International Journal of Management Reviews, Vol.

14, 18–38 (2012)

DOI: 10.1111/j.1468-2370.2011.00302.x

Diversification and Performance in

Developed and Emerging Market
Contexts: A Review of the Literature* ijmr_302 18..38

Saptarshi Purkayastha, Tatiana S. Manolova1 and Linda F. Edelman1

Strategic Management, Indian Institute of Management, Kozhikode, IIMK Campus P.O. Kozhikode-673570, Kerala,
India, and 1Business Policy and Strategy, Bentley University, 175 Forest St., Waltham, MA 02452, USA
Corresponding author email: ledelman@bentley.edu

The link between diversification and performance has become an important topic for
research in diverse fields such as strategic management, industrial organization and
financial management. However, a synthesis of the research done in developed
and emerging markets is missing. This paper attempts such a synthesis by comparing
and contrasting the past cumulative empirical research evidence on the relationship
between diversification and firm performance in the context of developed economies to
the more recent work in the emerging economies. The empirical literature has been
divided into three broad perspectives, and the paper highlights the considerable diver-
sity in its findings in developed and emerging markets across each of these perspectives.
Based on this study, it is proposed that related diversification is preferable in developed
economies and should be based on specific resources, whereas unrelated diversification
is appropriate in emerging economies and should be based on generic resources.
Although agency problems exist in both contexts, it is argued that the type of problem
differs in developed and emerging markets. The paper concludes by identifying three
directions for future research. First, the relationship between diversification and per-
formance should be examined across each industry separately and not in aggregate.
Secondly, future research needs to examine the organizational mechanisms required to
make diversification successful. Finally, the relationship needs to be examined under
unstable and dynamic situations such as the current global economic downturn.

Introduction strategies in the developed world during the period

Diversification is a popular growth option for firms in
both developed (Datta et al. 1991) and emerging
countries (Kakani 2000). Besides the advantages of
increased revenues and opportunities to spread risks,
it has the potential to create shareholder value through
the exploitation of economies of scope and the cre-
ation of efficient internal capital and labour markets.
Although the diversification trend which dominated
*A free Teaching and Learning Guide to accompany this
article is available at: http://onlinelibrary.wiley.com/
journal/10.1111/(ISSN)1468-2370/homepage/teaching___
learning_guides.htm
1950–1980 has been replaced by a trend of refocusing
(Wall Street Journal 1985), the competitive landscape
in emerging economies continues to be dominated by
large conglomerates such as the Tata Group in India or
the Group Carso in Mexico. These diversified and
often family-controlled conglomerates account for up
to 80–85% of the total sales and asset base of the
private sector in some emerging economies. The
effect of diversification on corporate performance in
the context of emerging markets is therefore an impor-
tant managerial and public policy concern.
While diversification continues to be a growth
strategy for firms, the relationship between diversifi-
cation and firm performance is not clear, because the

© 2011 The Authors

International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA
02148, USA
Diversification and Performance
findings of past empirical studies do not point to an
easy generalization (Palich et al. 2000). For example,
in developed economies, Rhodes (1973) and Chatter-
jee (1986) have advocated a positive relationship;
Bettis and Hall (1982) and Perry (1998) have found a
negative or no relationship, while Rumelt (1974) and
Markides and Williamson (1996) have found a curvi-
linear relationship between diversification and firm
performance. The situation is similar in emerging
economies. Although there is limited research in this
area (Hoskisson et al. 2000; Kakani 2000), the few
studies that have been done provide conflicting
results. For example, Chang and Hong (2000) found
that diversification has a positive influence on firm
performance; Kakani (2000) predicts an inverse
relationship; Khanna and Palepu (2000a,b) predict a
curvilinear relationship; while Saple (2000) and Chu
(2004) predict no relationship between diversification
and firm performance.
The sheer number and variety of diversification
studies in developed economies have made it difficult
to synthesize the results. As Hunter and Schmidt
(1990, p. 34) pointed out, ‘the need for today is not
additional empirical data but some means of making
sense of the vast amount of data we have accumu-
lated’. Without a clear synthesis of the existing
studies, the effect of diversification on firm perform-
ance cannot be answered. Thus the primary motiva-
tion of this study is to compare and contrast the past
empirical research on the relationship between diver-
sification and firm performance in the context of
developed economies to the more recent work in the
emerging economies. In doing so, we organize the
review into three broad perspectives: the external
perspective (industrial organization (I/O) and institu-
tional theories), the internal perspective (resource-
based view (RBV)) and the finance perspective, and
discuss them in the context of developed and emer-
ging markets, culminating the discussion by formu-
lating conclusions from prior research. Next, we
review firm performance measurement issues in
developed and emerging market context. The paper
concludes by identifying several directions for future
research.
Methodology
Given the large volume of research on diversification,
the study is constrained by strict temporal boundaries.
The literature review starts with the seminal work of
Rumelt (1974) and ends with the recent work of Lim
© 2011 The Authors
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
19
et al. (2009).1 In selecting the papers, we focused on
two questions. First, how has diversification and firm
performance research evolved over time? Second,
who has published most in this literature, and what is
their contribution to the evolution of this field? To
address the first question, we followed the develop-
ment of the diversification literature and then catego-
rized it into three broad perspectives, the external
perspective (industrial organizational (I/O) and insti-
tutional theories), the internal perspective (the RBV),
and the finance perspective for both developed and
emerging economies. Unlike Datta et al. (1991) and
Ramanujam and Varadarajan (1989), who developed a
framework to organize their literature review, we
anchor the review in the frameworks provided by
established theoretical perspectives. The disciplines
of I/O and finance have extensively researched the
diversification–performance relationship (Datta et al.
1991), while the resource-based perspective is an
emerging theory in this line of work (Perry 1998). The
institutional framework is considered the most appli-
cable paradigm for explaining diversification in the
context of emerging economies (Shenkar and von
Glinow 1994), but research in the other two areas has
been comparatively limited. In sum, we were as com-
prehensive as possible in selecting the theoretical
anchors for the literature review.
After categorizing the diversification–
performance literature in three perspectives, we iden-
tified the prolific authors in this field and followed
the evolution of their scholarship over time. We
selected these authors by tracking their publications
in the top management journals (e.g. Academy of
Management Review, Academy of Management
Journal, Journal of Finance, Management Science,
Journal of Management and Strategic Management
Journal). Specifically, we used the Social Science
Citation Index Journal Impact Factor to determine
whether an article was in a journal which we deemed
high enough quality to include. In the developed
economies literature review, all journals have a five-
year rolling impact factor of over 1. As a secondary
check or for an article that we deemed important but
was not published in the better cited journals, we
looked to Goggle Scholar to see the number of article
1
We choose Rumelt’s (1974) work as our boundary because
he developed categorical measures of diversification which
were widely used by other researchers (i.e. Bettis 1981; Chu
2004; Hoskisson 1987; Lubatkin and Chatterjee 1994;
Palepu 1985).
20
citations. If an article had over 50 citations, we deter-
mined that it was important and hence included it in
the review.
In the case of emerging economies, because of
the paucity of empirical research, we captured most
of the literature. The search process made extensive
use of the ABI-Inform and EBSCO databases, using
keywords such as ‘diversification’, ‘business group’,
‘firm performance’ AND ‘emerging economy/ies’.
Finally, we examined each study thoroughly to
determine its fit with the scope of the review. In
total, we reviewed 124 articles, 87 in the context of
developed markets and 37 in the context of emer-
ging markets.
The external view: industrial
organization (developed economies)
and the institutional perspectives
(emerging economies)
Most of the earlier studies on diversification in devel-
oped economies in the I/O literature (pre-Rumelt
1974 studies) have been concerned with the extent or
motives of diversification (e.g. Gort 1962; Miller
1969; Weston and Mansinghka 1971), and are based
on the structure–conduct–performance framework.
This section provides a critical analysis of the litera-
ture in the field of diversification which uses an I/O
framework, starting with the seminal work of Rumelt
(1974).
Rumelt and post-Rumelt works: diversification in
developed markets
Rumelt’s (1974) work is a seminal study in this
field, as he developed a new categorical measure of
diversification. One of his major findings was that
firms with related diversified portfolios outperform
other diversification types, owing to gains from
economies of scope. Researchers following
Rumelt’s 1974 study have found similar relation-
ships between diversification and firm performance
(Christensen and Montgomery 1981; Fryxell and
Barton 1990; Hill and Snell 1989; Hitt and Ireland
1986; Hoskisson 1987; Lecraw 1984; Palepu 1985;
Palich et al. 2000; Varadarajan and Ramanujam
1987).
Although there is strong support for Rumelt’s
(1974) perspective on related diversification, other
studies have shown that the performance of diver-
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
S. Purkayastha et al.
sified firms is associated with the structure of
the industry (Demsetz 1974; Montgomery 1985;
Phillips 1976). This finding led researchers to study
the effect of industry structure on diversification.
Bettis (1981) found that diversification leads to the
creation of entry barriers, which in turn leads to
higher industry profitability. Bettis and Hall (1982)
found that the differences between the profitability
of Rumelt’s categories disappeared after correcting
for the industry bias in the sample. Hill (1983) also
found no difference in the average profitability
among categories of diversification. Other studies
that did not find any significant differences between
diversification and firm performance after control-
ling for industry effects include McDougall and
Round (1984), Montgomery (1985), Johnson and
Thomas (1987), Grant and Jammine (1988), Hill
and Snell (1988), Chang and Thomas (1989) and
Chatterjee and Wernerfelt (1991).
Given the lack of conclusiveness in this line of
inquiry, researchers examined alternative perform-
ance measures and contingency factors. Michel and
Shaked (1984) and, subsequently, Dubofsky
and Varadarajan (1987) examined a market-based
measure of performance: the increase in sharehold-
ers’ value. They found that unrelated diversification
led to increased performance over related diversifi-
cation. Wernerfelt and Montgomery (1986) found
that industry profitability and industry growth, the
two dimensions of industry attractiveness, have dif-
ferent implications for related (which they termed as
efficient) and unrelated (which they termed as inef-
ficient) firms. They suggested that related diversified
firms would be better off in highly profitable indus-
tries, while unrelated firms would be better off in
high growth industries.
A group of studies by Hoskisson and co-authors
examined the relationship between diversification
and firm structure. Thus, Hoskisson (1987) and Hill
et al. (1992) found that related diversifiers need to
adopt co-operative organizational arrangements,
while unrelated diversifiers required competitive
arrangements. Hill and Hoskisson (1987) argued
that vertically integrated firms achieve vertical
economies by reducing transaction costs, related
diversified firms achieve synergistic economies by
exploiting synergy, and unrelated firms achieve
financial economies by risk reduction, portfolio
management and internal capital markets. Teece
et al. (1994) studied how environments affect firm
structure. They suggested that, with low path
dependence, slow learning and weak selection,
© 2011 The Authors
Diversification and Performance 21

conglomerates persist, but in environments with Market power and diversification

rapid learning and colliding technological trajecto-
A different approach to examining the effect of diver-
ries, networked firms may arise. Thus, from the per-
sification on firm performance is to analyse the
spective of different measures of firm performance
market power that a conglomerate has with respect to
and firm structure, no overall conclusions could be
specialized firms. Market power is the ability of a
derived.
market participant to influence price, quality and the
nature of the product in the marketplace (Markham
Synergy and diversification 1973). The fundamental prerequisite for market
power is the existence of entry barriers (Baumol
Researchers also examined the effect of synergies
et al. 1982). Entry barriers can be erected by the
and economies of scope on diversification. Two
diversified firm by cross-subsidization, mutual for-
businesses are said to have synergy if the union
bearance and reciprocal buying (Montgomery 1994).
of the two allows for opportunities that are not
Some researchers have found that diversification
available to either of them separately (Perry 1998).
based solely on market power has a positive relation-
Synergies may arise from the use of common infra-
ship with firm performance (Edwards 1955; Hill
structures, including resources that are either tan-
1985). They argue that, as long as the firm is larger
gible or intangible, such as marketing and R&D
than its competitors, it will have the advantage of
operations, brand names, production and distribu-
market power, irrespective of the type of diversifica-
tion systems (Teece 1982). Empirical studies on
tion strategy it pursues. However, other studies dis-
synergy and their relation to diversification do not
agree, stating that a firm’s expansion into businesses
abound in the literature because of measurement
that are related to its original products results in
problems. Carter (1977) examined the performance
transfer of skills in technology, marketing or special-
difference between diversified and specialized firms
ized management which can help in developing
and found that diversified firms outperform their
expertise and thereby market power in relation to its
specialized counterparts. He rationalized that the
competitors (Singh and Montgomery 1987). Related
source of superior performance can be related to the
diversifiers are more likely to create barriers to entry
synergy that arises because of diversification.
based on scope economies, patents, experience
However, there is a limit to diversification, because
advantages or brand reputation, thus giving more
over-extended use of shared resources may result in
market power relative to unrelated firms (Singh and
congestion and loss of control. Deneffe (1993)
Montgomery 1987). Although the increase in market
found that diversified firms delayed entry into new
power of unrelated diversifiers can arise from
markets compared with undiversified firms, because
increases in the absolute size and breadth of the firm,
the former tried to exploit cost externalities from
which allow opportunities for cross-subsidization,
experience transfer (because of synergy) from their
predatory pricing and reciprocity in buying and
core product to new markets.
selling (Markham 1973), these benefits should also
Economies of scope are a specific expression of
be available to related diversified firms and, thus,
synergy, usually thought of primarily in the context
related diversifiers should have more market power
of cost. They are said to exist when the cost of joint
than unrelated diversifiers (Singh and Montgomery
production of two goods by a multi-product (diver-
1987). However, the above observation must be
sified) firm is less than the combined cost of produc-
qualified by the fact that a diversified firm with an
tion of the two goods by two single-product firms.
insignificant position in a number of markets will
However, Teece (1980) says that this is not a suffi-
not, in sum, have market power (Gribbin 1976).
cient condition for exploitation of economies of
Figure 12 presents a model of the I/O stream of
scope. The proposition that he advances is that a cost
function displaying economies of scope has no direct
implication on the diversification of a firm if the cost 2
The conduct variable is shown by a dashed line because of
can be efficiently traded in the open market. Never- the initial I/O postulate that acceptable prediction levels of
theless, if economies of scope are based upon the performance can be made by using the structural variables.
common and recurrent use of propriety know-how or However, the seminal work of Rumelt (1974) and his clas-
sification of diversified firms into related and unrelated cat-
of a specialized and indivisible physical asset, the egories made the firm and hence conduct variables the focal
multi-product enterprise is an efficient way of orga- point. One may thus tend to conclude that the diversification
nizing economic activity. literature emerged out of I/O literature and entered the strat-

© 2011 The Authors

International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
22
Diversification
Structure Conduct Performance
Figure 1. The industrial organization stream
research on diversification and performance in the
context of developed economies.
The external view on diversification in emerging
economies: the role of institutions
Studies exploring the effect of industry structure on a
diversified firm’s performance in developed econ-
omies base their hypotheses on one critical assump-
tion: markets are competitive and strive towards effi-
ciency. However, this assumption cannot be made in
the context of an emerging economy because of
market impediments, such as the lack of inter-
mediary institutions (Khanna and Palepu 1997), the
lack of well-defined property rights that convey
exclusivity, transferability and quality of title (Devlin
et al. 1988), and the lack of a strong legal framework,
which results in opportunism, bribery and corruption
(Nelson et al. 1998). Given these constraints, in the
context of emerging markets, the I/O perspective has
been complemented by what we call the ‘institutional
perspective’.
The institutional perspective emphasizes the influ-
ence of systems surrounding organizations that
shape social and organizational behaviour (Scott
1995). Peng and Health (1996) and Child and Lu
(1996) argued that the internal growth of firms in
emerging economies is limited by institutional con-
straints and, as a result, network-based (diversified)
growth is expected to be more viable. Several other
studies concur (Guillen 2000; Khanna and Palepu
2000a,b; Kock and Guillen 2001; Palepu and Khanna
1998). The underlying argument is that, in emerging
egic management literature (Bettis 1981; Bettis and Hall
1982). However, a distinction between these two literature
streams has not been made in this paper because the distinc-
tion is not a very major one and the overall model is the
same. Moreover, post-Rumelt; researchers used the I/O
literature to great degree to explain the diversification–
performance relationship (Christensen and Montgomery
1981; Montgomery 1985; Palepu 1985).
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
S. Purkayastha et al.
economies, intermediate institutions – such as finan-
cial and market intermediaries – are either inefficient
or absent, and therefore diversified firms can gain
scope and scale advantages from internalizing those
intermediate functions typically provided by institu-
tions and markets in advanced economies (Chakra-
barti et al. 2007).
Khanna and Palepu (1997 1999, 2000a,b) argue
that greater diversification may enhance firm
performance in emerging economies because of
insufficient market and institutional development.
By diversifying, firms can create internal markets
that may be more effective than inefficient external
markets. As intermediaries are often absent or inef-
ficient in developing economies, internalization
may be viable and profitable. Diversified firms do
not gain equally in developed institutional environ-
ments, since it is more difficult for internal opera-
tions to match relatively efficient markets. Similar
arguments apply to the cost of diversification. Effi-
cient markets in developed economies detect and
penalize diversification costs more than the less
efficient markets of institutionally developing
economies. This may be because the internal inter-
mediate institutions of diversified firms in devel-
oped economies cannot match the efficiency levels
of open market institutions. Diversified firms thus
have higher costs, which results in lowering their
performance (Leaven and Levine 2007; Villalonga
2004). In institutionally developing economies,
however, the absence or inefficiency of external
intermediate institutions results in firms developing
these institutions internally, which helps firms to
lower their costs (Lins and Servaes 2002). Thus,
internalization in less developed institutional envir-
onments would bring about greater net marginal
benefits.
Backman (1999) proposes that, for many Asian
firms, diversification is motivated by aspects which
market efficiency factors do not adequately capture,
such as exploitation of privileged access to informa-
tion, licences and markets. However, such advan-
tages decrease with economic development,
suggesting that diversification is less beneficial in
more developed institutional environments (Kock
and Guillen 2001).
While the institutional perspective makes intuitive
sense, studies have been done that provide contradic-
tory results. Kakani (2000) found an inverse relation-
ship between diversification and firm performance
measures. The results were robust in the sense that
the inverse relationship was observed throughout the
© 2011 The Authors
 Diversification and Performance 23

Economic Orientation
Poor labour markets
Poor capital markets
Poor government
regulations
Poor product market
Decision to Performance
diversify
Sociological orientation
Political constrains
Cultural constrains

Figure 2. The institutional perspective

study period (1987–1999) and using multiple meas-
ures of diversification (i.e. categorical and continu-
ous) and performance (i.e. accounting and market
based). Saple (2000) measured the diversification of
Indian firms as a simple count of the number of
industries in which the firms’ divisions are present.
no effect She found that diversification does not have any
effect on the firm’s performance; however, synergy
had an inverted-U-shaped relationship with firm
performance. Considering synergy3 a proxy for
diversification in the econometric model, this study’s
conclusion did not differ from the studies done in
advanced countries. Figure 2 presents a model of the
institutional view on diversification in emerging
markets.
Khanna and Rivkin address this variation in the
performance of diversified firms by suggesting that
the inability to profit from diversification indicates
‘poorly developed selection environment, where
weak organizational forms4 are not weeded out’
(Khanna and Rivkin 2001, p. 47). There are two
issues in the logic of such an argument. The first is
whether one can empirically show how an organi-
zational form such as the diversified firm arises as a
response to market failure (Gould and Lewontin
1979). It can be argued that diversified firms do not
3
The computation of synergy by Saple (2000) is similar to
that computed by Berger and Ofek (1995) with the one
exception: the latter used median values, while the former
used mean values. Synergistic benefits of a diversified firm
are the difference between the actual values of an accounting
term (profits or asset utilization) and the benchmark value.
These benchmark measures are the total profits or asset
utilization that a diversified firm would have faced had it
operated in each of the industries separately as undiversified
firm with a size proportional to the sales output in that
industry to the total sales of the firm.
4
Weak organizational forms refer to undiversified firms.
emerge to solve market problems, but emerge
because of special skills and abilities of entrepre-
neurs (Granovetter 1994). A second issue is how to
validate the implicit assumption that an ideal state
exists in which individual firms do not need to
diversify because the missing institutions would
eventually emerge in the open market. Having risen
from the open market processes, these institutions
would be as efficient. Thus, once economies
reached this ideal state, the need for diversified
firms would disappear, and they would disintegrate.
However, diversified firms still exist in advanced
economies, assuming that their economies are
market driven and efficient. Thus, the rationale that
diversified firms arise because of market failures is
problematic.
Discussion
A review of more than four decades of re-
search within the I/O literature demonstrates that
no clear direction seems to be emerging in the
diversification–firm performance debate in devel-
oped economies. The dominant view in this stream
finds a positive relationship between related diver-
sification and firm performance (Hitt and Ireland
1986; Palepu 1985; Rumelt 1974; Varadarajan and
Ramanujam 1987). Related diversifiers enjoy the
benefits of synergy by sharing and transferring
resources and skill sets across different businesses.
In the case of unrelated diversifiers, superior market
power and profitability can arise from increases in
the size and breadth of the firm, allowing opportu-
nities for financial benefits (Hill and Hoskisson
1987). Since financial benefits are also available to
related diversified firms, but the potential benefits
of related diversification are unavailable to unre-
lated diversifiers, most of the studies in this stream

© 2011 The Authors

International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
24
of thought suggest that related diversified firms
should perform better than unrelated firms (Perry
1998).
The number of theoretical and empirical studies
using an institutional framework in emerging
economies is limited even though some theorists
have argued that this perspective is perhaps the
most applicable paradigm for explaining diversifi-
cation in such a context (Shenkar and von Glinow
1994). In such economies, the institutions required
for business are either absent or inefficient, so firms
that have internalized these institutions can diver-
sify across industries and be profitable. Diversified
firms can benefit from access to internal institutions
such as internal capital and labour markets to miti-
gate external market failures. Internalization of
these institutions entails fixed costs, so diversifica-
tion will only be beneficial when the fixed costs
required to set up these institutions can be distrib-
uted across divisions that are spread across a
number of industries. Thus, highly diversified firms
as opposed to less diversified firms will have super-
ior firm performance. Rumelt (1974) rationalizes
that firms initiate diversification by moving into
related industries because of the ease of sharing of
resources, and then gradually move towards unre-
lated diversification. Hence, highly diversified firms
are more likely to be unrelated diversifiers. Thus,
we conclude:
(a) In developed economies, related diversification
is likely to lead to superior performance.
(b) In emerging economies, unrelated diversifica-
tion is likely to result in superior performance.
The internal perspective: the RBV
The RBV in developed economies
The RBV offers new insights into the performance of
diversified firms. This theory proposes that there are
no long-term benefits to diversification based on
generic resources, as they are in abundant supply and
are imitable (Montgomery and Wernerfelt 1988;
Wernerfelt and Montgomery 1988). Besides,
resources lose value when transferred to markets that
are dissimilar to the one where it originated (Wern-
erfelt and Montgomery 1988). Researchers adopting
the RBV are interested in how firms obtain competi-
tive advantage through diversification in the long
term. The RBV theory suggests that developing a
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
S. Purkayastha et al.
diversification strategy based on inputs that are char-
acterized as valuable, durable, inimitable and non-
substitutable can provide the basis for sustainable
competitive advantage (Markides and Williamson
1996). Such inputs can only be firm specific and can
be exploited if firms diversify in related industries
(Collis and Montgomery 1995; Perry 1998). More-
over, firms should continuously upgrade their stock
of resources and capabilities5 to meet market-specific
demands and use them in existing or new markets
(Collis and Montgomery 1995; Grant 1991). The
reason for upgrading resources and capabilities
rather than simply using existing stock is that the
forces that affect market and competition are numer-
ous and complex, so an existing resource may fail to
provide lasting competitive advantage.
According to the RBV logic, resources and capa-
bilities also need to be leveraged beyond the products
that they were originally developed for; thus provid-
ing an opportunity for diversification (Prahalad and
Hamel 1990). Unfortunately, companies that can
sustain competitive advantage by upgrading or lever-
aging their resources and capabilities are the excep-
tion rather than the rule. Collis and Montgomery
(1995) identify three errors that companies commit
when trying to diversify by leveraging resources.
First, managers overestimate the transferability of
specific assets and capabilities to a different product
environment. As resources that provide sustainable
competitive advantage are inimitable, the company
may find it difficult to replicate them in new markets.
For example, although Levi Strauss was able to move
successfully into related jeans products, broader
moves into high fashion clothing have been less
successful. It appears that brand recognition is not
extensible across too broad a product line. Second,
managers overestimate their own capability to
compete in highly profitable industries. Such indus-
tries are profitable because entry (resource) barriers
limit competition, since accumulating the necessary
resources is difficult. Finally, managers assume that
generic resources would be a source of competitive
advantage in a new market, regardless of the dynam-
ics of that market. As economies of scope exist, man-
5
Resources encompass all input factors – both tangible and
intangible, human and non-human – that are owned or con-
trolled by the firm and enter into the production of goods and
services to satisfy human wants (Amit and Schoemaker
1993), while capabilities refers to the firm’s capacity to
acquire, develop and deploy its resources to achieve superior
performance relative to other firms (Dierickx and Cool
1989).
© 2011 The Authors
Diversification and Performance
Resources Capabilities
(R) (C)
Figure 3. The RBV on diversification
agers assume that resources that are not specific to
any product category can result in growth through
diversification. However, due to slow organizational
learning and causal ambiguity (Dierickx and Cool
1989) and competitive pressures to be efficient (Kock
and Guillen 2001), diversification based on generic
resources would not be sustainable. For example,
Philip Morris assumed that their generic resource of
distribution was transferable from tobacco products
to soft drinks. They acquired 7UP only to turn around
and divest it years later because of the difficulty of
managing the franchise distribution network. Thus,
according to the RBV view, firms will have sustain-
able advantage only if they diversify into products
that are related to the resources and capabilities that
they already possess, i.e. the firm must show ‘coher-
ence’ in its capabilities (Teece et al. 1994).
Although the RBV provides a deep theoretical
understanding of the link between diversification and
firm performance, there are few empirical studies
that investigate this link. One reason for this over-
sight is the difficulty in measuring the constructs of
resources and capabilities. Robins and Wiersema
(1995) used RBV logic to measure the flow of tech-
nology between businesses as an indicator of relat-
edness. They found that the greater the extent of
technological interrelationships, the more superior
the performance of the firms. Ilinitch and Zeithmal
(1995) studied the relationship between managerial
relatedness and the performance of diversified
firms. A significant positive association emerged
between the degree of managerial relatedness and
© 2011 The Authors
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
25
Whether
R&C are
Valuable Yes
Durable
Diversify
Inimitable
Non-
substitutable?
No
Do not
diversify
firm performance. Markides and Williamson (1994,
1996) developed indicators of relatedness based on
product or market-specific resources, such as brand
recognition, customer loyalty, distributor loyalty and
organizational systems, and found a positive associa-
tion between these resources and firm performance.
Brush (1996) examined the extent of resource
sharing between acquired and acquiring firms and
found that the higher the resource sharing, the more
successful the acquisition.
The results of the above studies have been remark-
ably consistent. By conceptualizing relatedness in
terms of shared specific resources (e.g. unique tech-
nology or managerial know-how), the above studies
have found that firms with highly interrelated busi-
ness portfolios outperform firms with lower levels of
portfolio relatedness. A model for this stream of
research is presented in Figure 3.
The resource-based perspective on diversification
in the context of emerging economies
The types of resources that firms acquire over time
are related to the country and the industrial environ-
ment surrounding them (Porter 1990). The emerging
economies of East Asia, Latin America and Southern
Europe developed in the late 1960s and 1970s,
mostly by entering into mature industries such as
simple assembled goods, electrical appliances,
rubber, transportation equipment, steel and chemi-
cals (Haggard 1990). The native governments of
these countries encouraged local entrepreneurs to
26
participate in the economy by protecting them from
foreign competition. These local entrepreneurs lever-
aged local and foreign contacts to obtain foreign
technology and resources to serve the local market.
Further, Kock and Guillen (2001) opine that protec-
tionism and other barriers in emerging economies
distort the value of firms’ resources and capabilities.
They propose that in addition to competencies and
technological abilities, resources such as political
and bureaucratic contacts and connections are impor-
tant for firm performance in such environments. This
ability to leverage contacts or harness political and
bureaucratic connections can be applied across
diverse industries, which results in the creation of an
organization form characterized by diversification
across a wide range of businesses. Known as the
business group,6 this organizational structure has
come to dominate the private sector in emerging
economies (Ghemawat and Khanna 1998). For
example, in 2000, Chinese business groups contrib-
uted close to 60% of the nation’s industrial output
(Liu et al. 2006) and Indian business groups con-
trolled about 75% of the total industrial output in the
private sector (data collected from CMIE7 database).
Business groups are defined as a set of firms
which, though legally independent, are bound
together by a constellation of formal and informal
ties and are accustomed to taking co-ordinated
actions (Khanna and Rivkin 2001). Leff (1978)
defines a business group as a group of companies
that do business in different markets under a
common administrative or financial control, and its
members are linked by interpersonal trust and on the
basis of a similar personal, ethnic or commercial
background. Research on business groups using the
resource-based perspective is limited (Khanna and
Palepu 2000a), and can be divided into a few broad
streams. Pioneered by Leff (1976, 1978), the domi-
nant stream of work conceptualizes business groups
as responses to the lack of intermediary institutions
resulting in market imperfections.8 Chang and
Hong (1998) found evidence that Korean chaebols
6
Business groups are known as groups in Latin America,
business houses in India, and chaebols in South Korea.
7
CMIE (Centre for Monitoring the Indian Economy) is a
database which has information for around 10,000 firms.
8
This view can be related to the role of institutions discussed
in the previous section. However, the RBV in emerging
economies is more comprehensive than the role of institu-
tions view, as the former includes the sociological and
political perspective of the diversification–performance
relationship.
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
S. Purkayastha et al.
run value-enhancing internal product and labour
markets. Khanna and Palepu (1999) established that
indices of product, labour, and capital market inter-
mediation for Chilean and Indian business groups are
positively correlated with both accounting and stock
market measures of firm performance. Chang and
Hong (2000) found that Korean business groups had
a positive influence on firm performance, while Yiu
et al. (2005) found that Chinese business groups that
have developed a unique portfolio of market related
resources and capabilities perform better than those
that have not.
A second stream of work emerges from sociology
and considers groups as a medley of formal and
informal relationships that link together affiliates
(Granovetter 1994; Keister 1988). This network of
relationships, also known as social capital (Adler and
Kwon 2002; Bhappu 2000), is built on mutual trust
and reciprocity. Violation of trust and reciprocity can
permanently damage the relationship, resulting in
both social and economic ostracization, so partici-
pants are encouraged to comply with the norms of
the network. The expected benefits of the network are
high quality information processing among the par-
ticipants, mutual influence and power, and resource
sharing (Adler and Kwon 2002). Thus, the economist
interpretation of business groups as primarily driven
by equity interlocks is disputed in this stream of
research. The downside of social capital is that overly
embedded intragroup networks can encourage paro-
chialism, xenophobia, isolationism and inertia,
which are detrimental to corporate performance and
globalization (Chung 2004).
The third stream of research sees business groups
as counterproductive because they enable a handful
of firms to obtain favourable treatment from the
power structure of the country in question, thus
posing a direct barrier to the operation of competitive
forces in allocating resources efficiently in the
economy (Ghemawat and Khanna 1998). Further,
this close connection to the power structure ensures
that the firms can be bailed out in times of distress,
especially when they are considered too big to fail.
The most influential study in this stream is the Fis-
man’s (2001) event study in Suharto’s9 Indonesia. He
found that announcements related to Suharto’s mor-
tality yielded sharp reductions in the market capita-
lization of firms that were considered to be in close
9
Suharto (8 June 1921–27 January 2008) was the second
President of Indonesia, holding the office from 1967 to
1998.
© 2011 The Authors
Diversification and Performance
proximity to the President. Much of the work in this
stream is descriptive (Encarnation 1989; Gill 1999),
so further empirical studies are needed to validate the
current findings.
Research needs to be done on the impact of busi-
ness groups not only on their affiliated firm perfor-
mance, but also on the economy as a whole. In
countries as varied as China, India, Korea, Malay-
sia, Mexico and South Korea, policy-makers and
managers are currently debating the future of busi-
ness groups. The debate has gathered momentum as
waves of deregulation and financial crises reshape
the economic landscapes of these countries. Some
policy-makers, as in South Korea, have advocated
the shrinking of business groups while others, as in
China, have encouraged the formation of business
groups. Yet others in India and South Africa have
adopted a mixed stance. It would be very difficult to
rationalize such marked variance in public policies
without prior understanding of the potentially dif-
ferent roles that business groups play in each of
these contexts. Studies that focus on the dynamic of
the business group would therefore make a strong
contribution to the diversification literature in
emerging economies.
Discussion
Resource-based-view theorists argue that diversifi-
cation in developed economies would be efficient if it
were based on specific resources, rather than generic
resources, so that synergistic benefits from econ-
omies of scope can be exploited (Teece 1980, 1982).
The issue of specificity arises because diversification
based on a resource that is not characterized as caus-
ally ambiguous (Reed and DeFillippi 1990), path
dependent, unique (Barney 1991) and perfectly
immobile (Peteraf 1993) will not lead to sustainable
competitive advantage. Therefore, firm-specific
resources should be valuable, durable, inimitable and
non-substitutable (Markides and Williamson 1994,
1996). We argue that firm-specific resources can only
be exploited in a single industry or at best in a limited
number of related industries. This is because a
resource which provides competitive advantage in
one industry may not do so in another.10 However,
resources that are not specific (i.e. generic) are in
10
The example that we cite earlier in the paper of Philip
Morris and their acquisition and subsequent divesture of
7UP points to that effect.
© 2011 The Authors
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
27
great supply, and thus cannot lead to sustained com-
petitive advantage (Montgomery and Wernerfelt
1988; Wernerfelt and Montgomery 1988).
In the case of emerging economies, resource-
based theorists point out that the rationale for the
development of business groups can be found in the
environment which prevailed during the beginning of
economic development in these countries. Local
entrepreneurs were encouraged by the native govern-
ment to participate in the economy; the selection of
entrepreneurs being based on their ability to use con-
tacts to combine knowledge of local markets with
technological and organizational resources from
outside the country (Oliver 1997). Moreover, firm
performance is also determined by political and
bureaucratic contacts and connections (Kock and
Guillen 2001). We argue that resources required to
develop such capabilities are generic, which created
incentives for firms to use them across diverse indus-
tries, resulting in the formation of business groups.
For example, Korean business groups were able to
acquire and deploy a set of non-specific industry
entry skills, such as obtaining licences, arranging
financial packages, acquiring technology and mana-
gerial know-how, with active support from the gov-
ernment (Amsden and Hikino 1994). Because these
resources are generic in nature, and unless repeatedly
used, they would become idle, business groups can
use these resources to diversify profitably across
unrelated industries (Guillen 2000). Therefore, we
conclude:
(a) In developed economies, only firm-specific
resources would lead to sustainable competitive
advantage, and hence firms should concentrate
on one industry or at best on a limited number
of related industries.
(b) In emerging economies, generic resources
would lead to sustainable competitive advan-
tage, which would create incentives for firms to
diversify into unrelated industries, resulting in
the formation of business groups.
The role of finance
The finance perspective in developed economies can
be divided into three broad streams. The first stream
comprises the risk-reduction motive of diversifica-
tion; the second stream consists of economies of
internal capital market, and, the third stream takes
the agency view.
28
Risk and diversification in developed economies
Unrelated diversification is pursued by firms because
negatively correlated earnings streams from two or
more businesses would reduce the total variance in
organizational earnings (Amit and Linvat 1988).
Considering that the goal of the firm is earnings
stability, the firm should seek new acquisitions or
investments with earnings streams different from that
of its existing business (Lewellem 1971; Perry 1998).
Risk diversification is therefore one of the benefits of
unrelated diversification.
Researchers, however, argue that an economic
advantage cannot be achieved by a conglomerate
merger (Levy and Sarnat 1970). Although firms can
minimize unsystematic risk, no value is expected to
be created due to risk pooling in unrelated diversified
firms even under the assumption of perfect capital
markets, since shareholders can achieve the desired
level of risks through individual portfolio diversifi-
cation at a cost lower than that of the firm (Mont-
gomery and Singh 1984). Thus, managers should not
be concerned with managing such risk, as it can be
done profitably by investors and thus would not be
rewarded by the stock market (Lubatkin and O’Neill
1987). Although firms can lower their systematic risk
by related diversification, that benefit arises from
synergies through sharing resources in related busi-
nesses rather than risk diversification (Lubatkin and
Chatterjee 1994).
Transaction costs of internal capital markets in
developed economies
Williamson (1975) suggested that the internal
capital market provides a rationale for diversifica-
tion. His argument is built on the proposition that
diversified firms have lower transaction costs com-
pared with undiversified firms in raising and allo-
cating capital. A single business firm is more
dependent on external resources for raising capital,
which is often more costly than internally created
capital (Caper 2003). Raising funds internally not
only reduces transaction costs, but also gives the
firm the ability to shift capital within the firm to
where it is expected to bring the greatest returns
(Stein 1997). Moreover, stockholders (members of
the external capital market) experience information
and control disadvantages owing to the diffused
ownership of a firm. The existence of information
asymmetries allows managers to behave opportunis-
tically and also restricts stockholders to taking dis-
ciplinary actions, owing to high transaction costs
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
S. Purkayastha et al.
even when they detect that managers are not invest-
ing funds in the most efficient way. In contrast, the
corporate office of a diversified firm, which acts as
an internal capital market, has rich information on
its divisions and auditing systems which allows it
effectively to control divisional managers by adjust-
ing their incentive if performance is inadequate
(Jones and Hill 1988; Williamson 1975). Thus, a
diversified firm can achieve an efficient allocation of
resources between divisions and also control them
effectively. Further, a cost–benefit analysis of inter-
nal market vs external debt market reveals that an
internal capital market leads to better monitoring
than financial institutional lending, and thus makes
it easier to redeploy efficiently the assets that are
poorly performing.
However, an internal capital market has some
disadvantages; first, it reduces managerial entrepre-
neurial incentives, as funding is decided by the head-
quarters (Gertner et al. 1994). Secondly, it can give
rise to agency problems because of the resources
at its disposal. However, agency problem may not
necessarily be a bad thing, as long as the tendencies of
managers are more or less in line with shareholder
value maximization (Stein 1997). Finally, an internal
capital market leads to inefficient allocation if the firm
segments are not financially independent, since a
financial shock in one segment affects the cost of
finance in another segment, even if the latter segment
has better profitability (Lamont 1997). Thus, invest-
ment does not depend on the segment’s better invest-
ment opportunities, and hence cross-subsidization is
not always efficient (Berger and Ofek 1995; Shin and
Stulz 1997).
Agency theory in developed economies
Agency theory explores the possibility that diversi-
fication may be motivated by managerial efforts to
make personal gains. This theory suggests that
diversification may benefit managers because of the
power and prestige associated with managing a
larger firm (Jensen 1986), the relationship between
managerial compensation and firm size (Jensen and
Murphy 1990) and reduction in the unemployment
risks of managers (Amihud and Lev 1981). Agency
theorists also argue that there is a conflict of interest
because of the difference in risk preference between
managers and stockholders. The managerial motive
of diversification is largely to decrease managers’
unemployment risk (Amihud and Lev 1981). In
contrast, as stockholders can diversify their own
© 2011 The Authors
Diversification and Performance
portfolios quickly and at a lower cost/risk than the
firm, so they have little to gain from the risk-
reducing aspects of unrelated diversification (Levy
and Sarnat 1970).
Besides the risk aspect of diversification, excess
cash flow can also lead managers to diversify. Man-
agers would be unwilling to deploy the extra
resources as dividends, as that would decrease the
resources under their control. Moreover, in the event
of resources being required, they have to depend on
the external capital market, resulting in increased
external monitoring of the firm. Managers will thus
use the free (excess) cash flow in value-reducing
activities such as diversification and takeovers
(Jensen 1986).
However logically compelling, the empirical
evidence points to an alternative explanation for
diversification. Evidence suggests that there is a
significant decrease in the number of firms engaged
in diversification activities (i.e. mergers) for
manager-controlled firms compared with owner-
controlled firms (Denis et al. 1997).11 There is evi-
dence of a monotonically increasing relationship
between diversification and the intensity of owner-
ship (Amihud and Lev 1981). This may be due to
the tendency of empire-building by owners. More-
over, concentrated ownership does not result in an
increase in value to the firm, and the refocusing that
had taken place mostly in the 1980s was mainly
because of external market conditions rather than
ownership changes (Denis et al. 1997). Figure 4
provides a summary model of the financial perspec-
tive of diversification.
The finance perspective applied to
emerging economies
When the financial perspective is applied to emer-
ging markets, it includes both transaction cost eco-
nomics and the agency perspective. Transaction cost
economists assert that, when open market costs are
low, firms should use market mechanisms to allocate
resources, but when such costs are relatively high,
firms should internalize the transactions (Choi et al.
1999; Todorova 2007). In an emerging market, there
are a variety of reasons for market failure: opportu-
nistic behaviour of suppliers, inefficient information
11
Manager-controlled firms are firms where no single group
owns more than 10% of the outstanding stock, whereas
owner-controlled firms are those where a single group owns
more than 10% of outstanding stock (Denis et al. 1997).
© 2011 The Authors
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
29
processing, ineffective price mechanisms or poor
contractual obligations (Chang and Hong 2000).
Inefficient external markets make it harder for firms
to conduct day-to-day business. Under these condi-
tions, business groups reduce the transaction costs of
affiliated firms mainly in three ways. First, business
groups are organizational structures for appropriat-
ing quasi-rents which accrue as a result of the low
transaction costs of accessing scarce and imperfectly
marketed inputs such as capital and information
(Chung 2004); second, business groups provide an
alternative to portfolio diversification owing to the
absence of developed capital markets; and third,
business groups engage in vertical integration to
eliminate problems arising from bilateral monopoly
or oligopoly (Chang and Choi 1988). Transaction
cost theory has also been used in conjunction with
social capital theory in emerging economies. As
mentioned earlier, social capital refers to a web of
social, interpersonal and structural relationships
which are built on trust and reciprocity (Adler and
Kwon 2002). The expected benefits of social capital
include high quality information processing among
the participants, mutual influence and power, and
solidarity (Tsai and Ghoshal 1998). Capitalizing
on these benefits, business group companies can
improve their firms’ economic performance by
reducing transaction costs.
Most agency theorists argue that professional
managers with little equity of their own may pursue
value-reducing actions such as diversification at the
expense of shareholders (Fama and Jensen 1983;
Jensen and Meckling 1976). Some further argue that
firms with concentrated ownership outperform those
with dispersed ownership, because they have a strong
incentive to monitor managers and discipline them
(Claessens et al. 1999; Thomsen and Pedersen 2000).
Continuing with this line of argument, Gong and
Kim (1999) argue that the efficiency of business
group managers is superior to that of professional
managers as the former have an ownership incentive.
However, agency problems may still exist in an
emerging economy between owners-cum-managers
(who have corporate control of the business group)
and minority shareholders of the affiliated firms of
that business group. Specifically, business group
managers may intentionally sacrifice or transfer the
resources from one group company to strengthen the
competitive position of another group company
without enhancing the wealth of the former com-
pany’s shareholders (Chung 2004). Moreover, as the
founder families also manage the business groups,
30 S. Purkayastha et al.

Risk Reduction
Negative Unrelated
relationship diversification
between may mitigate
unrelated risk but not
diversification better returns
and risk for investors.

Internal Capital Market

Reduces transaction Inefficient

costs in raising capital cross
Better allocative subsidization Firm
efficiency Reduces Performance
Better control of managerial
divisional managers entrepreneurial
incentives

Agency Theory

More power and No increase in

prestige the value of the
Better compensation firm
Reduce Free cash flow
unemployment risk results in value
Makes the manager reducing
indispensable for the activities like
firm diversification.

Diversification

Figure 4. The finance perspective on diversification

they can easily expropriate minority shareholders by
means of intra-group business transaction and abuse
of insider information (Chang 2003).
While agency problems may also arise in devel-
oped economies, they are constantly checked by more
robust corporate governance systems. The board of
directors, investor activism, and the capital markets
constantly challenge professional managers, and
when these forces are operating efficiently, poorly
performing managers are replaced. Even with such
elaborate corporate governance mechanisms, agency
problems still occur in advanced economies, as illus-
trated by the debacles of Enron and WorldCom and in
the recent financial crisis. In emerging economies,
where the corporate governance mechanisms are
weak, agency problems are acute and can potentially
threaten the survivability of business groups as illus-
trated by the Asian financial crises in the 1990s (Lim
et al. 2009). Although corporate governance mecha-
nisms have begun to be more prominent in emerging
economies, they still have a long way to go (Chung
2004).

© 2011 The Authors

International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
Diversification and Performance
Discussion
Proponents of agency theory within the financial
stream argue that, in developed economies, there is a
conflict of interest between professional managers
and shareholders because of their difference in risk
preference. Diversification, specifically unrelated
diversification, provides incentives for managers by
providing them with greater job security and higher
executive compensation (Amihud and Lev 1981;
Jensen and Murphy 1990). The managerial motive for
diversification is largely to decrease their unemploy-
ment risk (Amihud and Lev 1981). In contrast, share-
holders can diversify their portfolios at a much lower
cost/risk than the firm, so they have little to gain from
the risk-reducing benefit of unrelated diversification.
In emerging economies, agency theorists argue
that, because the business groups are owned and
managed by founder families, agency problems of
the type evidenced in developed economies are
absent (Chung 2004). However, agency problems are
created between the founder families who also
manage the business groups (principal/manager) and
the minority shareholders of the affiliated firms. As
the founder families command the controlling shares
of affiliated firms, they can expropriate minority
shareholders by means of intra-group business trans-
actions and abuse of insider information (Chang
2003). Such problems are further aggravated because
of the lack of efficient corporate governance mecha-
nisms. Hence we conclude that:
(a) in developed economies, agency problems arise
between shareholders and professional manag-
ers, whereas
(b) in emerging economies, agency problems arise
between minority shareholders and business
group managers.
Diversification and the measurement
of firm performance
The relationship between diversification and firm
performance depends to a great extent on the meas-
urement of firm performance. Researchers have used
both accounting measures (Bettis 1981; Hill 1983;
Palepu 1985) and market measures (Dubofsky and
Varadarajan 1987; Michel and Shaked,1984) in
examining this relationship.12 Empirical research, at
12
Detailed tables on the types of performance measures used
along with independent variables for each of the three per-
spectives are available in the online version of the paper.
© 2011 The Authors
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
31
least in developed economies, reveals conflicting
results when firm performance is measured in
accounting terms, such as return on assets (ROA) or
return on sales (ROS), vis-à-vis share price terms,
such as the Sharpe ratio or Treynor ratio. For
example, firms diversifying into related areas have
the highest ROA (Bettis 1981; Hoskisson 1987),
while firms diversifying into unrelated areas have the
highest Sharpe, Jensen and Treynor ratios (Michel
and Shaked 1984; Dubofsky and Varadarajan (1987).
Although firm performance is a multi-dimensional
concept, a review of the literature reveals a growing
consensus that performance is at least a two-
dimensional construct consisting of risk and return
(Bettis and Hall 1982; Lubatkin and Rogers 1989).
Traditionally, performance was measured by returns
only, and it is only recently that attention has been
given to risk measurement, because diversification
which results in improved returns but at the cost of
increased risks does not leave a firm better off than
one which results in lower returns and also lower
risks (Bettis and Mahajan 1985). Further, if risk is
excluded, it is simplistically assumed that managerial
motives of diversification for the purpose of risk
reduction do not exist, which, according to the
agency theory, is not true. Thus, risk and return act in
concert to motivate diversification.
The second critical aspect is that each dimension
of performance can be measured using either
accounting- or market-based data. Accounting-based
measures are oriented towards the past and thus may
be susceptible to accounting manipulation (Chakra-
varthy 1986), so they may not reflect the expected
future cash flow which a firm is likely to generate.
Researchers have found that there is a strong positive
correlation between accounting-based measures and
market-based measures of firm performance (Jacob-
son 1987). However, when these measures are used
to evaluate diversification strategies, they lead to
conflicting findings (Dubofsky and Varadarajan
1987; Hoskisson et al. 1993; Lubatkin et al. 1993).
This may be due to the time lags in reflecting the
impact of a firm’s diversification strategy on
accounting-based measures of performance (Dubof-
sky and Varadarajan 1987) or to the greater role that
environmental instability plays in stock market
returns (Keats and Hitt 1988). Studies have also used
hybrid approaches wherein they have combined
accounting and stock market data (Kakani 2000;
Khanna and Palepu 2000a). These measures indicate
how stockholders value a firm’s assets. Fundamental
to the belief of superiority of market-based measures
32
Table 1. Classification scheme for measuring firm performance
ROA, ROEa, ROS, ROIb,
ROCc, Growth in sales,
Return Risk and return measured
Growth in earnings per
using accounting-based share
data
Variability in ROA, ROC and
Risk
earnings
a
return on equity.
b
return on investment.
c
return on capital.
is the assumption that the market acts efficiently, and
all future benefits of diversification are fully antici-
pated and incorporated into the firm’s stock price
(Lubatkin 1983). Table 1 represents the classification
scheme of the alternative approaches found in diver-
sification literature for measuring firm performance.
Summary
So far, we have discussed three broad perspectives in
the literature on firm diversification – the external
perspective, the internal perspective and the finance
perspective – in two contexts, developed and emer-
ging markets. We enriched the review with a discus-
sion of the measurement issues on firm performance.
The perspectives discussed above postulate different
relationships between diversification and firm per-
formance. Given the objective to present a unified
perspective on the benefits and pitfalls of firm diver-
sification, the lack of convergence in outcomes is
disturbing. Reasons for the divergence of outcomes
in the diversification literature include differences in
the operationalization of variables used to measure
diversification and performance. For example, some
researchers have used continuous variable measures,
while others have used categorical measures. Simi-
larly, firm performance has been measured using
both accounting and/or market-based measures.
Table 2 summarizes the major findings across the
three theoretical perspectives and two contexts, and
the implications for future research in this area.
Implications and conclusions
Based on the extensive review of the diversification–
performance relationship, we can identify several
directions for future research. First, the relationship
between diversification and firm performance has
been examined across all industries in aggregate. In
International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
S. Purkayastha et al.
Abnormal returns, Sharpe
Index, Treynor Index,
Return
Market to book equity, Risk and return measured
Tobin’s Q using market-based data
Total risk, Systematic and
Risk
unsystematic risk
the aggregate analysis, some researchers have not
considered the effect of industry (Amit and Linvat
1988; Bettis 1981; Hill 1983; Palich et al. 2000),
while others have controlled for industry effects
(Hoskisson 1987; Khanna and Palepu 2000a,b;
Montgomery 1985; Villalonga 2004). Yet even when
researchers have controlled for industry effects, we
argue that the functional form of diversification and
firm performance relationship in different industries
may not be identical. Specifically, industry-wise
analysis may capture the intra-industry variation
which gets lost when studies are done at the aggre-
gate level. Future research thus needs to examine the
diversification and firm performance relationship
across each industry separately.
Secondly, future research also needs to include the
role of organizations in examining the relationship
between diversification and firm performance. All
three broad perspectives discussed in the paper agree
that firm performance would be enhanced if there
were transfer of skills and sharing of resources across
different businesses. However, the crucial link that
examines the type of organizational mechanisms
required to promote such transfer or sharing of skills
remains virtually unexplored. Although Hill and
Hoskisson (1987) argue that related diversified firms
need to adopt co-operative organizational structures,
and unrelated diversified firms require competitive
organizational structures, empirical work done in this
area is sparse in the context of developed economies
and almost non-existent in the case of emerging
economies.
Finally, we concluded that unrelated diversifiers in
emerging economies are likely to be more profitable
than related diversifiers and that related diversifiers
are likely to be more profitable than unrelated diver-
sifiers in the context of advanced economies. This
conclusion is based on studies that have been carried
out in relatively stable environments. There have been
relatively fewer studies that compare diversification
© 2011 The Authors
Diversification and Performance 33

Table 2. Summary of the major findings of the three perspectives

The external view The internal view The finance perspective

Major findings in developed
economies
Related diversification is the
best with accounting
measures of performance.
Industry profitability plays a
major role.
Unrelated diversification is
the best with market
measures of performance.
Related firms that can create
a structure by which
strategically important
resources can be
transferred will be
successful.
Systematic risk is not
diversifiable hence
diversification is not
beneficial.
A diversified firm can have
the advantages of internal
capital market.
Diversification may be
motivated by managerial
efforts to make personal
gains.

Some papers Bettis 1981; Hill et al. 1992;
Michel and Shaked 1984;
Palepu 1985; Palich et al.
2000; Rumelt 1974
Collis and Montgomery
1995; Ilinitch and
Zeithmal 1995; Markides
and Williamson 1996;
Robins and Wiersema
1995
Amihud and Lev 1981; Amit
and Linvat 1988; Jensen
1986; Lubatkin and
Chatterjee 1994; Stein
1997

Implications for future
research in developed
economies
The exact relationship
between diversification
and performance.
Which of the effects – that of
diversification strategy or
of industry structure – has
the greatest influence?
Empirical studies are rare
because of the difficulty of
measuring the constructs
of resources and
capabilities.
Debate whether systematic
risk is diversifiable or not.
Empirical evidence of
monotonically increasing
relationship between
diversification and
intensity of ownership in
contrast to agency theory.

Major findings in emerging
economies
Institutions are inefficient so
greater diversification is
not harmful.
As emerging markets mature Undeveloped capital markets
firms must learn not only leads to diversified
to acquire but also to hierarchical firm
share intangible resources development.
and capabilities across
other firms within the
same business group.

Some papers Kakani 2000; Khanna and Chang and Hong 2000; Chang and Choi 1988;
Palepu 1999 2000a,b; Khanna and Rivkin 2001; Chung 2004; Claessens
Peng and Health 1996 Yiu et al. 2005 et al. 1999

Implications for future
research in emerging
economies
Research is limited to China,
Korea and East European
countries, and thus
broadening is required.
Benefits of diversification in
times of major and broad
changes to the economy.
Importance of business
groups is fairly recent and
both theoretical and
empirical work is required.
Inefficiency of capital
markets and how they can
be negated by the
emergence of business
groups.

and firm performance in unstable periods such as an
economy-wide shock (Lim et al. 2009). An economy-
wide shock, such as the Asian financial crisis, reduces
the internal market benefits for diversification and
increases management and organizational costs for
both developed and emerging markets (Chakrabarti
et al. 2007). Moreover, an unstable environment
increases managerial discretion, influence and control
over the organization at the expense of other stake-
holders, as unpredictability clouds the effect of mana-
gerial decision (Haleblian and Finkelstein 1993).
Thus managers can engage in buffering, collusion
without fear of censure from other stakeholders. This
results in an increase in agency problems, and the
mechanisms designed to control agency problems
become less effective in unstable environments.
Future studies can establish the boundaries of our
conclusions from this prior research by comparing

© 2011 The Authors

International Journal of Management Reviews © 2011 British Academy of Management and Blackwell Publishing Ltd.
34
diversification and firm performance relationship
under stable and unstable periods.
To sum up, this paper compares and contrasts the
past cumulative empirical research on the relation-
ship between diversification and firm performance in
the context of developed economies with the more
recent work in emerging economies. The review of
literature points to considerable diversities in find-
ings across studies done in these two contexts, which
can be attributed to theoretical and methodological
reasons. In order to address these issues, we advance
three directions for future research. Given that diver-
sification is likely to remain a popular growth option
in both the developed and the emerging market con-
texts, we suggest that scholars should look at the
implications of industry on diversification decisions
and that managers of diversified firms should
become aware of the implications of their diversifi-
cation decisions as they continue to alter the scope
and scale of their firms.
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Supporting information
Additional supporting information may be found in
the online version of this paper:
Table S1. Summary review of empirical research
papers in the external perspective that examines
the relationship between diversification and firm
performance.
Table S2. Summary review of empirical research
papers in the internal perspective that examines
the relationship between diversification and firm
performance.
Table S3. Summary review of empirical research
papers in the finance perspective that examines
the relationship between diversification and firm
performance.
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