Thursday, June 22, 2006

Corporate diversification may not be such a bad thing afterall

SUPER SHORT VERSION: If facing expropriation, managers may maximize shareholder wealth by diversifying their firm.

Corporate Diversification is bad

The standard line for the past 20 years has been that corporate diversification is bad for shareholders. We have seen this in the diversification discount work of Comment and Jarrell (1995) and many other papers (for instance Megginson, Morgan, and Nail) have shown that diversification lowers firm value.

Corporate Diversification is NOT always bad
More recently however, there has been some questioning of that position. This strand of research has largely been driven by the idea that for some firms diversification is good.

This school of thought won support in the 2005 Journal of Finance article by Rene Stulz where he showed that diversification may lower the risk of expropriation in countries with poor shareholder protections (i.e. where there is a high risk of expropriation).

Now Beneish, Jansen, Lewis, and Stuart show the same thing happened within the US tobacco industry. Namely that the tobacco industry's diversifying deals (for instance when Philip Morris bought Kraft) lowered the probability of (or minimally delayed) government lawsuits and expropriation.

In the authors' words:
"Although prior work has often shown diversification transactions to be negative net present value projects, we propose that diversification created value in the tobacco industry by building "political capital" and making tobacco firms less attractive targets of regulation and litigation by changing the composition of tobacco firms' assets."
The authors then use three methods to back up the theory that diversification in the face of high expropriation risk can be good for shareholders. (the three methods are: the examination of diversification-increasing announcement returns, the positive association of thee returns with proxies for expropriation risk, and the examination of the changed behavior of firms after the 1998 Settlement whereby expropriation became a reality)

The authors then measure how "good" this diversification is for shareholders.

With admittedly noisy models, they conclude that in the case of tobacco firms, diversification "protected from $5.7 to $15.3 billion in shareholder value through delayed or reduced expropriation."

Lesson? Corporate diversification can be good for shareholders facing a high risk of expropriation.

Beneish, Messod Daniel, Jansen, Ivo Ph., Lewis, Melissa Fay and Stuart, Nathan V., "Diversification and Shareholder Payments in the Tobacco Industry: The Expected Expropriation Cost Reduction Hypothesis" (June 8, 2006). Available at SSRN:

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