Why Firms Diversify: An Empirical Examination

Abstract

There is substantial evidence that the market placed a lower value on diversified than specialized firms during the 1980's (Lang and Stulz (1994) and Berger and Ofek (1995)). However, many firms diversified anyway. This paper addresses the question, "Why do firms diversify in the first place?" I use the Compustat segment tapes to investigate firms which are specialized and then become diversified. I find that not all segment changes represent economic events. I test the hypothesis that firms diversify due to agency costs between managers and shareholders. Looking at managerial ownership I do not find evidence of agency costs but it is possible that managerial ownership is not a good indicator of agency costs. I test the hypothesis that diversifying firms may be primarily in low growth industries and reject this hypothesis. I find evidence that diversifying firms have slightly worse financial performance than their specialized counterparts. They have free cash available to diversify or more likely have built up their cash balance to make an acquisition. The most significant explanation I find for firm diversification is that diversifying firms have not engaged in as much research and development as their non-diversifying counterparts. In order to grow or perhaps even maintain their current status, they must buy growth in areas outside of their current operations.