Study of relationship between product diversification and corporate performance in Indian perspective

BACKGROUND OF STUDY Diversification is a corporate strategy which is characterized by business interest in different industries and multi-unit organizational structure controlled by single firm. A firm can be called diversified if it reports sales in two or more industry segments. The industry segments are defined at the two digit SIC code level. The vertically integrated firms who are integrated between manufacturing and distribution, are classified as single segment firms. Diversification can be expanded into a new segment of same industry that the firm is operating in, or in a new industry outside the scope of existing business. Measurement of Degree of Diversification Measurement of diversification has always been a challenge. The Standard Industrial Classification (SIC) distinguishes between related and unrelated diversification. The SIC based indices of diversification relies on level of aggregation of industrial classification. However, there are some drawbacks of SIC based measure of diversification. The SIC based measure ignores differences in marketing and distribution channels between two industries. Another drawback of this approach is, SIC based measure of diversification considers only the potential relatedness based on industries. The actual relatedness requires additional information beyond SIC code. (Cantwell, Gambardell, & Granstrand, 2004) The SIC based measure of diversification has found wide acceptance. The advantage of SIC based measure of diversification is, availability of national industry classification data published by the government. The 2 digit (Division), 3 digit (Group), 4 digit (Class), and 5 digit (Subclass) SIC can be used to measure the degree of diversification. (CSO, 2008). 2. REVIEW OF LITERATURE Much effort has been made to understand the impact of diversification on corporate performance. There are numerous examples where diversification in new business had negative impact on the performance of a company. At the same time, there are numerous examples where a business successfully diversified in new industry and achieved high growth. Christensen and Montgomery (1981) investigated the relationship between degree of diversification and financial performance of the firm. Chatterjee and Wernerfelt (1991) studied the impact of resource profile on type of diversification a firm engages in. Rumelt (1974) established that related diversified firms perform better than those who engage in unrelated diversification. Post Rumelt, many researchers conducted research in this area. Lang and Stulz (1994) investigated the correlation between degree of diversification and market's valuation. Diversification did not provide the firms valuable intangible assets that could improve their performance. But, there is not enough evidence to determine which diversification hurts performance. The firms who diversified were already performing poorly before diversification. It indicates that poor performance of diversified firms cannot be mainly because they diversify. Khanna and Palepu (1997) argue that institutional context drives strategy. The institutional dimensions are: capital market, labor market, product market, government regulation, and contract enforcement. The institutional contexts of developed countries and emerging market are quite different. Method of financing also influences diversification strategy of a firm. Kochhar and Hitt (1998) examined the relationship between diversification strategy and method of financing of diversification. This study argues that related diversification adds more specific assets as compared to unrelated diversification. 3. RELEVANCE OF THE STUDY Though most of the studies have established negative relationship between diversification and corporate performance, most of the successful companies around world have diversified product portfolio. Specially in developing countries like India, most of the successfully companies have business interest in multiple industries. Most of the studies are conducted in developed countries. The developing countries like BRICS countries (Brazil, Russia, India, China, and South Africa) are growing at very fast rate and they are poised to become economic super power. China has already surpassed Japan to become second largest economy in world. The business, political, and social environment in a developing country is quite different from the business, political, and social environment in developed countries. So, impact of diversification on corporate performance in developing countries may not be in line with the impact observed in developed countries. Before 1991, there were licenses and quota imposed on businesses. A firm could not exceed the quota of production even though there were demand. A company needed to get license to operate a business. This forced businesses to diversify in new businesses to achieve growth and earn higher profit. So, diversification became a popular practice for firms, specially conglomerates. But after liberalization in 1991, a firm could focus on its core business and achieve growth. This shifted focus from diversification to building competitive advantage in core businesses. There is no denying that diversification mitigates unsystematic risk. Shareholders can diversify their investment portfolio to mitigate unsystematic risk, but diversification of business further contributes to their risk mitigation strategy. However, more often than not the agency cost outweighs the benefits from diversification. Majority of researches find negative relationship between diversification and corporate performance. The related diversification may generate synergy and improve effectiveness of firm. But, there is no concrete theoretical argument in favor of unrelated diversification. Still, firms diversify their business in unrelated businesses. The business environment in an emerging market is different from the business environment in developed markets. There is need to study the impact of unrelated diversification on corporate performance in emerging markets. The study of impact of unrelated diversification on corporate performance will be useful in strategy development. A firm can assess the pros and cons of diversification and what a firm needs to do to improve corporate performance through diversification. 4. RESEARCH OBJECTIVES Objectives of the research are as follows: 1. To explore theoretical relationship between diversification and corporate performance. 2. To examine impact of diversification on corporate financial performance. 3. To identify industry-wise and size-wise variation in financial performance. 4. To study funding pattern of diversification and the impact of funding option on risk and corporate performance. 55. HYPOTHESES In this study, following hypothesis will be tested: Most of the studies established a negative relationship between diversification and corporate performance. . (Agrawal et al., 1992; Lang & Stulz, 1994; Berger et. al. 1999; Hyland & Diltz, 2002; Lins & Servaes, 1999) But these studies were conducted in developed countries. For this study, first hypothesis will be: Hypothesis-1 H0: There is no impact of unrelated diversification on corporate financial performance. H1: There is significant impact of unrelated diversification on corporate financial performance. The impact of diversification on corporate performance may not be uniform across industries. An industry having high concentration ratio is likely to exhibit better economic performance. However, a firm diversifying into an industry having high concentration ratio does not guarantee that new entrant firm will also achieve dominant position and market power. (Montgomery, 1985) Hypothesis-2 H0: There is no industry wise variation in impact of unrelated diversification on corporate performance. H1: There is industry wise variation in impact of unrelated diversification on corporate performance. The short term and long term solvency position of a firm influences its financial performance. (Rees, 1990; Varazdin, 1999) So, how diversification is funded may have influence on performance of the firm. This study will examine the effect of funding option on impact of unrelated diversification on corporate performance. Hypothesis-3 H0: There is no effect of funding option on impact of unrelated diversification on corporate performance. H1: There is significant effect of funding option on impact of unrelated diversification on corporate performance. Hypothesis-4 H0: There is no effect of size of corporation on impact of unrelated diversification on corporate performance. H1: There is significant effect of size of corporation on impact of unrelated diversification on corporate performance. 6. RESEARCH METHODOLOGY Type of Data and Data Sources For this study following data will be collected for each company selected in sample: Turnover, net profit, operating income, current asset, long term asset, total asset, current liabilities, long term liabilities, total liabilities, stock holder’s equity, inventory, stock price, EPS, dividend. For the purpose of study, secondary source of data will be used. Annual report of the companies will act as major source of data. The financial data and annual report will be obtained from public domain. The financial data will also be obtained from database maintained by Center for Monitoring the Indian Economy (CMIE). Other important sources of information are: SEBI website, Exchange (NSE/BSE) website, moneycontrol.com, Press releases issued by company, and exchange information published in leading financial newspapers. Criteria for Selection of a Company for Study The companies chosen for study must satisfy all of the following criteria: 1. Turnover of company should be at least 500 Crores in the reporting year company is diversifying. 2.