1. Introduction
Market efficiency hypothesis argues that markets are rational and the prices fully reflect all available information. Due to the timely actions of investors prices of stocks quickly adjust to the new information, and reflect all the available information;
therefore, no investor can beat the market by generating abnormal returns. However, it is found in many stock exchanges of the world that these markets are not following the rules of EMH. The functioning of these stock markets deviate from the rules of EMH, and thus deviations are called anomalies. According to George & Elton (2001), anomalies are defined as irregularity or a deviation from common or natural order or an exceptional condition. While in standard finance theory, financial market anomaly means a situation in which a performance of stock or a group of stocks deviate from the assumptions of efficient market hypotheses. Such movements or events which cannot be explained by using efficient market hypothesis are called financial market anomalies.
There are a lot of researches done on the existence of various types of anomalies.
From the perspective of the market environment, we can find that some investors can beat the market and generate abnormal returns. Different authors segregated anomalies into three main types: calendar anomalies, fundamental anomalies and technical anomalies. Calendar anomalies exist due to deviation in normal behaviors of stocks with respect to time periods, including weekly effect, January effect, and Turn-of-the-Month Effect. Another type is fundamental anomalies that prices of stocks are not fully reflecting their intrinsic values, including dividend yield anomaly, price to earnings ratio anomaly and low price to book anomaly. Technical anomalies are based upon the past prices and trends of stocks; for example, momentum effect.
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Technical anomalies also include trading strategies like moving averages and trading breaks which includes resistance and support level ( Madiha Latif, Shanza Arshad, Mariam Fatima, and Samia Farooq, 2011 ).
Form the prospect of business operations, there are also many studies done on anomalies; for instance, size effect and corporate governance. In terms of size and market valuation, size effect, which is the most prevalent theory proposed by Fama and French (1992), argues that investors demand higher return due to the higher risks of smaller firms. However, the theory is still subject to counter arguments and debates.
Fernandes and Ferreira (2007) find a significantly negative relation between size and Tobin’s Q (hereafter, Q), whereas Moses (1987) proves that size and Q are positively correlated. Thus, both directions between size and market valuation are possible. As for corporate governance, Sanjai Bhagat and Brian Bolton (2008) found that better governance is significantly positively correlated with better contemporaneous and subsequent operating performance.
Ansoff (1957) first used the term “diversification” to illustrate corporate growth strategies. And the most researched linkage in the strategic management literature is that involving diversification and performance ( Leslie E. Palich, Laura B. Cardinal, and C. Chet Miller, 2000; Sheng-Syan Chen, 2006). Growth strategies (i.e., organizational form), focus versus diversification, become more and more important since these growth strategies play a vital role in explaining the valuation effects on firms. A number of studies have carefully investigated how growth strategy exerts an effect on Q (e.g., Bhagat, Shleifer, and Vishny, 1990; Berger and Ofek, 1996; Servaes, 1996; and Heron and Lie, 2002).
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Diversification is defined both narrowly and broadly. As Villalonga (2004) points out, SFAS 141 defines a segment as “a component of an enterprise engaged in providing a product or service or a group of related product and services primarily to unaffiliated customers for a profit.” Furthermore, Ramanujam and Varadarajan (1989) define diversification as “the entry of a firm or business unit into new lines of activity, either by process of internal business development or acquisition, which entails changes in its administrative structure, system, and other management processes.”
Lim, Thong, and Ding (2008) use three methods to measure the degree of diversification, namely, the number of segments in a corporation, Herfindahl index (HI) from sales, and diversification dummy. All these measurements are narrow definitions of diversification. In the current study, we selected all of the three narrow definitions to analyze the diversification of a company. Thus, we would like to clarify that in this work, “segment” is used instead of “subsidiary” for diversification.
Lang & Stulz (1994)；Berger & Ofek (1995) explain the corporate diversification discount; they found that diversified firms trade at a discount relative to focused firms in the same industries. As mentioned by Wernerfelt and Montgomery (1998), Lang and Stulz (1994), Servaes (1996), Chen (2006), Chen (2008), and others, focused firms tend to exhibit better investment opportunities than diversified firms. The fundamental argument made against corporate diversification is that it somehow exacerbates managerial agency problems. Inefficient investments due to cross-subsidization between divisions can exist in diversified firms. Shin and Stulz (1998) and Rajan et al. (2000) find evidence of inefficient diversion of corporate resources from divisions with good investment opportunities to failing divisions.
Therefore, agency problems have been proposed as an explanation for the
1 A formal document issued by the Financial Accounting Standards Board (FASB), which details accounting standards and guidance on selected accounting policies set out by the FASB. The standards are created to ensure a higher level of corporate transparency.
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diversification discount effect, and the negative impacts of corporate diversification can be referred to the agency cost hypothesis. Also, managers frequently cite the desire to mitigate asymmetric information as a motivation for increasing firm focus (Jonathan E. Clarke, C. Edward Fee, and Shawn Thomas, 2004). Diversified firms are subject to larger asymmetric information problems than are focused firms, and diversified firms operate with less efficiency.
On the other hand, Villalonga (2004) uses new database (Business Information Tracking Series) and finds the diversification premium. Besides, the premium is robust to variation in the sample, business unit definition and measures of excess value and diversification. Indeed, the management in diversified firms can broaden their internal capital market and acquire these economies by diversifying. For instance, a diversified firm can bypass the external capital market by shifting funds from business segments with poorer investment opportunities to business segment with better investment opportunities. This suggests that diversified firms allocate resources more efficiently. Morck and Yeung (1998) propose the theory of synergy, indicating that the benefits of synergy come from the existence of valuable information-based assets within the firm. According to Thomas (2002), diversified firms have potential information benefits of diversification. Aggarwal and Samwick (2003) also report that the advantage of diversification outweighs its drawback.
As mentioned previously, Villalonga (2004) use a new database (Business Information Tracking Series) and finds the diversification premium which is robust to variation in the sample, business unit definition, and measures of excess value and diversification. According to Morck and Yeung (1998), the theory of synergy indicates that diversification contributes the value of market. However, earlier studies, such as Lang and Stulz (1994), find that Q and firm diversification are negatively
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related because of diversification discount, that is, firms operate with less efficiency.
Berger and Ofek (1995) claim that diversified firms trade at a discount relative to single-segment firms in the same industries. This phenomenon might be attributed to agency cost for outside investors due to information asymmetry. Therefore, the relation between diversification and market valuation is still inconclusive.
The 20th anniversary of what came to be known as “Black Monday”—19 October 1987—provides a memorable platform for considering, yet again, the role of risk in our financial markets (John C. Bogle, 2008). On that single day, the Dow Jones Industrial Average dropped from 2,246 to 1,738, an astonishing decline of almost 25 percent. In fact, during 2007, we witnessed an unprecedented series of amazing market swings, known as financial tsunami. Whereas in the 1990s and 2000s, the daily changes in the level of stock prices typically exceeded 5 percent only one time or two times a year. For example, the Asian financial crisis, internet bubble, Enron financial scandal, the September 11, 2001 terrorist attacks. In this paper, we call these events with rarity, extremeness, and retrospective predictability “Black Events”. Refer to “Black Monday,” the definition of “Black Events” is that the Dow Jones Average Index fell over 5% (greater than 5%) in one day. These stunning declines shocked nearly all market participants, although some veterans were not surprised, outperformed the market even. As a result, these big-shock events provided an opportunity to examine the role of growth strategy in explaining the benefit to the market valuation.
A number of studies discuss the relation between diversification and the firm value.
Moreover, this study wants to see the difference of growth strategy in special condition, as called “Black Events”. This study contributes to the literature by examining the importance of focus versus diversification in explaining the value from
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market following the black event. In a sample of 534 outperformed firms from 2002 to 2004, our findings indicate that long-run valuation effect (BHARs) of corporate growth strategy is differentiated. Our evidence leads to the conclusion that there is a negative relation between Q and diversification. The reason for this relation does not appear to be that good firms diversify and therefore become bad firms. In our sample, there is some evidence that multi-segment firms are firms with lower Q's relative to other focused firms but not relative to firms in their industry. This evidence could imply that firms diversify when they no longer have growth opportunities in their industry or that the market anticipates ill-fated diversification and already impounds it in the firm's value.
Our results are important for two specific reasons. At first, there has been no empirical evidence on the role of growth strategy in explaining the value from market following the black event. Furthermore, by taking into account the issue on the effect of focus and diversification on the value from market following the black event, this study also adds to existing literature on whether the nature of growth strategy is an important consideration in assessing the value from market. Our main findings are robust to different measures in diversification.
Figure 1 shows this paper’s background about the relationship between
diversification and market valuation. Apparently, both signs are possible for each study. Previous studies might point out either positive or negative relation between diversification and Q. However, such results might be biased or distorted due to the failure to consider other variable. Here, we use a broader perspective to examine the whole picture of diversification and market valuation.
The remainder of this paper is organized in sections. Section 2 explains the methodology, including the sample selection, variable definitions and model. Section
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3 presents the empirical results and findings on the value from market. Finally, section 4 provides the summaries and conclusions.
Figure 1.The main purpose and hypothesis of this paper
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