Accepted Manuscript

Title: Diversification Strategy, Efficiency, and Firm

Performance: Insight from Emerging Market

Authors: Alex Kwaku Gyan, Rayenda Brahmana, Bakri Abdul

Karim

PII: S0275-5319(16)30309-9
DOI: http://dx.doi.org/doi:10.1016/j.ribaf.2017.07.045
Reference: RIBAF 735

To appear in: Research in International Business and Finance

Received date: 1-10-2016

Revised date: 23-5-2017
Accepted date: 3-7-2017

Please cite this article as: Gyan, Alex Kwaku, Brahmana, Rayenda, Karim,
Bakri Abdul, Diversification Strategy, Efficiency, and Firm Performance:
Insight from Emerging Market.Research in International Business and Finance
http://dx.doi.org/10.1016/j.ribaf.2017.07.045

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Diversification Strategy, Efficiency, and Firm Performance: Insight from Emerging
Market
1
Alex Kwaku Gyan, 2Rayenda Brahmana, 3Bakri Abdul Karim
Department of Accounting and Finance, Faculty of Economics and Business, Universiti Malaysia Sarawak,
Kota Samarahan, Malaysia, 94300
1
Kraha27@yahoo.co.uk, 2brkhresna@unimas.my, 3akbakri@unimas.my

Abstract
We investigate further the inconsistencies of the diversification-performance link by
introducing efficiency as moderating factor. A data of 319 firms was used to conduct a panel
data analysis excluding the financial sector industries and the results show three important
findings. First, industrial diversification shows a significant contribution in performance
improvement while international diversification shows no effect on performance. Yet,
international-conglomerate shows a significant negative relationship with performance.
Meanwhile, the efficiency results are contrary to our conjecture. We find that efficiency is a
factor to enhance performance, but it is not the moderating variable on the diversification-
performance link. This implies that the efficiency of the firm has no connection with the link
between diversification and performance.
Keywords: diversification, efficiency, firm performance, corporate strategy

Introduction

Diversification is a strategic expansion of business into markets, sectors, industries and/or

segments, mostly induced by reaction to competitiveness in the business environment (Wang,
Ning & Cheng, 2013; Yang, Cao & Yang, 2017). Even though diversification is widely
practiced and significantly researched, conflicting theoretical and empirical disagreements
still dominate the expanse finance literature on the relationship between diversification and
firm performance (Chakrabarty, 2007; Delbufalo et al., 2016; Lee et al., 2012; Sun & Govind,
2017). What worsens the situation in emerging economies bothers on the fact that, significant
amount of work on this relationship has focused on data from the developed economies and
consequently, findings regarding diversification and firm performance in smaller and
emerging economies are sparse (Lee et al., 2012; Mathur, Singh & Gleason, 2012). In
breaking the deadlock of the mixed views in the diversification-performance link, several
variables playing both moderating and mediating roles have been investigated by previous
research. These variables include productivity (Gyan, 2017), ownership structure (Lee at al.,
2012), effect of economic environment (Charkrabarti et al., 2007), corporate governance
tools (Anderson et al., 2001), degree and composition of diversification (Guo & Cao, 2012),
and technology effects (Cesaroni, 2002). In all these previous analysis, diversification-
performance relationship has been inconclusive. Meanwhile no research has touched on the
moderating effect of efficiency to ascertain its impact in that link.

The fundamental contention holds that single focus firms are better off in terms of
performance (Berger & Ofek, 1995; Lamont & Polk 2002; Lang & Stulz, 1993; Rajan,
Servaes & Zingales, 2000) as compared with diversified firms. Nevertheless, proponents of
diversification have also argued in favor of diversification and this has been corroborated in
the study of Guo (2011); Pandya & Rao (1998); Villalonga (2004) and Tate & Yang (2015).
Considering the fact that efficiency of firms has not yet been explored in that link, this study
uses efficiency of firms as a moderating factor to ascertain its impact towards attenuating the
inconclusiveness in diversification and performance nexus. Accordingly, this study
introduces technical efficiency of firms computed using Data Envelopment Analysis (DEA).
The study has the view that diversification itself cannot determine performance or otherwise,
rather it’s about the degree of efficient practices and utilization of resources.

Since diversification can either create or discount value (Bodnar, Tang & Weintrop, 1997;
Pandya & Rao, 1998), efficiency through monitoring, control and meticulous utilisation of
resources has the higher probability to tilt diversification towards the side of higher
performance (Berger & Ofek, 1995; Bettis, 1986; Baik et al., 2013). The motivation and
essence of using efficiency as a moderator is justified in the fact that, efficiency reduces
unsystematic risk and shocks within firms which in turn attenuates the systematic shocks that
affects industries and this is inherent in the strong predictive power and profitability gained as
a result of efficiency (Baik et al., 2013). The study on this account contends primarily that
efficiency promotes economic value of firms (Frijns, Margaritis & Psillaki, 2013).
Additionally, since the efficient application of strategic logic affects firm performance
(Markides & Williamson 1994), we argue that, the efficient and strategic logic embedded in
the technical efficiency of firm determines the firm’s performance and not just diversification
per se.

Empirical evidences pointing to the mixed views and findings between diversification and
firm performance in emerging economies have been documented with emphasis on the
inconsistencies in the relationship between diversification and firm performance. In Turkey,
Tevfik (2008) shows negative relationship, followed by Chen & Chu (2012) in Taiwan and
Chen & Ho (2000) in Singapore. However, Olu (2009) found that diversification impacts
positively on firm performance among Nigerian firms. Meanwhile, there have not been any
conclusive results in Malaysia regarding diversification and firm performance. Lee et al.
(2012) found that international diversification adds no significant value to firms in Malaysia
whereas industrial diversification adds very little value to firms locally. However, Lins &
Servaes (2002), Napier (2006) and Palepu (1985) assert that diversification increases value of
Malaysian firms and other emerging economies, citing high cost of the external capital
market and comparatively cheaper internal capital market as reasons.

The contribution of the study is three fold. Firstly, the study adopts and contributes to three
theories i.e internal market efficiency hypothesis, agency theory and resource based theory to
argue out the efficiency interaction with diversification-performance link. The choice of these
theories is to align the findings with the following contentions: (1) that in emerging
economies with less developed external capital markets, firms do well with diversification
strategy, hence Malaysia as an appropriate setting for this research. (2) Agency theory
(concept which is grounded in the contention that mischief happens when the interest of firm
owners and agents diverge) is analyzed in tandem with resource based theory in manner that
shows that agency cost in turn weakens the resource base power of a firm, leading to
inefficient use of resources by the firm. Ultimately, efficiency within the firm is affected
negatively and vice versa. We propose that, this will have significant moderating impact on
diversification-performance link. Secondly, the paper makes a significant contribution to the
scanty diversification literature of the emerging economy of Malaysia showing whether firms
could base their diversification strategy on efficiency or otherwise. Lastly, the study
contributes to knowledge on both international and industrial diversification in relation to
performance.

The methodology of the research is drawn from Fauver et al. (2004) which is later modified
by Lee et al. (2012). Return on Asset (ROA) and Tobin’s q are used as proxy for the
measurement of performance. The paper extends the previous work by investigating the
moderating role of efficiency in the inconsistency prevailing in diversification and
performance association. The rest of the paper is arranged in the following sequence: Section
two deals with the related literature review, theoretical development and hypothesis
formulation of diversification-performance link. Section three describes the methodology and
sample description. Section four discusses the empirical results and section five concludes the
paper.

Diversification
One of the aims of the firm is growth and the reliable and efficient organizational structure
that comes with growth is firm diversification (Agarwal et al, 2011). The study focuses on
international, industrial and international-conglomerate forms of diversification (Ramanujam
& Varadarajan, 1989; Symeou & Kretschmer, 2012; Lee et al., 2012). International
diversification is the company’s extension of its business beyond the frontiers of its
geographical confines and markets in which it operates (Denis, Denis & Yost, 2002).
Industrial diversification on the other hand is defined to cover a firm’s activity in more than
one kind of product segment or market (Sirmon et al., 2007). International-conglomerates
explains diversification style where firm has more than 10% foreign sales and more than one
foreign segment (Lee et al., 2012). The justification for diversification across the globe is the
same, including benefits from economies of scale and scope, improved management skills
and brand reputation (Wang, Ning & Cheng, 2014). Further, diversification reduces risk and
uncertainties, promotes competive advantage and increases market share (Park & Jang,
2013a). However, a significant unique justification for diversification in Malaysia is the
support level from the external capital market, a contention corroborated in the internal
market efficiency hypothesis (Lee et al., 2012). Accordingly, the paper establishes argument
around the internal capital market hypothesis, a substantive and unique justification backing
diversification-performance relationship in emerging markets.

Diversification in Malaysia
Historically, Malaysian economy is extensive in its productivity and as a result, it has
remained diversified since its active involvement in economic activities. Certain factors have
contributed to the success of large diversification of the Malaysian economic sector. These
include favorable institutional and economic policies such as tax reduction, the promotion of
laissez faire economy (free market economy), availability of different kinds of natural
resources and multiple areas of manufacturing prowess (Drabble, 2000). Diversification in
Malaysia emerged in a graduated sequence. By the nineteenth century it relied basically on
primary products like tin, rubber and palm oil for export. Malaysia further graduated into the
manufacturing sector and by 1960s manufacturing became its main output for export. As at
1970, Malaysia has already entered into international diversification and has aggressively
targeted foreign manufacturing firms. Oil and gas are the late discoveries that added to the
range of diversity in the activities of the Malaysian economy (Ahmad, Ishak & Manaf, 2003;
Lee et al, 2012). Given the varied economic resources, it is consistent that corporate bodies in
Malaysia entered into diversification in such a wide magnitude. The economic resources offer
enough flexibility and luxury to facilitate entry into any of the viable options of economic
activities and hence the large number of diversified firms in Malaysia.

In addition to the above factors, firm efficiency has shown certain dynamism in performance
among firms in Malaysia. Kalirajan & Tse (1989) show that, efficiency plays vital role in
firm performance among Malaysian manufacturing industries. Differences in efficiency are
vital to understanding the reason why some Malaysian manufacturing firms do well while
others perform poorly. Malaysian manufacturing firms achieve a maximum of 73% of their
output target. The efficiency slack of 27% means that improvement in the efficiency strategy
is necessary and can add to the existing value of the firm. In reaction to the efficiency slack,
some economic and strategic decisions adopted by most of these firms to optimize their
efficiency is diversification, hence a wide array of diversification in Malaysia. Noor et al.
(2014) also found that about 90% of the total variations on the efficiency frontier of firms in
Malaysia are due to technical efficiency disparities. The previous empirical research on
efficiency therefore enhances the justification to propose that efficiency plays a crucial role in
determining the performance of Malaysian firms.

Agency and the resource base theory interaction

The relevance of the concept of agency theory and its application to diversification-
performance relationship is mainly on the managerial mischief (Dalton, Hitt, Certo & Dalton,
2007; Nyberg et al., 2010) that has the potential to induce managers to pursue diversification
strategy diluted with personal interest rather than shareholders interest. The contention here is
about the ease with which agents carryout their mischief through diversification strategy.
Some characteristics of diversification per se is an avenue for managerial mischief, for
example firm size matches compensation (Jensen & Murphy. 1990) and a reduction in the
risk of managers undiversified personal portfolio (Amihud & Levy 1981). In accordance
with this background, managers aspire to obtain private benefits that far exceed their private
cost (Jensen & Meckling, 1986). Furthermore, Agency hazards like shirking, perquisite
consumption, managerial opportunism and quest for managerial power lead to high
operational cost, reduction in performance capabilities and ultimately corporate value loss.
Agency theory proposes that the mischief level of management declines where firm aligns
agent- owner interest through equity participation and structure of compensation (Nyberg et
al., 2010). Against this backdrop, we prose that where agency problem exist, diversification
shows discount, demonstrated through inefficient strategy, induced by personal interest.
Similarly, where there is efficient and meticulous application of diversification strategy and
utilization of resources, all things being equal, diversification premium is to be expected.

This connection between performance and resource base of the firm comes from the unique
ability of the firm to organize efficiently the human, financial, technological, physical and
reputational resources in the right mix to attain and sustain a competitive advantage with the
resources at the firm’s disposal (Coner, 1991). We adopt the resource base theory as
complementary theory to the agency theory, arguing from the perspective that agency
mischief that causes diversification discount, operate successfully by channeling resources in
a manner that incapacitate the resource power of the firm. According to Amit & Schoemaker,
(1993) complementarity, durability, scarcity and appropriability are the attributes of resource
power that confer advantages to the firm. These culminate to empower competitive advantage
to firm. We show that agency cost does not operate in vacuum but inherent in the inefficient
utilization of resources of all types. Where agency problem is high, we anticipate inefficiency
which in turn affects the resource advantage of the firm. The study therefore proposes that
agency theory problems in turn incapacitate the full potential of the resource base theory.
Accordingly, we posit as a hypothesis that where there is efficiency borne out of lower
agency problems, diversification performance is likely to go up, an advantage derived from
the value attained from meticulous use of firm resource and the associated competitive
advantage.

Internal capital market efficiency hypothesis

We draw on internal capital market efficiency hypothesis to deal with the concept of
diversification in emerging economies i.e Malaysia. One unique advantage of diversification
strategy in emerging and less developed economies is internal capital funding, as necessitated
by the high cost of external capital market financing (Lee et al., 2012; Shackman, 2007).
Internal capital market is usually functional in economies where there is information failure,
undeveloped financial markets and institutions (Chakrabarty, 2007). The theory therefore
appears more beneficial to diversified firms in emerging economies where institutions and
external capital markets are less developed compared to matched portfolios of diversified
firms in developed economies. The impact of internal capital markets on the performance of
diversification in the United States for example strengthens the significance of the theory in
areas where the external capital markets are less developed. Matsusaka (2002) shows that
diversification and firm value relationship declined in 1960s to the 1980s when the external
capital markets in the U.S. economy developed and became cheaper. Building on the
assumption of this theory, the paper anticipates that diversification in Malaysia shows
positive relationship with performance as it shows characteristics of economy with less
developed external capital markets (Lee et al.2012), less developed institutions and traits of
inefficiencies (Powel, Sommer & Eckles, 2008). Even though internal capital market
advantage for diversified firms in emerging economies is plausible, we argue further that, its
functionality can be affected by efficiency dynamics and hence the paper moderates the role
of efficiency in that relationship.
We want to ascertain the effects of lack of transparency and investments anomalies that
characterise diversified firms resource allocation and accordingly, we introduce efficiency to
determine its strength in the internal market hypothesis or otherwise. Internal capital market
under diversification create value when head office allocates funds to divisions with the
highest expected return on investment eschewing all self-centered behavior by management
(Stein, 1997). However the benefit of the internal capital market can be twisted by personal
interest which could induce management to allocate resources poorly among divisions of the
firm. The high cost of external capital market may even benefit firms in emerging economies
than the internal funding if efficiency is compromised. The ulterior mindset embedded in the
management, C.E.O. and shareholder relation to a larger extent encourages the stronger
segments helping out the weaker segments, a practice that undermines efficiency of internal
capital market (Scharfstein & Stein, 2000).

Does efficiency matter?

The pre-dominant aim among business units is to improve on performance and add to assets
of the firm to maximize shareholder wealth. These corporate objectives are achieved by
creating the right plans needed, pulled together requisite resources and use these resources to
implement and achieve objectives. Considering the fact that resources are scarce, the need to
be efficient becomes very important phenomenon. Ability of firm to use the least available
inputs to achieve higher outputs, in the bid to realise a given objective, maximizes frim value.
Alam & Sickles (1998) show that efficiency makes transaction easier and viable due to its
inherent predictability advantage.

Accordingly, empirical studies have buttressed the need for efficiency in the operations of the
firm. Baik et al. (2013) shows that efficiency changes reflect directly the future earnings of a
firm and affords firms information power to improve on forecasting. Similarly, Greene &
Segal (2004) show that efficiency improves on profitability (return on equity) of the firms in
the insurance industry. The value of a firm and the utilisation of the firm’s resources have a
strong positive link. Accordingly, Alam & Sickles (1998) show a positive relationship
between technical efficiency of firm and performance (return on assets) which has the
potential to defy the efficient market hypothesis.

The Moderating Role of firm efficiency

Diversification has several inherent benefits as well as cost components. The onus lies on the
level of operational efficiency within the firm in directing purposefully between the cost and
the benefits to achieve the desired performance. For example Weston (1969) and Williamson
(1975) confirm that corporate managers of diversified firms possess control over information
regarding the activities of external capital markets. This helps corporate decision makers to
make efficient allocation of resources within their business units by comparing the use of
their internal capital to the external capital market. Stulz (1990) argues that diversified firms
create internal market inefficiency by directing funds from the high performing units to the
low performing segments hence causing misallocation of resources. To delineate and have
the best, one must think of how to manage efficiently in between the analogy of Williamson
(1975) and Stulz (1990) to get the best out of diversification. Diversification per se is not a
means to an end, rather it presents a platform which could be twisted purposefully or
otherwise based on the efficiency level within the firm.

Symeou et al. (2012) proposes that diversification by itself does not generate advantages
automatically to induce performance. However, performance enhancement can be attained
by organizational mechanisms that increase efficiency. Efficiency on Managers know-how
and expertise as well as foresight in the discharge of their managerial duty is part of the key
success factors of diversification and not diversification per se (Bettis & Prahalad, 1995).
Tevfik (2008) affirms that firms must not rush into diversification while doing well in their
current type of business just because of foreseeable prospects of diversification, however
firms must adhere efficiently to their growth strategies and opportunities in their current
business until they are fully ready to diversify. According to Nayyar (1993), managing
diversification requires knowledge in the approach of the diversification strategy considering
the limit and the extent of diversification. Firms must know the limit of the extent to which
they can diversify. Failure to recognize the requisite limit for diversification can affect the
performance of the firm. Markides (1994) confirms that diversification creates value when
efficient managers minimize diversification in the form of refocusing strategy and this is
possible when mangers have the skill to efficiently recognize the corporation’s limit to
diversify.

[INSERT TABLE 1 HERE]

Table 1 shows summary of the four groupings of the listed firm in Malaysia. The four groups
are: domestic-focused, domestic-conglomerate, international-focused, and international-
conglomerate. The average number of listed firms not diversified is 67 firms. Meanwhile,
number of internationally diversified listed firms is 58. There are 162 firms that are
industrially diversified. The last part is that, only 31 listed firms did both industrial and
international diversification in Malaysia.
[INSERT FIGURE 1 HERE]

Methodology

The paper follows the methodology of Fauver et al., (2004) and Lee et al. (2012), however
this paper concentrates on the moderating effect of efficiency instead of ownership. For
robustness reason, this paper uses two measurements. First measurement is accounting book
performance which is return on asset (ROA). The second measurement is market-based
performance which is Tobin’s q. Prior the estimation data variables, we estimated
Augmented Dickey–Fuller test to ascertain the presence of unit root in our data. The
interaction term adopts the methodology of Lee et al. (2012).

Baseline model
Before the estimation of the role of efficiency on diversification-performance link, the paper
introduces first the baseline model of the performance. There are four control variables of the
model which are age, size, growth, and leverage. Those variables are commonly used in
corporate finance studies as the control variables (See Fauver et al., 2004; Lee et al., 2012).
Therefore, firm performance is the function of firm age, firm size (measured by natural
logarithm of total assets), firm growth (measured by the ratio of capital expenditure on
operating Income), and firm leverage (measured by the ratio of total debt to total assets). The
function is as follows.

Performance  f (age, sze, growth, leverage)

To estimate the above relation empirically, all sample firms are pooled and the following
regression equation is estimated:
Performancei ,t   0  1 NYI i ,t   2 LTAi ,t   3CES i ,t   4 LEVi ,t   i ,t
……………….. 1

Where: NYI denotes as the firm AGE (the number of years since inception of the firm to the
time data is collected), LTA denotes as firm size, CES is firm growth, and LEV is firm
leverage.

The Full Estimation Model

Following Fauver et al. (2004) and Lee et al. (2012), this research categorizes the Malaysia
listed firm into binary variable. The categories are as thus: equals to 1 if international
diversification, or if industrial diversification, or if industrial and international diversification.

1 If firm has > 10% foreign sale

DINT 
0 If firm has ≤ 10% foreign sale

1 If firm has > 1 segmental industry

DIND 
0 If firm has ≤1 segmental industry

1
DINTIND  If firm has > 10% foreign sale, and > 1 segmental industry
0 If firm has ≤ 10% foreign sale, or ≤ 1 segmental industry, or both

The model of diversification-performance is by adding diversification variable into the

baseline model. In other words, diversification dummies are added to Model (I) to create
Model (II). To formulate the regression model (II) and avoid the dummy trap, we treat the
Domestic focused firms as the bench mark against which the other three categories are
valuated. Therefore, the new function of firm performance is as follows.
Performance = f(age, size, growth opportunity, leverage, international diversification,
industrial diversification, multi-segment international diversification)

All sample firms will then be pooled and the following regression is modeled empirically:
Performancei ,t   0  1 NYI i ,t   2 LTAi ,t   3 CES i ,t   4 LEVi ,t
  5 DCog i ,t   6 DInti ,t   7 DCogInti ,t   i ,t
…………………2
The Role of Efficiency on Diversification-Performance
As the main objective of this research is to ascertain the role firm efficiency (FE) in
diversification-performance link, we built another estimation model by using equation (2) as
the baseline. The efficiency is computed using data envelopment analysis. This measure is
more appropriate due to its powerful quantitative and analytical tool in measuring input and
output base firm efficiency. The non-parametric nature of the (DEA) means that criteria
based on assumption are minimal and will add to the robustness of this paper. The results of
the efficiency will be fused into the regression model. These will be in a dummy form where
efficient firms will be coded One (EFFI=1) and their relative inefficient firms will be coded
zero (INEFFI=0).

Performancei ,t   0  1 NYI i ,t   2 LTAi ,t   3CES i ,t   4 LEVi ,t

  5 DCog i ,t   6 DInti ,t   7 DCogInti ,t
  8 EFI i ,t   9 EFI * DCog i ,t  10 EFI * DInti ,t   i ,t
……………………3

Measuring Efficiency
In this research Efficiency is the moderating variable that is going to be used to test the
strength or the direction of the relationship between firm performance (dependent variable)
and diversification (independent variable).
Firm efficiency is measured using the Charnes, Cooper and Rhodes model known as the CCR
MODEL proposed in 19978 (Charnes, Cooper & Rhodes, 1978). The application of DEA in
measuring firm efficiency has increased since 2004 and this is due to its precision in
measuring efficiency. Since 2004 the use of DEA by researchers has been on the ascendency
and it is used almost every day within the year (Doaei & Shavazipour, 2013). The CCR
model allows for multiple inputs and outputs; differentiates efficient units from inefficient
units; detects defects that are not detected by other techniques; devises an efficiency score
relative to other production units

Following the work of Doaei & Shavazipour (2013) these inputs and outputs are selected for
the measure of efficiency due to their significant effects on firm performance and firm goals
achievement. The selection of inputs and outputs are germane in any Data Envelopment
Analysis (DEA) application. These inputs and output reflects the management goal and the
research purpose. In this section of the DEA measure, return on equity (ROE), Profit Margin
(PM) and Market to Book Ratio (MBR) are used as output measure. The inputs are Size,
Leverage and Capital Investment.
s
 u1 1 j  u 2 2 j  ...................u s  s j
( FPo )  Max   r 1

  1 1 j  v2  2 j  ................... m  m j
V ,U m

i 1
 s

u r yrj
r 1
m
1
v
i 1
i xij

u1 , u 2 .............................u s  0

V1 , V2 ..........................Vm  0

The fractional model above is typically not used to calculate the actual efficiency score. This
is due to the non – convex and the non –linear properties inherent in it. Charnes and Cooper
(1962) recommended a transformational model which converts the above model (1) into a
linear program. The linear program is equivalent to the fractional program.

( FPo )  Max U1Y1  U 2Y2  ...................U sYs

V ,U

Such that:

V1 X 1 J  V2 X 2 J ................VM X M J  1

U 1Y1 J  U 2Y2 J ....................U S YS J  V1 X 1 J  V2 X 2 J ................VM X M J

V1 , V2 ..........................Vm  0

U 1 , U 2 .............................U s  0

Data and Sample Description

World scope data base is used to gather data set of panel annual financial and segment data of
companies listed on the Main Board of Bursa Malaysia/Malaysian stock exchange. The data
covers the period of 2010-2015. The sample data include all the listed companies on the
Malaysian stock exchange. Following Lee et al. (2012) two digit SIC codes is used to
categorize industries into segments. The data base has further sorted sales into geographic
and product segment based on the SIC codes. Financial service industries are excluded from
the list of companies due to many regulatory policies in the financial service industries
compared to non- financial service industries and also to ensure consistency with previous
work. Firms with incomplete data within the period of 2010–2015 are expunged from the list.
Efficiency measurement is done by the use of Data Envelopment Analysis (DEA) to classify
firms into efficient and inefficient categories.

RESULTS AND DISCUSSION

Summary of descriptive statistics
Table 2 shows summary statistics of the 319 firms sampled over the six-year period from
2010-2015. The mean, median, standard deviation, minimum and the maximum values are
calculated for each variable for the purpose of easy comparative analysis.

[INSERT TABLE 2 HERE]

Table 2 documents the descriptive characteristics of variables that are used in the
computation and the classification of variables employed in the estimation of the regression
model and which also gives an overview of the trend of performance. These variables include
sales, debt, asset and equity. The mean, median, standard deviation, the minimum and the
maximum values are provided for easy comparison and analysis. The minimum values and
the maximum values of asset shows that the firms in the sample contain varying sizes,
meanwhile the level of debt among firms shows how some firms lack interest in acquiring
external funding or alternatively how difficult it is for firms to access external funding. Sales
show minimum sales capacity of 0 and 16,154,251 a clear indication of wide performance
differences in terms of sales performance. Equity funding is present among all the firms
with a minimum value of 17,683 and a maximum value of 18,045,890. Comparing the mean
values of equity and debt, it is normal to suggest that equity financing is dominant among the
listed firms in Malaysia.
[INSERT TABLE 3 HERE]

The results in table 3 shows the outcome of summary statistics obtained from a sample of
319 listed Malaysian firms with 1914 observations across six fiscal years (2010-2015). The
table shows the mean values of all the variables employed in the study and this facilitates
comparison across the variables. There are also the median values, standard deviation, the
minimum and the maximum values of the variables used in the regression model to determine
the relationship between diversification-performance link. The variables are firm
characteristics (age, growth, leverage and size) diversification (industrial diversification,
international diversification and international conglomerates) and efficiency with its
interactive terms with diversification dummies (Effdint, Effdcog and Effdintcog).

The corresponding efficient values are arranged in table 4 showing the number of efficient
firms in each category across the years (2010-2015). In numerical terms domestic
conglomerate shows the highest number of efficient firms followed by domestic focus,
international focused and finally international conglomerate. In terms of years, the year 2010
recorded the lowest number of efficient firms (62 firms), followed by the year 2015 with 64
efficient firms and 2013with 65 efficient firms. The year of 2011 and 2014 recorded 68
efficient firms each while the year 2012 had the highest number of efficient firms (75 firms).

[INSERT TABLE 4 HERE]

Analyzing estimates for diversification and performance
The study begins by explaining estimates of firm performance with Tobin’s q as a
performance proxy. Table 5 shows estimates for four control variables that form the baseline
model of this paper. Growth opportunity is not significant in the baseline model, however
leverage, age and growth are statistically significant with age and size showing a positive
association with q while leverage shows a negative association with q. The r-square of the
model is 0.276 and adjusted r-square 0.253.

Further, diversification dummies are added to the baseline model to produce model 2. In
model 2, the estimates show consistency in coefficient signs and significance level as in
model 1. Industrial diversification shows a positive and significant association with q at 1%
significant level. International diversification and international conglomerates both show
significant negative association with q at 1% significance level. The r-square is 0.316 and the
adjusted r-square is 0.314.

In the final model efficiency and the interactive terms with diversification dummies are
estimated together simultaneously. The results for firm characteristics show consistency
across all the models however, in the final estimates diversification dummies in the models
show different results. International diversification shows no significant association with q
whereas international-conglomerate shows a negative and significant association with q
however the significance level changes from 1% in model 2 to 5% in model 3. Efficiency
shows a positive and significant association with q which implies that if firms are efficient
their performance (q) increase and if firms are inefficient their performance decreases.
Efficiency is interacted with the diversification dummies to ascertain its moderating impact
on diversification. The term (Dint X Eff) shows insignificant association with performance.
Similarly (DintDcog X Eff) shows insignificant association with q. Note industrial
diversification (Dcog) and its interactive term (Dcog X Eff) treated as omitted variable to
avoid dummy trap issues.

To attest to the robustness of the findings of this paper, the variables are estimated once more
using return on asset (ROA) as a performance proxy. The results show similar outcome as
shown in q above except that there were some slight changes in the significance levels from
1% in q to 5% in ROA. Further international diversification shows a negative and significant
relationship with q before controlling for efficiency meanwhile under ROA international
diversification is not significant. The rest of the finding is in conformity with results under q
estimates.

The study shows that international diversification has a negative and significant association
with q but not significant under ROA before controlling for efficiency. International
conglomerate show negative association with performance both before and after controlling
for efficiency. After controlling for efficiency the study shows that international
diversification is not significant both under q and ROA. However the study finds that
industrial diversification affects firm performance significantly before and after controlling
for efficiency. The results primarily suggest that efficiency does not affect diversification
performance significantly and this is consistent with the previous studies.

Meanwhile the results further show that efficiency has a bearing on firm performance among
firms in Malaysia. The results show a positive and significant relationship with both
performance proxies (ROA and q). The positive and significant association implies that, if a
firm is efficient, its performance increases and if a firm is not efficient its performance is
likely to decrease. However, the interactive terms of efficiency with diversification dummies
reveal that efficiency has no moderating impact on diversification performance since the
interactive terms are all not significant.

The paper finds that international diversification has no impact on performance, probably
drawing from the strength of being international-focus firm, less managerial complication and
fewer agency problems as compared to the international conglomerates, which possibly offset
the international demerits of diversification. International conglomerate’s negative
association with performance is triggered by adaptation issues in the new markets,
connectivity, the state of being foreign in the market and agency problems, a result consistent
with the study of Wan-Hussin (2009). The firms face constraints that the locally diversified
firms escape. Accordingly, Malaysian international diversified firms show negative
performance and this is as a result of complication associated with beginning stage of
penetration, competition against already established competitors, branding and agency issues.
The corporate annual report of Malaysia shows that, QL resources failed in India and
Vietnam because it was hard to beat JAFPA who is also in the same food production. Proton
Malaysia could not survive in south East Asia considering the heavy presence of automobile
industries like Toyota and Honda. The performance of Petronas in Philippines and Indonesia
was not paying off considering the presence of Total, Shell and Local companies like
PERTAMINA in Indonesia and PETRON in the Philippines. To conclude that the negative
discount of the international diversification emphasises only inefficiency is over
simplification of the concept. However, it is worth noting that an efficient firm is still
susceptible to suffer marketing issues of branding and difficulties in the beginning stage as
compared to related firms that have learnt on the job over a number of years with local
advantage.

The results of industrial diversification lends support to the internal market efficiency
considering the fact that external capital market in Malaysia is not advanced and expensive to
borrow from. By diversifying industrially (locally) firms are able to bypass these high cost of
funding from the external market to fund net positive investment from the accumulated
internal funds to increase performance. There is the advantage of being an indigenous firm
because this comes with merits like close monitoring by owners resulting in lower agency
complications. The results corroborate the work of Lee et al. (2012)

The study further finds that efficiency has no significant effect on diversification-
performance link. This is true for all the forms of diversification controlled for in this study.
The possible reason is that most firms in Malaysia are typically family owned firms and firms
that can trace their root to a specific owner, family or group (Wan-Husssin 2009). In
accordance to this pattern of ownership, agency problem, the main cause of inefficient
diversification among firms becomes minimal and hence efficiency within the firm might not
be a factor to cause diversification discount. In other words, firms have put in place
maximum efficiency standards as induced by lower agency problems which make
performance increase or decrease not due to inefficiency. Within the Malaysian context, the
result shows that efficiency effect is not significant enough to show any moderating impact in
the link between diversification and firm performance, a finding consistent with the study of
Khan (2013). The level of efficiency among firms in Malaysia hovers around 70% meaning
that there is stills more room for improvement in order to reach the efficiency frontier. In
comparative terms however, Sufian & Kamarudin (2016) show that, Malaysian firms on the
average show higher efficiency.
[INSERT TABLE 5 HERE]

[INSERT TABLE 6 HERE]

Conclusion
The study posits as a primary hypothesis that diversification (both international and product
diversification) do better in terms of financial performance in emerging economies, than
matched portfolio of diversified firms in developed economies as contented by the internal
market efficiency hypothesis. The results obtained here have not corroborated the assertion of
the internal market efficiency hypothesis. We find inconsistencies since international
diversification shows no significant relationship with performance. Further, international
conglomerates rather defy completely the principle of the internal market efficiency
hypothesis by showing a significant negative relationship, a result which is rather
characteristic of the developed economies. Product diversification weakly supports our
contention in this regard. The presupposition is that the external capital market of Malaysia is
gradually drifting away from its high cost of extending funds which instead makes internal
funding of diversified firms rather expensive. Again, we assume the effect of the greater
integration of international capital markets among economies, which is weakening the
strength, monopoly and high cost of country specific external capital funding. Accordingly,
the internal capital market of the diversified firm loses the comparative importance derived
from the high cost of external funding. Our result on product diversification is similar to
findings of Lee et al. (2012) while international conglomerates and international
diversification reflects the earlier findings of Chen & Chu (2012), Santarelli & Trans 2016
and Tevfik (2008).

We use agency theory and the resource based theory to back the contention that efficient use
and management of resources within diversified firms could offset the demerits of
diversification. Agency theory and the resource based theory are integrated here because, we
see interrelatedness where an improved agency performance impacts on the resource
capability of the firm. Accordingly, we expected that efficiency (efficient firms) shows
positive relation with performance. Our findings corroborated our conjecture where
efficiency shows a positive relationship with performance. The finding is in line with Baik et
al. (2013), who show that efficiency adds to performance of firm. However, we could not
substantiate the hypothesis that efficiency exerts any maximum impact in the diversification
performance link. Our results show that there is no significant moderating effect of efficiency
in the relationship that exists between diversification and firm performance. Considering the
fact the efficiency add to performance, we expected its moderating influence on that link to
be significant. The surest explanation is rooted in agency theory perspective of manager-
ownership dynamics. Again, we infer the non-significant moderating role of efficiency from
agency theory contention that when owners manage their firms, efficiency is adhered to
within the firm. Malaysian firm’s data set demonstrate high family and /or individual
ownership concentration (Wan Hussin, 2009; Lee et al., 2012) and in accordance with the
agency theory, agency cost is lower as such firms have already incorporated efficient use of
resources. We believe that, such situation alleviated the moderating impact of efficiency in
our results using data from Malaysian firms. However, such impact could be significant in
other data sets where owner-manager is distinctively separated. There is therefore strong
support of agency theory assertion in this study regarding the moderating impact of efficiency
in diversification-performance link. In summary, since majority of the firms in Malaysia can
trace their sources to families and/or individuals, supervision and monitoring mitigating
agency cost are high, hence minimal inefficient practices. Firms have already exhausted their
potential benefits derived from being efficient and hence our efficiency interaction showing
insignificant results.
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Figure 1: Research framework
Table 1: Classification of firms into international and industrial diversification

Single Industry Multi Industry

Domestic International Domestic International
No of Firm
67 58 162 31
(Mean over 6 years)

Table 2: Summary statistics of firm values used for diversification-performance link

Mean median std. Dev Min Max

Asset 1,396,419 329,384.5 3,853,362 19,255 43,802,925
Debt 385,356.8 42,182.5 1,533,894 0 25,757,035
Sales 748,772.5 231,746.5 1,731,636 0 16,154,251
Equity 1,011,063 266,181 2,640,780 17,683 18,045,890

Table 3: Summary statistics of sampled firms between (2010-2015)

Variable Mean Median Std. Dev. Min Max

Tobin's Q 1.85 1.83 0.33 0.87 3.30
ROA 4.05 3.73 17.73 -124.68 649.49
Growth 10.51 3.35 54.90 0.00 142.187
Leverage 1.07 1.35 0.71 -2.00 2.01
Age 2.52 5.52 0.97 1.00 6.00
Size 5.59 2.00 0.60 4.28 7.64
Dcog 0.51 0.00 0.50 0.00 1.00
Dint 0.18 1.00 0.39 0.00 1.00
Dintcog 0.10 0.00 0.30 0.00 1.00
Efficiency 0.21 0.00 0.41 0.00 1.00
EffDcog 0.08 0.00 0.27 0.00 1.00
EffInt 0.04 0.00 0.19 0.00 1.00
Effdintcog 0.02 0.00 0.13 0.00 1.00
N 1914
N 319
T 6
Table 4: The number of efficient firms under the types of diversification (2010-2015)

Efficiency
International &
Industrial
Non-Diversified International Domestic diversified Efficiency
2010 19 14 23 6 62
2011 22 13 26 7 68
2012 24 12 31 6 73
2013 24 11 25 5 65
2014 30 12 21 5 68
2015 27 10 22 5 64
Table 5

Regression estimates of diversification and firm performance link using Tobin’s q

These model estimates the baseline (model 1), Model 2 and Model 3, where the performance is measured by
Tobin’s Q. The regression is then performed using panel regression with a fixed effects model while controlling
for the Heteroskedasticity and autocorrelation errors. Similarly, white robust standard errors are used as well as
firm clustering, year clustering, year effect, and industry effect. Period of data ranges from 2010 to 2015. The
coefficient values are stated in figures while the standard errors are stated in the figures in parentheses. ***, **,
and * denotes the level of significances of 1%, 5%, and 10% respectively.

model 1 model 2 model 3

Constant 3.356*** 3.3652*** 3.3217***
(0.316) (0.07) (0.07)
Growth -0.004 0.001 0.001
(0.003) (0.00) (0.00)
Leverage -0.07*** -0.09*** -0.099***
(0.018) (0.00) (0.00)
Age 0.392*** 0.041*** 0.044***
(0.124) (0.00) (0.00)
Size 0.299*** 0.269*** 0.263***
(0.059) (0.01) (0.01)
Dcog - 0.026*** -
(0.00) -
Dint - -0.027*** -0.0142
(0.01) (0.01)
DintCog - -0.059*** -0.0284**
(0.01) (0.01)
Eff 0.0737***
(0.02)
Eff*Dint -0.105
(0.05)
Eff*Dcog

Eff*DintCog -0.046
(0.06)
Firm 319 319 319

Observation 1914 1914 1914

r2 0.276 0.316 0.322

adjusted r2 0.2528 0.314 0.319

Table 6
 Regression estimates of diversification and firm performance link using ROA These models
estimates the baseline (model 1, Model 2 and Model 3) where the performance is measured by Return on Asset
(ROA). The regression is then performed using panel regression with a fixed effects model while controlling for
the Heteroskedasticity and autocorrelation errors. Similarly, white robust standard errors are used as well as firm
clustering, year clustering, year effect, and industry effect. Period of data ranges from 2010 to 2015. The
coefficient values are stated in figures while the standard errors are stated in the figures in parentheses. ***, **,
and * denotes the level of significances of 1%, 5%, and 10% respectively.

model 1 model 2 model 3

Constant 3.518* 1.417* 1.464*
(2.01) 0.69 (0.76)
Growth 0.00 -0.00 0.002
(0.004) (0.00) (0.005)
Leverage -1.32** -2.90*** -1.8***
(0.594) (0.48) (0.51)
Age 1.932** 0.738*** 1.161***
(1.045) (0.24) (0.27)
Size 4.696** 4.299*** 4.486***
(1.99) (1.37) (0.42)
Dcog - 1.932*** -

- (0.37) -

Dint - 3.278 0.75

- (3.92) (0.49)

DintCog - -4.566** -1.772**

- (2.17) (0.60)

Eff - - 1.390***

- - (1.32)

Eff*Dint - - 1.292

- - (1.76)

Eff*Dcog - - -

- - -

Eff*DintCog - - -1.47
- (1.65)

Firm 319 319 319

Observation 1914 1914 1914

r2 0.31 0.316 0.266

adjusted r2 0.283 0.314 0.261