification performance relationship is reviewed in the second section. In the third section, the theoretical expectations of the relationship are discussed and hypotheses to be tested in this study are developed. The empirical analysis is presented in the fourth section. The concluding section presents a discussion of the results and their implications for research and practice. LITERATURE REVIEW Industrial organization literature Gort (1962) was one of the first to examine the profitability of diversified firms. He analysed 111 large U.S. corporations over the years 1947-197, using three measures of diversification: (1) a simple count of industries in which a firm operated; (2) the complement of the specializat ratio (the ratio of a firm’s primary industry output to its. total output) and (3) the product of (1) and (2). U.S. Bureau of Census data on unemployment and manufacturing payrolls were used to compute the three measures. The analysis showed that there was no significant cross-sectional correlation between profitability and diversification. Arnould (1969) studied 104 U.S. food processing firms. He employed four diversification measures: (1) the complement of the specialization ratio; (2) the complement of the specialization ratio multiplied by the number of four-digit industries in which a firm operates; (3) the summation of the share of a firm’s output in each industry multiplied by the four-firm concentration ratio of that industry and (4) the summation of the share of a firm's output in each industry multiplied by the total output of the industry accounted for by the firm. The latter two indices attempted to account for the structure of the industries entered by a firm, and the former two were those used by Gort. Amould also concluded from his analysis that no significant cross-sectional relationship existed between any of the above measures of diversification and profitability. Markham (1973) analysed the public policy implications of corporate diversification. His analysis found that in all of the multiple regression models relating diversification with various firm-specific variables, whenever profitability entered at a significant level, it entered with a negative sign. Commenting on his results, Markham speculated that diversification during the period 1961-1970 was not generally a profitable activity. All of the above studies examined the hypothesis that the total diversification and profitability are cross-sectionally correlated. Their results failed to support this hypothesis. As this paper argues, one of the crucial limitations of the above studies was their failure to distinguish between related and unrelated diversification and their focus on the cross-The Entropy Measure 241 sectional relationship between diversification and profitability. The strategic management studies discussed next remedied these two limitations. Strategic management literature The work of Rumeit (1974) was pioneering among the strategic management studies that examined the profit impact of diversification. Discarding the unidimensional product-count measures used by the industrial organization studies, Rumelt adopted a categorical measure of diversification. He viewed a firm's diversification strategy as having two critical dimensions: ‘¢i) the firm’s commitment to diversity per se, (ii) the strengths, skills and Purposes that span this diversity, demonstrated by the way new activities are related to the old’ (p. 11). Rumelt operationalized the above definition of diversification strategy by extending the classification system first proposed by Wrigley (1970). Using a set of quantitative and subjective criteria, Rumelt placed each firm into one of nine diversification categories. The classification scheme is summarized in Appendix 1. Rumelt later modified this scheme to hhave seven categories. Using this scheme, he analysed the profit performance of 246 diversified firms and concluded that firms that diversified but restricted their range of activities to a ‘central skill or competence’ have shown better performance than other types of firms’." Two subsequent studies replicated and extended Rumelt’s work. Christensen and Montgomery (1981) analysed a subsample, 128 firms, from Rumelt’s original sample. The time period covered by their study was the years 1972-1977. Rumelt’s main finding—that related diversifiers show a superior profitability when compared with unrelated diversifiers—was reaffirmed by Christensen and Montgomery's study. Rumelt (1982) himself replicated his original study, employing a statistical methodology different from his original one, and found the results to be consistent with his original findings. ‘The conclusion emerging from the strategic management literature is that firms pursuing related diversification over an extended period of time achieved significantly superior performance. Firms with a set of unrelated businesses failed to achieve this performance despite their diversification THE PRESENT STUDY: HYPOTHESES, MEASURES AND DATA. Hypotheses The arguments in the industrial organization literature linking diversification to profitability revolve around the notion of market power (sec Markham, 1973; 24-26). Because of its ability to acquire and exercise market power, a diversified firm is alleged to be able to subvert competitive market forces through mechanisms such as cross-subsidization, predatory pricing, reciprocity in selling and buying, and barriers to entry.’ Another | in terms of Rumel's diversification categories, the dominary-constained ond the dominani-Knked categories showed the bishest performance, followed by firms ia te reiated-linked, the single Business and the acquisitive conglomerate caegores. ‘Thedominant-retica and unrelated passive categories were the pootest performers. "fle engages in crost-subsidication wien i epioys the revenves earned in one product line to support the activities pertaining 19 another. Predatory pricing sa senlar mechanism: 2 firm ceats a stavegi weapon against competition Dy wsing the revenues earned in some product divisions to fubsidize the lower prices of others. Reciprecty in buying and selling Occurs ‘when a firm's actual and potential customers are also actual or potential supplies, It is believed that the more diversified Company, the larger wil be the numer of markets in which i buys and sell ard, hence, the large isthe liklinood of ‘opportunities vo practie reciprocity. erriers (9 enry isa strctural phesomenon ofan industry. Economists claim tha ery of large diversined firms ino industries previously populated entirely by small undiversied firmus ses the stage for rising conceatratioe ia the acquted hrm's industry.242. Krishna Palepu mechanism that is expected to allow diversified firms to sustain supernormal profits is the ‘information loss’ that arises from the ability of a diversified firm to conceal the profitability of its individual business segments.’ ‘The above arguments lead to the hypothesis that the more diversity a firm has in its operations, the better are its chances of extracting supernormal profits. Stated more precisely, this leads to the following hypothesis on a cross-sectional relationship between overall diversification and profitability. Hypothesis HI. On average. the profitability of firms with high total diversi- ‘Sication is greater than the profitability of firms with low coral diversification. ‘The three industrial organization studies examined the above hypothesis and found no evidence to support its validity. One possible explanation for this is the failure to distinguish between related and unrelated diversification. When a firm operates in a set of related businesses, it is possible for it to exploit its ‘core factors’ leading to economies of scale and scope, efficiency in resource allocation, and ‘opportunity to exploit particular technical and managerial skills. (See Rumelt (1982) for a more elaborate discussion.) Ansoff (1965) refers to several types of synergy that might result when a firm takes care to select its products and markets in a systematic manner. These include sales synergy through transfer of know-how across products, and management synergy through transfer of general management skills across products. Salter and Weinhold (1978) argue that a diversified firm can apply particular skills and knowledge acquired in one business to solve problems and exploit opportunities in other businesses. By its very nature, unrelated diversification provides few operating synergies. Although it is possible to achieve financial synergy through unrelated diversification, the benefit probably is marginal—if the existence of well functioning financial markets is assumed. An Unrelated diversifier, therefore, has to rely on its market power to achieve superior performance. The possibility of successfully exploiting market monopoly power i considerably reduced by the presence of the antitrust regulations. Whatever marginal gains remain to be exploited can be expected to be offset by the possible diseconomies of managing a set of unrelated businesses. The net benefit of unrelated diversification, thus, seems questionable. These arguments lead to the following hypothesis Hypothesis H2. On average, the profitability of firms with high related diversi- Aication is greater than the profitability of firms with high unrelated diversification. Both H1 and H2 postulate a cross-sectional relationship between diversification and Profitability. However, it is possible for diversification to have a significant impact on a firm's profitability without any cross-sectional relationship empirically existing between diversification and profitability. This seeming cont can be illustrated through the following hypothetical example. Consider two firms A and B. Firm A has a high current profitability and seeks to diversify in order to exploit exceptional opportunities to earn still higher returns. Firm B, on the other hand, seeks diversification as a means to improve its current poor performance. Though starting with very different Jevels of profitability—and * Microeconomic theory argues thatthe existence of supernormal profits ina indesiry wil, other things being equal, induce few entry. Lows of profit information due to comolidaicd reporting by diveriied firms inhibls this process as the Drofrabilky of specific product lines of ube fms not indicated, This raises barriers to enry. helping sustain supernocral Profs for aconsiderably longer ine,® 47:56:37 The Entropy Measure 243 quite conceivably ending with different levels—the two firms seek to accomplish the same: they seck improvement over their starting profitability levels through diversification. This example shows that the performance variable of intcrest is change in profitability over time rather than the profitability level itself. Keeping this in mind, we can make the following longitudinal hypothesis. Hypothesis H3. On average, the profitability growth rate of firms with high related diversification is greater than the profitability growth rate of firms with hhigh unrelated diversification. If H3 is valid, in the long run firms that consistently pursue related diversification may even show high absolute profitability levels due to the cumulative superior profit growth over the years.‘ This leads to the following corollary to H3. Hypothesis H3". On average, the profitability of firms that pursue related diversification over an extended period is greater than the profitability of firms ‘that pursue unrelated diversification over the same period. It is important to distinguish between H2 and H3". Though both postulate the relationship in terms of profitability level, H2 simply refers to a cross-sectional relationship whereas H3” (like H3) refers to a longitudinal relationship. Both Rumelt (1974, 1982) and Christensen and Montgomery (1981), in fact, tested H3", This can be concluded from the fact that they examined the diversification strategy of firms over a 10-year period for classifying firms into various diversification categories. Finally, note that although H3 implies H3°, the former is a more robust hypothesis than the latter for the purpose of empirical testing because H3 is less crucially dependent than H3° on the length of the time period over which the analysis is performed. Of the four hypotheses discussed above, two have been examined by previous studies. The industrial organization studies tested HI and found no evidence to support it. The strategy studies examined H3" and found that the evidence is consistent with it. Hypotheses H2 and H3 have not been examined by the earlier studies. The primary focus of this study is to examine H3. In order to make the analysis complete and to understand better the reasons for the failure of the industrial organization research to establish an empirical relationship between diversification and firm profitability, the study examines HI and H2 also. Similarly, H3’ is included in the analysis to examine whether the results of this study are consistent with the findings of the strategy literature. Based on the results of the earlier studies and the arguments presented above, the prior expectation is that the results would not support HI and H2 and would support H3 and HB, Measures The measurement of diversification is central to the empirical investigation of performance implications of corporate diversification strategy. As Montgomery (1982) points out, the index approach employed by the industrial organization researchers and the categorical approach used by the strategy researchers have their respective strengths and weaknesses. ‘The diversification indices are simple, easy to compute, objective and replicable. However, all the indices used to date in examining the diversification-profitability relationship have a iguish between related and unrelated diversification. one ofthe referee, whove comments edt this analysis.244 Krishna Palepu Rumelt’s classification is rich and captures well the subtleties of a firm’s diversification strategy. However, it is subjective and very time-consuming. The diversification measure used in this study enables the researcher to retain the simplicity of the index approach while capturing the essential richness of Rumelt’s approach. The measure was originally proposed by Jacquemin and Berry (1979) who designated it the ‘entropy measure of diversification’. They employed it to analyse the relationship between corporate diversification and growth. The Jacquemin-Berry entropy measure is based on three elements of a firm’s diversity of operations: (1) the number of product segments in which the firm operates; (2) the distribution of the firm’s total sales across the product segments and (3) the degree of relatedness among the various product segments. What distinguishes the entropy measure from other diversification indices is its ability to consider the third element. Because of this, the entropy measure overcomes the limitation of the earlier diversification indices and allows the decomposition of a firm’s total diversity into two additive components: (1) an ‘unrelated’ component that measures the extent to which a firm’s output is distributed in products across unrelated industry groups and (2) a related component that measures the distribution of the output among related products within the industry groups. The entropy measure, however, still retains the computational simplicity of the other index measures. The definition and the detailed technical exposition of the Jacquemin-Berry entropy measure are presented in Appendix 2. An intuitive explanation of the measure is as follows. The related diversification arising out of operations within an industry is the weighted sum of the shares of each of the product segments in the firm’s sales in that industry. If the firm operates in several industries, the net related diversification is the weighted sum of the related diversification within each of these industries. In addition to the related diversification, a firm operating in several industries has unrelated diversification. This is computed as the weighted sum of the shares of each of the industries in the firm's total sales. The measure thus provides three indices for each firm: (1) the index of related diversification; (2) the index of unrelated diversification and (3) the index of total diversification which is equal to the sum of (1) and (2). A hypothetical example at the end of Appendix 2 provides an insight into the nature of the entropy measure. The standard industrial classification (SIC) is used in this study to define related and unrelated product groups. Products belonging to different four-digit SIC industries within the same two-digit industry group are treated as related; products from different two-digit SIC industry groups are defined as unrelated.’ ‘The performance measure employed in this study is profitability. Return on sales (ROS) is used as a measure of firm profitability. It is computed as the net profit after taxes (excluding extraordinary items) as a percentage of net sales. Profitability growth rate between two years has been computed as a percentage change in ROS from the base year to the final year. (The entire analysis presented in this study was replicated using an alternative measure of profitability, namely return on equity. The results were essentially the same as those presented here and have been excluded only in the interest of brevity.)* The SIC clasifcation isnot free of limitations. However, is use is dictated by several considerations: () tia well accepted éassiieaon system und is frequently used in industrial organization researc; i) the analysis presente ia this paper ca be ‘plicated by others and (il the data are realy avalable inthe required form. "I acquisitions in pursuit of diversification are nanced by cash or deb, the equity base of a company may grow very litle the absoluie size of the profs increases due to the new acquisitions. The we of te return on equity (ROE) measur Intiodvce | consequence of factors such asthe debt-equity mix used in financing the acquisitions. The return on sales (ROS) measure avokds this problem. Thus, in the contest ofthe present study, the use ofthe ROS measures probably superior {ote ROE measures. Iam grateful to one ofthe referes for porntng this Out 19 me.The Entropy Measure 245 Data and computation of measures Diversification indices are computed using segment sales data as reported by the companies in accordance with Statement 14 of the Financial Accounting Standards Board (FASB, 1976) and compiled by Standard and Poor on their business segment Compustat tape.’ Profitability and profitability growth rate are computed using data reported by the ‘companies as compiled by Standard and Poor on their annual Compustat tape. The period covered by the study is 1973-1979, the years for which segment sales data were publicly available at the time this study was undertaken. Diversification indices are computed for each company for each year using the SIC codes and sales data for each of the principal products of the company. In a few cases, when an industry segment of a firm consists of only one principal product and it is not possible to assign a unique SIC code to that segment, the sales are split equally between the two SIC codes assigned for that segment. The sensitivity of the final results to this allocation assumption has been tested by replicating the analysis using another rule by which sales are split in the proportion of 90 per cent to 10 per cent between the two SIC codes. It has been found as a result of this test that the sensitivity of the results to the allocation rule is insignificant. Data for the computation of profitability measures are drawn from the expanded annual industrial Compustat tape. First, return on sales for each of the companies for each year during the period 1969-1979 is computed. Then 5-year moving average ROS for the years 1973 and 1979 is computed.’ The moving average, rather than yearly ROS, is chosen for use as the profitability index to eliminate some of the noise in the accounting numbers. Profitability growth rate is computed as the percentage change in ROS between the years 1973 and 1979. Sample ‘The statistical analysis presented in the following sections is based on 30 firms from the food products industry group. (This is industry group 20 under the SIC classification scheme.) The sample for investigation is drawn from a single industry so that industry- specific effects can be controlled for in the analysis. The choice of the food industry itself is random. All the firms in the industry that met the data requirements for computing the diversification and profitability measures during the years 1973-1979 are included in the analysis. This resulted in the sample consisting of 30 firms. The names of these firms are listed in Appendix 3. It should be noted that since meeting the data requirements is the criterion employed in choosing firms, the sample is not a random sample in the probabilistic sense. Any biases that may have resulted due to this could not be avoided. Statistical tests To analyse the data and test the hypotheses, the F-test, the median test and the Mann- Whitney U-test are employed. The s-test is a parametric test for testing the equality of "Standard and Poos busses information Compustat I tape ince am indus segment le ofthe dat reported by fs ‘in accordance wth FASD Stent Is, Te le contin up (07 years of informatio foreach compan), the perio covered irenty bong 1973-197. For exch year ring whic dats were avadable Tora company hee area 1010 econ of indy seer data, with each indy sepmen!reerd providing information om apart’ indy segment Each tecord conus dita up to four prin products ofthe ndoxry text. Each Segment i agned at SIC code irewards thew ic ctu bn net ei he see are ahgne. Fer each of the principal products lied ts SIC code pd ales data ave avaible. For move ‘eae descrioien ofthe data tnd te tae: ee Standard and Poor Compustat Srvc anal om Dine Informaion Serpent *Porexampc the nveraue ROS forte ya 197) seid asthe average of he yearly ROS fre yar 196 hough 173means. The median test and the Mann-Whitney U-test are non-parametric tests for testing the equality of the medians. (For a description of these non-parametric tests, see Scigel (19S6).) The t-test is commonly the test employed to analyse the type of hypotheses examined in this study. However, given the small size of the sample, the parametric assumptions underlying the test may not hold. The non-parametric tests are used to guard against this possibility. These tests are robust in small samples and do not impose strong assumptions on the distributional properties of the data. In the present context, the results of the non-parametric tests are thus more reliable than those of the parametric /-test. 246 Krishna Palepu ANALYSIS AND RESULTS Hypothesis H1 The hypothesis that the average profitability of firms with high total diversification is greater than that of those with low diversification is tested using data from two years, 1973 and 1979.’ First, the sample is split into two equal groups on the basis of the level of DT73, the total diversification in 1973. Firms with a DT73 value above the sample median are classified as the ‘High DT’ group, and those with DT73 below the sample median are classified as the ‘Low DT” group. The mean and median profitability of the two groups during 1973 (denoted as ROS) is computed. The above procedure is repeated using total diversification and profitability in the year 1979."" The means and median profitabilities of the two groups in 1973 and in 1979 are shown in Table 1. The results of the r-test (testing the difference of the means), the median test and the Mann-Whitney U-test (testing the difference of the medians) are also shown in the same table. The f-test and the Mann-Whitney U-test show that the 1973 profitability of the Low DT group was significantly greater than that of the High DT group at the 0.05 level; the x" statistic is also very close to being significant at the 0.05 level and points to the same conclusion. Thus, contrary to the HI hypothesis, the low diversifiers were more profitable than the high diversifiers in 1973. The conelusion is quite similar in 1979, although the profitability difference is not significant under any of the three tests."! The evidence, thus, does not support the notion that high total diversification is cross- sectionally associated with higher profitability. This finding is consistent with that of the carlier industrial organization research. Hypothesis H2 Hypothesis H2 posits that the average cross-sectional profitability of the high related ersified group of firms is greater than that of the high unrelated diversified group in any given year. This hypothesis is tested, once again, using data from two years, 1973 and 1979. "The analyse for Ht perio 1973-1999. The results are essentially the sion is confined to the years 2 was also caried out fo the other yea in +1973 and 1979. To keep the presentation brief and focused the di fs 1979 and 1979. The conducted separately forthe two years and hence do 8 require consamt group membership ators 1 yetrs. The sume holds good in the case of H2. MTable | shows thatthe low diversfrs experienced « decline in ROS between 1973 and 199 whereas the high diversifens ined theit ROS atthe sare level. This can be Interpreted 10 mean that (1) the ROS of the industry as a whote declined ‘between 1973 and 1979 and (2) the high diversifers avoxded this decline whereas the low diversifers could not. As the sibucquent analysis shows, the superior ROS growth of the high diversify i predominantly due 1o related diversification.The Entropy Measure 247 Table 1. Profitability and total diversification Low DT group High DT group 1973 ‘Number of firms Is 13 Mean ROS (4) 6o 3.37 statistic ‘ ~ 3.65 Median ROS (*) ous 3.30 statistic 3.35 Mann-Whitney U-statistic 0 1979 Number of firms 1s Is Mean ROS (%) 4.96 3.69 ‘tstatstic -079 Median ROS (*) 42 3.40 ‘¢-statistic o ‘Mana-Whitney U-statistic 88 Nowe 1 DT—total diversification: ROS—retur on sales. 2, The -statsie is computed to tet the equality ofthe two groups" mean ROS agains the alternative hypothesis hat the mea ROS a the High DT aroup sae. The cal evel that the tae shoud exceed ee the nul hypothe athe ‘3. The yataisic and the Mann-Whliney U-stsic are computed to test the equality of the mean ROS of the two groups against the akernatve hypothesis that the median ROS ofthe High DT group is higher. For rejection ofthe nal hypothesis {tthe 005 level, the x should exceed 3.84 and the Usatistc should not exceed 72 For testing H2, we need subgroups of firms that are predominantly related diversifiers and predominantly unrelated diversifiers. For this purpose, the sample is split into four ‘groups on the basis of the 1973 levels of related and unrelated diversification. The firms with above median related diversification and below median unrelated diversification, labelled ‘High DR-Low DU’, are predominantly related diversifiers. The firms with below median related diversification and above median unrelated diversification, labelled ‘Low DR-High DU’, arc predominantly unrelated diversifiers. These two groups consist of 13 firms each. These firms are used in testing H2. The firms with both related and unrelated diversification below median are non-diversifiers. The firms with both kinds of diversification above median are neither predominantly related diversifiers nor predominantly unrelated diversifiers. Two firms belonged to each of the last two types, and they have been omitted from further analys The above procedure is repeated using the 1979 data also. In 1979, the High DR-Low DU. (or the predominantly related diversifier) group and the Low DR-High DU (or the predominantly unrelated diversifier) group consist of 12 firms each. The mean and median profitability of the high related diversifiers and the high unrelated diversifiers are shown in Table 2. The statistics computed to test for any significant differences in the profitability of the two groups are also presented in the same table. The High DR-Low DU group seems to be marginally more profitable than the Low DR-High DU group, However, the difference is not statistically significant in either 1973 or 1979. The evidence, thus, is not strong enough to support the proposition in H2. Hypothesis H3 Hypothesis H3 states that the profitability growth rate of high related diversifiers is ‘expected to be superior (o that of high unrelated diversificrs. The hypothesis is tested using248 ‘Krishna Palepu Table 2, Profitability: related versus unrelated diversification High DR-Low DU Low DR-High DU 197 ‘Number of firms B B Mean ROS (%) 5.08 “7 statistic 0.296 Median ROS (84) 4s 436 statistic o Mann-Whitney U-statstic 81 179 "Number of firms 2 2 ‘Mean ROS (0) as7 3.67 statistic 13 fedian ROS (%) 448 3.29 ‘estatstic 1s Mann-Whitney U-statistic “6 Noes 1, DR—related diversification; DU—unrcated diversification; ROS—return on sles. 2, The ¢staistic tests the nal hypothesis of equal means against rhe alternative hypothesis that the mean ROS of the High DR-Low DU group is higher. For rejecting the null hypothesis atthe 05 level, the (statistic should exced 1.7 3. The y-staitis and the Mann-Whitney U-statistic fest the oull Aypothess of cqaal medians against the typotheis that the median ROS of the High DR-Low DU group it higher. For rejecting the tll ypothess level, the statistic should exceed 3.84 and the Ustatistic shouldbe les than 42 the profitability growth rates between the years 1973 and 1979. As in the case of H2, the sample is split into four groups based on the diversification levels in 1973. The proposition tested is that the group of firms that belonged to the High DR-Low DU group in the year 1973 achieved significantly superior profitability growth rates over the following 7 years compared to the Low DR-Hizh DU group of 1973. ‘The mean and median profitability growth rates of the High DR-Low DU group and the Low DR-High DU group are presented in Table 3. The mean and median profitabi growth rates of the High DR-Low DU group and the Low DR-High DU presented in Table 3. The mean profitability rate of the high unrelated diversifiers per cent and that of the high related diversifiers is — 0.27 per cent. (The small negative mean of the related diversifiers is due to one large negative observation. If this observation is, excluded, the mean becomes 3.1 per cent.) The median profitability growths of the unrelated and related diversifiers, respectively, are — 12.05 and 2.59 per cent. Thus, the profitability growth rate of the unrelated diversifiers seems to be much smaller than that of the related diversifiers. The f-test and the Mann-Whitney U-test show that the profitability growth rate of the Low DR-High DU group was significantly smaller than that of the High DR-Low DU group at the 0.05 level. The x°-test points to the same conclusion at about the 0.10 level. The evidence, thus, indicates that the high related diversifiers showed a superior profit growth performance compared to the high unrelated diversifiers, Hypothesis H3" If related diversification leads to superior growth in profitability, it should eventually lead to a higher profitability level itself. This, of course, assumes that the firm continues to pursue the strategy of high related diversification. To test this proposition, which is stated as H3’, the tests have to be confined to firms that pursued the same diversification strategy over an extended period of time.The Entropy Measure 249 Table3. Profitability growth: related versus unrelated diversification High DR73-Low DUT3 Low DR73-High DU73 1973 ‘Number of firms 8 Mean ROSG (%) 0.201 ‘statistic 213 Median ROSG (%0) 239 statistic 2.46 Mann-Whitney U-statistic a DR73—related diversifcaion in 1973; DUT3—unreated diversification in 1973; ROSC—growth rate of return on sales between 1973 and 1979 defined as (ROS79 - ROST3)/ROST3. 2, The Fatatiste tess the null hypothesis of equal means ROSG for the rwo groups agains thea smear ROSG of the High DR-Low DU grou i higher. For reecting the all hypothesis, te -statstic should exceed [711 abe 0.05 level. 3, The Yscauste ad the Mann-Whitney U-statsic tet the null hypothesis tha the median ROSG ofthe High DR-Low DU srcup is higher. For rejecting the aull hypothesis at the O05 level, the statistic should exceed 3.84 aad the Usstatnie Should be less than 42, The x"statistc lo the table becomes signicant a slighty more than the 0.10 level, whereas the O- ‘Sati i sigeifcant a the O08 level, Of the 13 firms that belonged to the High DR-Low DU group in 1973, 11 remained in the same groups in 1979. Similarly, 12 of the 13 firms from the 1973 Low DR-High DU group retained the same status in 1979. Hypothesis H3” is tested using these 23 firms. The mean and median profitabilities of the two groups in 1973 and 1979 are shown in Table 4. Tests 10 compare the profitabilities of the wo groups in the Wwo years are also presented in Table 4. The profitability levels of the high related diversifiers and the high unrelated diversifiers are virtually identical in 1973. However, by 1979, the profitability ‘Table 4, Profitability of firms with the same diversification strategy over the period 1973-1979: related versus untelated diversification High DR-Low DU Low DR-High DU [Number of firms u 2 1973 ‘Mean ROS (%8) S08 3.07 statistic 0.003 Median ROS (%) a7 4s x-statistic 0.408 Mann-Whitney U-sta a 1979 Mean ROS (94) sor 368 estatstic, 1a Median ROS (*%) 4s 3.29 statistic 20 Mann-Whitney U-staistic 0 Nove 1. DR—telaed diversification; DU— unrelated diverication; ROS—return on tle. 2. The ratatisc tests the nal hypothesis of equal mean ROS; (or the two proups against the alternative hypoxhesi hat the yw DU group has higher "A ¢tatne value off the 005 level, the x ‘sgnifcant at approsimately he 0.18 level.250 Krishna Palepu levels of the two groups begin to show a difference in the direction expected by H3’, namely, that the profitability of the related diversifiers is greater than that of the unrelated diversifiers. The test statistics in 1973 are highly insignificant. However, by 1979, the test statistics, although still falling short of being significant at the 0.05 level, are quite close to achieving significance. The conclusion is that although failing to achieve significance at the conventional level, the results are generally in the direction expected by H3”. ‘A possible reason for the above weak results is that 7 years, the period over which the above analysis is carried out, is not sufficiently long for significant profit growth differences to translate into significant profit level differences. Rumelt’s study used a 10-year horizon ‘and discovered significant profit differences. The general direction of the results in this study is consistent with Rumelt’s findings. SUMMARY AND CONCLUSIONS ‘The strategic management studies of Rumelt and others reported a systematic relationship between diversification and firm profitability. The empirical industrial organization studies, however, failed to uncover any such relationship. This study attempts to reconcile this difference in the empirical findings of these two streams of literature by modifying the ‘methodology of the previous industrial organization studies in two ways: (1) the simple index measures are replaced by the Jacquemin-Berry entropy measure of diversification to capture the essential richness of the strategy studies and (2) the cross-sectional analysis of diversification-profitability is replaced by the longitudinal analysis of diversification and change in performance over time. The results lead to the following conclusions. (1) There is no significant cross-sectional difference between the profitability of firms with high and low total diversification. Similarly, there is no significant cross-sectional difference between the profitability of firms with predominantly related and unrelated diversification. (2) Over time, the profitability srowth rate of related diversifiers is significantly greater than that of unrelated diversifiers. (3) The superior profitability growth of related diversifiers seems to translate into superior profitability level for the firms that continue to be related diversificrs over an extended period. The evidence for this is, however, not highly significant. A possible reason for this is that the time period of analysis in this study is not long enough. The above results have a number of implications. From the point of view of the industrial organization research, the results provide clues to the reasons for the failure of the earlier studies on diversification and profitability. The results indicate that the earlier studies’ failure was due not to their use of diversification indices per se, but to their use of indices that did not distinguish between related and unrelated diversification. Another flaw of the earlier industrial organization studies seems to be their focus on the cross-sectional relationship between diversification and profitability. This is in contrast to the strategy studies, which examined the performance of firms that followed a given diversification strategy over an extended time, The results, once again, point out that this is an important reason behind the failure of the industrial organization studies. The study's results are not new to strategy researchers. However, its methodology is different from that of the earlier studies. This underscores the reliability of the previous studies’ conclusions and shows that their validity is not critically dependent on the particular methodology employed by Rumelt and others. Strategy researchers working in the area of diversification have come to view SIC-basedThe Entropy Measure 251 diversification measures as too simplistic to facilitate meaningful analysis. This led them to sacrifice the objectivity and simplicity afforded by such measures in favour of more complex and semi-subjective classification schemes. Montgomery (1982) attempted to upgrade the respectability of the product-count measures by showing that they exhibit systematic correlation with Rumelt's diversification categories. The results of this study take this effort one step further. They demonstrate that a properly constructed diversification index can facilitate managerially meaningful distinction in a firm’s diversification strategy and yet allow the researcher to take advantage of their computational simplicity and objectivity. It is hoped that this, along with the availability of line-of-business data, would provide an impetus for further analysis, of corporate diversification using large samples. The use of samples larger than the one employed in this study would, in all likelihood, improve the statistical significance of the results. Strategy researchers such as Rumelt, Salter and Weinhold argue that the primary gains from diversification seem to come from synergies and the possibility to exploit a firm’s ‘core factors’. The results of this study are consistent with this view. In the case of diversification, more does not always seem to be better. Hence, rather than pursuing diversification for its own sake, the management of a firm needs to choose businesses that lead {0 real economic gains, Related diversification seems to offer a better chance of accomplishing this. This study demonstrates, using a limited sample of firms, the feasibility of employing the product segment data and the entropy measure in analysing diversification. The results of this study can be extended by future research in two directions. First, the analysis ean be extended to larger samples covering many industries. The substantial effort required by a Rumelt-type methodology restricts the possibility of replication and large sample analysis. The methodology employed here, along with the availability of the segment data on computer tapes, eliminates this problem. ‘A second direction of future research, one that the author is currently pursuing, is directly comparing the entropy measure with Rumelt’s diversification categories. Montgomery (1982) shows that simple diversification indices show a systematic variation across the different diversification categories. {t would be interesting to compare the related and unrelated components of diversification, as computed by the entropy measure, across Rumelt’s diversification categories. A reasonable correspondence between the variation in the two components and the diversification classes would provide additional evidence of the measure’s validity. ACKNOWLEDGEMENTS 1 am deeply indebted to Michael van Breda for his help and advice throughout this research. 1 also benefited from the helpful comments of Edward Bowman, Morris Mcinnes, Peter Brownell, Ram Ramakrishnan and two anonymous referees.252 Krishna Palepu APPENDIX 1. RUMELT’S CLASSIFICATION SCHEME Criterion Type SR VR ORR Other Single business poss = = Dominant vertical <09s 207 = Dominant unrelated 0.98-0.7 <0.7 0.5(SR+1) = Dominant constrained <0.7-<0.7_0.5(SK+1)_ diversification buliding on some central strength Dominant linked 0.7 £07 OS(SRH1)_ diversification building on a set of strengths Related constrained <0.7 —<0.7._-—«@0.7__ diversification building on some central strength Related linked <0.7 — <07 —-=0.7__ diversification building on a et of strengths Uneelated passive <07 £07 07 = Conglomerates <0.7 — <0.7—<0.7__(a)at least 10 per cent EPS growth rate over past 5 years {(b)at least five acquisitions over past $ years {(c) market value of new equity issued over past S years ‘eater than total common dividend '5R = specialization rato, tbe proportion ofthe frm's revenue fom Ka largest single Business RR = related ratio, the proportion ofthe Nr evenve altabulable 0 is argest g#OUp of related business. {VR vertical ratio, the proportion of the hems revenue that arses from all by products, iniemediate products and end products of a vertically integrated chan, APPENDIX 2. ENTROPY MEASURE OF DIVERSIFICATION "* Consider a firm operating in N industry segments. The entropy measure of total diversification DT is defined as follows. Let P; be the share of the ith segment in the total sales of the firm. Then DT=5, P,In(i/P) The above expression is a weighted average of the shares of the segments, the weight for each segment being the logarithm of the inverse of its share. The measure, thus, takes into consideration two elements of diversification: (i) the number of segments in which a firm operates, and (ii) the relative importance of each of the segments in the total sales. An attractive feature of the entropy measure is that it recognizes a third dimension of diversity, namely the degree of relatedness among the various segments in which a firm operates. To see this, let us define an industry group as a set of related segments. The segments within an industry group are expected to be more related to one another than segments across groups. Let the V industry segments of the firm aggregate into M industry groups, (N>M). Let DR, be defined as the related diversific ing out of operating in several segments within an industry group /. Following the definition of the entropy measure, DR, can be written as DR,= E PpIn(i/Py where Pi is defined as the share of the segment / of group in the total sales of the group. ‘Since our firm operates in several industry groups, its total related diversification DR is a |The exposition in thie appendix i based on the dacutsion of the entropy measure by Jasquerin and Berry (1979),The Entropy Measure 253 1M. It is defined as “ function of DRy, j DR==, DR, Pi where P/ is the share of the jth group sales in the total sales of the firm. Note that DR is the weighted average of the related diversification within all the M groups. Each group gets 2 weightage equal to its share, a measure of its importance in the total operations of the firm. Let DU be the unrelated diversification. This arises out of operating across several industry groups. Consistent with the definition of DT, DU is defined as DU -f, Piin(/P) which is the weighted average of all the group shares. Tt can be shown that, under the above definitions, the sum of the related and unrelated components equals the total diversification. To see this, first note that Pi=P/P and that PHER. Now, DR+DU=¥, DR P+ ¥, PrIn/P) -f, PE Pyln(l/P) + 1n(1/P =f, PIE (P/P) In(P/P) + In(1/P)) =f, I P,In/P) +1n(P) + 1n01/P9) -f EP iIni/P) =pT In this study, the SIC classification codes are used to define the industry segments and groups. SIC industries at the two-digit level are treated as the industry groups. SIC industries at the four-digit level are treated as the industry segments. The following hypothetical numer lustrates the behaviour of the index. ‘Sales Diversifation Group | Total Segment 1 Segment 2. Segment | Segment 2 Segment 3 Total Related Unrelated 100, 0 ~ = = ° ° o 100 95 5 = 7 = 020 © 0.20 0 100 % 10 = = = 032 032 0 100 8% 10 10 = = 06 032032 100 m 20 0 = = 0s = oa 032 100 o 10 0 10 10 12306261 100, » 2» 0 2» 2» Ve 084 087254 Krishna Palepu APPENDIX 3, LIST OF COMPANIES IN THE SAMPLE Name CUSIP number ‘Amalgamated Sugar Co. 22771 ‘American Maize Products Co. or9 ‘Amstar Corp. oszi72 (CPC Imernational Inc. 125149 Campbell SoupCo. 1329 Campbell Tageart Inc. 38469) Carling O*Keefe Lis 142263 Carnation Co. 143483 Central Soya Co. 133177 Coca Cola Bottling Co. of New York tne 191162 Coca Cola Co. 191216 Concolidated Foods Corp. 200219 Darté Kraft Inc. 237410 Dr. Pepper Co. 256129 Federal Co, 31325 General Cinema Corp. 369352 Heinz(HJ.)Co. a2074 Hershey Foods Corp. 27866, Hormel (Geo. A.) &Co, ‘s404s2 Kane Miller Corp. 484098 Kellogg Co. 487836 Nabisco Brands Ine. 629525, Pabst Brewing Co, 3715 Ralston Purina Co. 751277 Royal Crown Companies tne. 780240 Schlitz Joseph) Brewing Co. ‘806823 Seagram Company Ltd, 811850 Tasy Baking Co. 876553 Tootsie Roll Industries inc. 890316 Walker (Hiram) Resources Ltd 931687 REFERENCES Ansoff, H. 1. Corporate Strategy, McGraw-Hill, New York, 1965. Arnould, R. J. ‘Conglomerate growth and public policy’, in Gordon, L. (ed.), Economics of Conglomerate Growth, Oregon State University Department of Agricultural Economics, Corvallis, OR, 1969, pp. 72-80. Christensen, H.” Kur ‘and C. A. Montgomery. “Corporate economic performance: diversification ‘strategy versus market structure’, Strategic Managemen! Journal, 2, 981, pp. 327-383. FASB. Statement of Financial Accounting Standards No. 14: Financial Reporting for Segments of a Business Enverprise, Stamford, CT, December 1976. Gort, M. Diversification and Integration in American Industry, Princeton University Press, Princeton, NJ, 1962, Jacquemin, A. P. and C,H. Berry, ‘Entropy measure of diversification and corporate growth’, The Journal of Industrial Economics, 21(4), June 1979, pp. 389-369. Markham, J. W. Conglomerate Enterprise and Economie Performance, Harvard University Press, Cambridge, MA, 1973, Montgomery, C. A. “The measurement of firm diversification: some new empirical evidence’, Academy of Management Journal, 25(2), |982, pp. 299-307. Rumelt, R.P. Siraiegy, Structure and Economic Performance, Harvard University Press, Cambridge, MA, 1974.The Entropy Measure 255 *, Strategic Management Journal, 3, 1982, Rumelt, R.P. ‘Diversification strategy and profitabil pp. 359-369. Salter, M.S. and W.A. Weinhold. ‘Diversification via acquisition: creating value’, Harvard Business Review, July-August 1978, pp. 165-176. Scigel, S. Nonparametric Statistics for the Behavioral Sciences, McGraw-Hill, New York, 1956, 95-156. Wrigley, L. ‘Divisional autonomy and diversification’, Doctoral Dissertation, Harvard Business School, Boston, MA, 1970.