Summary of the PhD thesis: The impact of diversification on performance and risk of firms

Evaluate the impact of BDIV on the performance and risk of firms; assess the impact of ADIV on the performance and risk of firms through the mediating effect of BDIV; evaluate the impact of the CDIV on the performance and risk of firms through the mediating effect of ADIV.

HO CHI MINH CITY OPEN UNIVERSITY

The thesis is completed at the:

HO CHI MINH CITY OPEN UNIVERSITY

Reviewer:

1:……… Reviewer:

2:………

The thesis will be defended in front of the Thesis Committee at Academy level,

at the Open University of Ho Chi Minh city

At…… date …… month …… year 2018

CHAPTER 1 INTRODUCTION 1.1 Research problem

Diversification is considered as one of the strategic activities of a firm (Ramanujam and Varadarajan, 1989) and it has a profound effect on many aspects of firms; notably, its impact

on performance and risk Following the structure-conduct-performance paradigm (S – C – P paradigm) in theory of industrial organization (IO theory), the output of a firm is linearly related

to the market structure (Weiss, 1979) The S – C – P paradigm describes the structure of the market determines the behaviour of the firms, and then the behaviour of the firms determines their output (McWilliams and Smart, 1993) The S – C – P framework is integrated into the theory of strategic management (Jemison, 1981) to describe the impact of a variety of strategic activities, including diversification, on business performance (McWilliams and Smart, 1993) Thus, derived from industrial organization theory, diversification is regarded as a component of strategic management and this component has significant implications for firms’ output

Besides performance, risk also receives particular attention in strategic management The link between diversification and risk was soon considered by Bettis and Hall (1982) and has since formed a direction to this day The impact of diversification on risk is quite complicated This complexity is due to the diversity of the type of firm diversification, each of which diversifies into lower-level diversification based on different classification Different types of diversification at the lower level tended to have different impacts on risk, and each type

of diversification itself may have certain relationships For example, business diversification in

a firm is divided into two broad categories which are related and unrelated diversification Diversification of related business can increase performance (Palich et al., 2000) but also increase specific risk (Bettis and Hall, 1982) Meanwhile, unrelated diversification has the opposite effect

Based on the theoretical and empirical studies on the effects of diversification on the performance and risk, the thesis found some following issues:

Firstly, the study of the impact of business diversification (BDIV) is prevalent in the world However, the dissertation has not found any similar study up to 2015 By 2016, the research by Santarelli and Tran (2016) on the effect of diversification on the performance of Vietnamese enterprises appears The study used GSO data to measure overall BDIV and to estimate the impact of this variable on business performance The study has not conducted an estimation of the impact of various types of diversification on performance; in particular, the effect of related and unrelated business on performance According to Palich et al (2000) and Benito-Osorio et al (2012), the related and unrelated BDIV tended to have different effects on the performance due to the distinctive characteristics of the two types of diversification Thus,

by combining these two types of diversification into overall business diversification, it is difficult for firms to choose which type of diversification is appropriate for their business In practice, firms need to decide what type of diversification to pursue (diversification of the related business, diversification of the unrelated business, geographic diversification, international diversification, ) rather than pursue diversification in general

Secondly, the impact of BDIV on risks, especially bankruptcy risk, which has rarely been studied in the empirical literature, has been reported in about 17 studies up to 2016 Bankruptcy risk variables are primarily measured by the Atman Z - Score, a measure that is only suitable for the US market that may not be suitable for an emerging market like Vietnam

Thirdly, the study of the effects of BDIV on the performance and bankruptcy risk is often conducted separately in individual research models without being simultaneously performed in an empirical model

In addressing the three issues mentioned above, the thesis deals with the first topic titled "The impact of business diversification on performance and risk." This topic will explore the impact of related and unrelated business diversification on performance, and this research employs the Linear Structural Model (SEM) to estimate these relationships Also, firm performance variables will be viewed from a shareholder's perspective and measured by ROE (return on equity), the bankruptcy risk variable is measured MKV model (probability of default) Using SEM model and MKV bankruptcy risk measurement can be considered as the new point

of the research

Fourth, diversification can be seen in various angles when placed in relation to the performance and risk of a firm Diversification can be seen in terms of business diversification (Asoft, 1957), product diversification (Rumelt, 1974), geographic diversification (Stopford and Wells, 1972; Daniels and Bracker, 1989; and Sullivan, 1994), merger diversification (Morck et al., 1990), and customer diversification (Hsu and Liu, 2008) These types of diversification are commonly referred to as business diversification because they are all oriented towards the business of firms However, there are other forms of diversification taking place in the internal environment of a firm such as capital diversification or asset investment diversification have been not be explored The three types of diversification are capital diversification (CDIV), asset investment diversification (ADIV), and BDIV that may have a specific relationship with each other in the context of corporate financial decision-making In particular, CDIV may impact on ADIV and then ADIV may impact on BDIV In addition, ADIV and CDIV may also affect performance and risk if based on such theories as Rumelt's "escape hypothesis" (Rumelt, 1974), theory of resource-based view” (Wernerfeld, 1984 and Barney,1991), the capital structure theory (Modilligani and Miler, 1958 and Myers, 1977), and theory of free cash flow of Jensen (1986) Given the above, two questions are posed: first, is there a practical effect of ADIV on performance and the risk of bankruptcy through the mediating effect of BDIV? Moreover, secondly, is there a practical effect of the CDIV on performance and risk through mediating effect of ADIV?

In response to these two questions, the thesis continues to carry out two further research topics The second research topic titled "The impact of asset investment diversification

on business diversification, performance and risk," and the third research topic titled "The impact of capital diversification on asset investment diversification, performance and risk "

On the second research topic, the dissertation will classify the ADIV into two components, namely, related assets and unrelated assets to the core business of a firm Then the dissertation builds the theoretical relationship among ADIV, BIDV, performance, and risk Then, the thesis builds the SEM model to estimate these relationships empirically Building the

links among ADIV, BDIV, performance, and risk and employing SEM model to estimate these links can be considered as a new point in the thesis

Similarly, in the third research topic, the thesis will classify CDIV into equity diversification and debt diversification The thesis then builds the theoretical relationship among CDIV, ADIV, performance and risk Next, the thesis employs the SEM model for empirical estimation Establishing the links among CDIV, ADIV, performance, and risk, as well as estimating with the SEM model, may be considered as a new point in the thesis

1.2 Research questions

The thesis should answer three research questions as follows:

Question 1: How does the BDIV affect performance and risk?

Question 2: How does ADIV affect performance and risk through the mediating effect

of BDIV?

Question 3: How does the CDIV affect performance and risk through the mediating effect of ADIV?

1.3 Research objectives

The dissertation should address three research objectives as follows:

Objective 1: Evaluate the impact of BDIV on the performance and risk of firms

Objective 2: Assess the impact of ADIV on the performance and risk of firms through the mediating effect of BDIV

Objective 3: Evaluate the impact of the CDIV on the performance and risk of firms through the mediating effect of ADIV

1.4 Object and scope of the study

The object of the study is the impact of the diversification on the performance and risk of a firm More specifically, the impact of BDIV on the performance and risk of firms; the impact of ADIV on the performance and risk of firms through mediating effect of BDIV; and impact of the CDIV on the performance and risk of firms through the mediating effect of ADIV

The research scope is non-financial businesses listed on the Ho Chi Minh City Stock Exchange and the Hanoi Stock Exchange between 2008 and 2015

1.5 Research contents

Based on research, the research questions and objectives, the dissertation has four main research contents as follows:

Firstly, a theoretical study on the linkages between the three types of diversification, including the BDIV, ADIV, and CDIV

Second, a theoretical study on the linkage among the three types of diversification, performance, and risk

Third, develop a research method to empirically estimate relationships mentioned above, including (i) BDIV, performance, and risk; (ii) ADIV, BDIV, performance, and risk; (iii) CDIV, ADIV, performance, and risk

Fourth, empirically estimate these relationships and discuss results

1.6 New research contributions

The thesis has three research topics to address three research objectives and has new contributions described as followings:

Topic one: The impact of business diversification on performance and risk This topic

is performed in chapter two The research in topic one is still a repetitive study of the impact of BDIV on performance and risk However, by measuring the risk of bankruptcy using the Merton-KMV model (probability of default model), and estimated these relationships using the SEM model, the research in the topic has contributed in terms of: (i) measuring the risk of bankruptcy by Merton-KMV model and (ii) employing SEM model to estimate empirically

Topic two: The impact of ADIV on BDIV, performance and risk The research is addressed in chapter three The second topic considered ADIV as related and unrelated assets diversification and built the relationship between these two variables with BDIV, performance, and risk Thus, the second research topic has contributed regarding: (i) create new concepts (related and unrelated asset investment diversification) and (ii) build new link among concepts (ADIV, BDIV, performance, and risk)

Topic three: The impact of CDIV on ADIV, performance, and risk The topic is organized in chapter four The research on the topic focused on understanding the CDIV The study analyzes CDIV as two components: equity diversification and debt diversification Then the thesis establishes the linkage of these two variables to the ADIV, performance, and risk Thus, similar to topic two, topic three has contributed to the following new points: (i) build new concepts (equity diversification and debt diversification) and (ii) establish new relationships among concepts (CDIV, ADIV, performance, and risk)

1.7 Thesis structure

The thesis is organized into five chapters with the following title:

Chapter 1 Introduction

Chapter 2 Impact of business diversification on performance and risk

Chapter 3 Impact of Asset investment diversification on business diversification, performance, and risk

Chapter 4 The Impact of capital diversification on asset investment diversification,

performance, and risk

CHAPTER 2 THE IMPACT OF BUSINESS DIVERSIFICATION ON

PERFORMANCE AND RISK 2.1 Literature review

2.1.1 ĐDH

This section explores four issues: (i) concept of diversification, (ii) classification of diversification, (iii) identification of diversification content used in the thesis, and (iv) measure diversification

The favourite way to measure diversification in studies is to combine the classification

of Rumelt (1974) and the entropy method The first author proposed using entropy to calculate the degree of diversification was Jacquemin and Berry (1979) Then Palepu (1985) based on Rumelt's classification and associated with the theory of entropy calculated a firm diversification, including total diversification, related diversification, and unrelated diversification Whereby:

Of which: r is the rth segment related to the primary business, “pr” is the sales of the

rth segment to total sales

Of which: “u” is is the uth segment unrelated to the primary business, “pu” is the sales

of the rth segment to total sales.

2.1.2 Performance of Firms

2.1.2.1 Definition

This study approaches the concept of "business performance " from a shareholder's point of view, so corresponding to this angle is the profit aspect of firms Profit is considered the common factor used in most studies on the effects of diversification on performance

2.1.2.2 Performance measurement

This research measures performance in a shareholder's perspective because shareholders will be interested in the company's strategic activities, including diversification Also, this is also a measure of the accounting performance of firms and is widely used by many studies (Lee and Li, 2012) The variable employed to measure performance under shareholder’s perspective is "return on equity" (ROE)

of bankruptcy of a firm

2.1.4 The relationship between BDIV and performance

2.1.4.1 Theories on the effect of BDIV on performance

Theory of firm growth

According to Penrose (1959), the goal of business owners is to increase long-term profitability and to achieve this goal the firm must achieve growth through expansion including diversification This theory indirectly explains the relationship between BDIV and performance firm growth

Economies of scope

The theory of economies of scope was developed by Panzar and Willig (1977) This theory states that the average cost of production falls when firms expand on the type of goods and services it produces Firms get a cost advantage when they produce complementary products while they still concentrate on their core competencies As firms diversify their products, especially the diversification of related products, they will have the opportunity to convert resources and share resources, such as skills and technology… (Rumelt, 1982; Teece, 1982; Markides and Williamson, 1994; and Barney, 1997) If two or more businesses of firms share some common resources with each other, the total cost of production will decrease; hence, the efficiency will increase This theory is used to explain the positive relationship between RBID and performance

Theory of resource-based view – RBV

Wernerfelt (1984) and Barney (1991) then developed Penrose's perspective on RBV theory According to Barney (1991), firms’ resources including all kinds of assets, capabilities, processes, knowledge, are controlled by firms and can help firms perform effective strategies Resources will provide a sustainable competitive advantage if they have characteristics that are: valuable, rare, imperfectly imitable, strategically nonsubstitutable This theory is used to explain the negative impact of UBIDV on performance

2.1.4.2 Empirical evidence on the impact of BDIV on performance

The thesis explored 71 articles and 51 articles on the impact of the RDIV and UDIV

on performance alternately The study found that for the RDIV variable, the positive impact dimension was dominant (45.6%); In contrast, negative influences account for a majority (39.2%) in the studies the effect of UDIV on performance

Based on the theory, empirical studies and meta-analyses, the thesis hypothesizes the relationship between BDIV and performance as follows:

Hypothesis H1.1: RBDIV tends to have a positive impact on the performance of a firm

Hypothesis H1.2: UBDIV tends to affect the performance of a firm negatively

2.1.5 BDIV and risk

2.1.5.1 Theories on the effect of BDIV on performance

Lubatkin và Chatterjee (1994a)

Lubatkin and Chatterjee (1994) research the impact of business diversification on the specific and systematic risk of a firm They argue that portfolio theory may not be applied to all cases of the impact of business diversification on risk; notably, the impact of business diversification on the specific risk (unsystematic risk) They conclude that related diversification reduces unsystematic risk; conversely, unrelated diversification has a positive effect on this risk Their conclusion is contrary to the theory of portfolio They explain that firms diversifying into related industries own some synergistic interrelationship (tangible and intangible interrelationship), so that specific risk is reduced On the contrary, when firms expand their

business into unrelated industries, they will lack internal relationships, and it will lead to the increase in unsystematic risk

Bettis và Hall (1982)

Bettis and Hall (1982) study on the relationship between business diversification and accounting risk They state that related diversification has a lower effect on accounting risk than unrelated diversification They explain as follows:

Assuming that a firm operates only in one industry and it gains profit R1 Based on the theory of tradeoffs between profit and risk, the variation of R1 (Var (R1)) is the accounting risk of the firm The meaning of the Var (R1) is that if the profit of firm increases or decreases considerably in successive periods of time, the risk rises rapidly

Next, the firm expands from the existing industry to other R1 and R2 alternatively represent the profit of the first and the second industry, the combined risk of both industries gets measured by the sum of the variances of both R1 and R2:

Var(R1 + R2) = Var(R1) + 2Cov(R1,R2) + Var(R2)

If Cov(R1, R2) is positive or the correlation between returns is positive, the combined risk is higher Conversely, if the correlation is negative, the firm gets the smaller sum of risk Bettis and Hall (1982) suggest that when a firm operates in two related industry, Cov(R1, R2)

is positive On the contrary, if a firm operates in two unrelated industry, Cov(R1, R2) is negative These imply that the firm copes with the problem of the business cycle when they enter more than an industry Unrelated diversification can eliminate the cycle and lower the risk while related diversification can exacerbate firm business cycle downturn and raise the combined risk

From here, the thesis presents the relationship between business and bankruptcy risk

2.1.5.2 Empirical evidence on the impact of BDIV on risk

The following table summarizes the impact of BDIV on specific risks

Table 2.12 Summarize the impact of business diversification to specific risks

Frequency Percent Frequency Percent Possitive effect 5 29.4% 10 58.8% Negative effect 9 52.9% 5 29.4%

No effect 3 17.7% 2 11.8%

2.2 Methods

2.2.1 Empirical model

The thesis proposes an empirical SEM model, consisting of a two-equation system for research topic one as follows:

{P = f(RB_DIV, UB_DIV, Control variables) (1.1)

R = f(RB_DIV, UB_DIV, Control variables) (1.2)

In which: P is the performance, R is the risk, RB_DIV represents the related business diversification, UB_DIV represents the unrelated business diversification

2.2.2 Variable measurement

2.2.2.1 Dependent variable

(i) Performance variable

𝑅𝑂𝐸 = 𝐸𝐴𝑇𝐸𝑞𝑢𝑖𝑡𝑦

(ii) Risk variable

In Chapter 2, the study specified Merton-KMV model to estimate bankruptcy probability Based on the study by Kealhofer and Bohn (1998), McQuown (1997) and Vasicek (1984), the thesis will calculate the bankruptcy probability of the firm over a nine year period (Measurement of risk variables is described in detail in Appendix 2)

2.2.2.2 BDIV measurement

The BDIV consists of two variables: RB_DIV and UB_DIV This study will incorporate Rumelt's (1974) calculation and entropy density Details of the measurement of business metrics are described in Appendix 1:

Control variables affect risk: Firm size, the ratio of operating costs to revenue, current payment ratio, cash conversion cycle, assets turnover, price to book ratio, operating cash flow ratio, and Interest Coverage Ratio

2.2.3 Estimation

The study will use the method of "maximum likelihood estimation" to estimate the SEM model and perform necessary model tests such as (i) Good-of- Fitness test), (ii) homoscedasticity test, and (iii) normal distribution of residuals If the model encounters heteroscedasticity or residuals have not a normal distribution, the GSEM (Generalized structural equation model) can be employed to replace SEM.2.2.4 Dữ liệu nghiên cứu

2.2.4 Data

This study is conducted within the scope of non-financial firms listed on Vietnam's stock market from 2008 to 2015 470 firms are selected (over about 700 listed firms), with a total of 3760 observations (= 470 x 8)

2.3 Analysis and result discussion

2.3.1 Data description

2.3.1.1 Number of firms divided in each stock exchange

Table 2.16 Number of firms divided in each stock exchange

(i) Dependent variable

Table 2.22 Dependent variable

ROE 0.0016 20.18 0.147 0.34 Risk 0.002 0.72 0.186 0.26

(ii) Business diversification

Table 2.23 Business diversification

RB_DIV Bit 0.00 1.15 0.79 0.42

UB_DIV Bit 0.00 1.01 0.45 0.33

2.3.3 Correlation matrix analysis

2.3.4 Regression results

2.3.4.1 Regression results and SEM model tests

It can be concluded that the model is overall consistent with market data Also, the study conducts a homoscedasticity test and a normal distribution test to analyze the consistency

of the model The test results (item vi and vii) give the P-value of the two tests less than 0.05,

so these imply that the structural model encounters both problems: heteroscedasticity and normal distributions of residuals

non-2.3.4.2 GSEM estimation results

As mentioned above, SEM model regression has encountered two problems; then the regression results are not biased but inconsistent We propose GSEM model combined with robust estimation techniques to replace the original model The regression coefficients of the GSEM model are not different from the ones of SEM model but more robust than SEM model The results of GSEM model described below:

Figure 2.28 Summary of GSEM estimation

Notation Name of variables Expectation Coef Robust

AS Assets structure - -0.16050(***) 0.0260 0.00

AT Assets turnover + 0.04156(***) 0.0076 0.00 RB_DIV Related business + 0.09568(***) 0.0027 0.00 UB_DIV Unrelated business - -0.12297(***) 0.0012 0.00 _cons 0.07000(**) 0.0313 0.03

Affecting RISK

CR Current payment ratio - -0.00100 0.0013 0.45 SGA_S The ratio of operating costs to

revenue + 0.02755(***) 0.0084 0.00 EBIT_I Interest Coverage Ratio - 0.00000(**) 0.0000 0.23 P_B Price to book ratio - 0.01049(**) 0.0051 0.04 LNA Natural log of total assets - 0.00014 0.0005 0.78 CCC Cash conversion cycle + 0.00000 0.0000 0.72 OCF_S Operating cash flow ratio - -0.00976(**) 0.0049 0.04

AT Assets turnover - -0.00395 0.0053 0.45 RB_DIV Related business + 0.00678(***) 0.0019 0.00 UB_DIV Unrelated business - -0.00376(***) 0.0009 0.00 _cons 0.54440(***) 0.0169 0.00

Secondly, the impact of RB_DIV and UB_DIV on ROE and RISK is a trade-off However, the trade-offs may not be commensurate

Thirdly, regarding the impact on ROE, the marginal impact of UB_DIV is higher than that of RB_DIV and vice versa This is also consistent with about 78.5% of the previous research

Finally, regarding factors affecting RISK, the marginal impact level of RB_DIV is higher than that of UB_DIV and vice versa

2.4 Conclusion and recommendation

2.4.1 Conclusion

Firstly, the SEM estimation model in the thesis satisfies most of the required tests except for two tests that are heteroskedasticity and normal distribution of residuals From here, the study recommends employing GSEM model for estimation

Secondly, from the GSEM model, RB_DIV has a positive impact on ROE and RISK Conversely, UB_DIV has a negative impact on both ROE and RISK

Thirdly, RB_DIV affects ROE positively

Finally, considering the impact of the variable UB_DIV on ROE, the regression coefficient of the variable UB_DIV is negative

2.4.2 Recommendation

Based on the results of the analysis, the thesis gives some recommendations related

to the business activities of firms as follows:

Firstly, if firms expand their business to related business, the ROE will be improved but RISK will increase Conversely, expanding the business to unrelated busines will reduce RISK but also reduce ROE If the core business of the business is high risk, the business can consider the business diversification in the unrelated sectors to minimize RISK and accept the return as ROE will reduce If the business sector tends to go down or have a low level of risk, then the business should expand the business to related industries

Secondly, on the whole, the impact of the two types of diversification to ROE and RISK is significant, but the tradeoff is not symmetrical Thus, firms in the normal business condition should be expanded to related business

2.4.3 Limitations and further research

CHAPTER 3 THE IMPACT OF ASSET INVESTMENT DIVERSIFICATION ON

PERFORMANCE AND RISK 3.1 Literature review

3.1.1 Asset investment diversification definition and measurement

3.1.1.1 Asset investment diversification definition

(i) Related asset investment diversification (RADIV): Investments in assets that generate revenue classified as the same 2-digit SIC level but not classified as the same 3-digit SIC level with the primary business

(ii) Unrelated asset investment diversification (UADIV): Investments in assets that generate revenue not classified as the same 2-digit SIC level as the primary business

3.1.1.2 Asset investment diversification measurement

(i) Related assets:

Of which: r is the rth business industry is invested and this is related to the main

business, “pr” is the ratio of a related asset to total assets

(i) Unrelated assets:

Of which: u is is the uth business industry is invested, and this is unrelated to the

primary business, “pu” is the ratio of an unrelated asset to total assets

3.1.2 The link between ADIV and BDIV

In the area of financial management, there are four main types of decisions: (i) financing decision, (ii) asset investment decision, (iii) asset management decision, and (iv) profit distribution decision Financing decisions relate to how to find the source of funds, the amount

of capital, the cost of capital, the maturity of the capital, and the structure of the capital used to invest in assets Decisions on asset investment involve using of financial capital to invest in assets that generate revenue Asset management decisions concern about how to use asset structure effectively, which related to short-term assets and long-term assets management The decision to divide the profit is whether the business decides to distribute the profit such as cash dividend for shareholders or retained earnings for future investment Firm diversification does not fall outside this decision flow On the financing side, a firm can make decisions regarding

the diversification of capital supply In terms of asset investment, a firm can diversify different types of assets to generate revenue Alternatively, in the business aspect, business diversification involves expanding business activities

It is possible to model this relationship as follows:

Figure 3.1 The relationship between management decisions and diversifications

The three aspects of diversification place a firm in different decision-making choices and these decisions can have a specific impact on the performance and risk of the firm

From here, two hypotheses are proposed as follows:

Hypothesis H2.1: Diversification of related assets will increase the diversification of related business

Hypothesis H2.2: Diversification of unrelated assets impacts positively to the diversification of the unrelated business, but this effect is weaker than the effect of related asset diversification on related business diversification

3.1.3 The relationship among ADIV, performance and risk

3.1.3.1 ADIV and performance

Based on the theory of investment behaviour of firm, Rumelt (1974) build the "escape hypothesis" to explain the phenomenon of firm diversification and the relationship of diversification to performance Accordingly, when the current business industry is not attractive enough or the competition is fierce, firms will find ways to "escape" from the current industry

by investing in other types of assets to have the opportunity to receive higher profit Some recent studies, such as Hutzschenreuter and Gröne (2009), also agree with Rumelt (1974), they demonstrate that firms tend to invest assets abroad when domestic competition becomes fiercer

Also, following theory of resource-based view (Wernerfelt's, 1984 and Barney, 1991),

we realize that if a firm converts available resources into assets related to the existing business, the conversion will become easier It is due to certain similarities in the characteristics of new