Research background and motivation

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Chapter 1: Introduction

1.1 Research background and motivation

Diversification is a popular strategy in business. Diversification is defined as the expansion of involvement in more factor and product markets through internal business development or acquisition (Palich et al. 2000; Nath et al. 2010).

Diversification is one significant strategy for firms to maintain competitive advantage and increase their operational performance (Chen and Yu 2012). Diversity creates value for firms through scale of economies or market power (McDonald et al.

2008; Rumelt 1982). There are two major types of diversification which are product diversification and geographic diversification (Geringer et al. 2000; Qian et al.

2008; Denis et al. 2002). Product diversification means extend produce or sales in different product areas (Rumelt 1982). On the other hand, geographic diversification is selling similar product in new markets (Geringer et al. 2000).

Diversification strategy is critical for firm operations especially in emerging markets. The immature industries and less-developed capital market in emerging markets offer firms large opportunities and benefits to engage in diversification strategy (Chen and Ho 2000; Delios et al. 2008). Furthermore, the environment of emerging markets is insufficient and uncertain. Therefore, firms in emerging markets usually find benefit from higher levels of product diversity. Emerging market firms like to pursue product diversification more than other types of diversification. Firms implement product diversification by using the existing rent-generating resources of the firm and generate economies of scope to earn profit. Using existing resources make firm diversify into other products easier than diversification into different geographic areas. On the other hand, product diversity helps emerging market firms to

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cover the weakness of external capital markets by creating internal financial economies. For example, internal financial economies may compensate for inadequate external capital markets by allocating resources among internal business units more efficiently (Wan and Hoskisson 2003; Hill and Hoskisson 1987). Product diversification is motivated by searching for better growth prospects and higher performance (Bettis 1981; Chen and Yu 2012). In addition, the political and other relationship becomes important in emerging markets because of the high structural uncertainty. Political relation helps firm achieve more institutional support. Relation with other firms increases interfirm resource exchanges (Luo 2003). The product diversity build from connect with other firms helps emerging market firms to leverage new businesses. In conclusion, product diversity is the most important types of diversification for firms in emerging markets. Therefore, this study focuses on discussion the influence of product diversification in an emerging market.

In recent years, many researchers discuss the relationship between diversification and firm performance. However, those studies have conflicting results. Some studies highlight that diversification have positive impact on firm performance by increasing debt capacity and risk reduction, in addition to the reasons I highlighted above (Wan and Hoskisson 2003; Nath et al. 2010; Stern and Henderson 2004). Moreover, based on the resource-based view, diversification brings firms economies of scale by allowing them to better leverage various resources, including tangible and intangible resources (Tanriverdi and Venkatraman 2005).

On the other hand, some researchers suggest that diversification may destroy firm value and firm performance (Comment and Jarrell 1995; Denis et al. 2002).

The cost of diversification is high because of the high business environment uncertainty and volatility resulting in the lack of information (Hill and Hoskisson

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1987). These negative findings show that firms find it is difficult to reap the diversity as theorized by resource-based view. Therefore, this study investigates what moderators affect firms’ ability to reap the benefits while decreasing the cost from complexity and risk. I argue that it depends on the diversity of human capital the firm has.

Product diversification is one types of strategic decision. Shrivastava and Grant (1985) recognize whether a decision is strategic from the using of organizational resource, diversity of expert, influencing by external environment agents and restructuring organization. Product diversification satisfied these criteria for strategic decisions. Organizational decision making is complex and rely on knowledge about the environment. However, decision makers usually face incomplete information about the uncertain environment. Under this complex situation, decision makers are expected to rely on any knowledge it can access about corporate strategy and the competitive environment (Carpenter and Westphal 2001). Professional knowledge is important in decision making especially in product diversity. High product diversified firms produce and sale many different types of product. Product diversification requires firms to have extensive knowledge about new product development (Nath et al. 2010). Kor and Leblebici (2005) address that the key point of success in implementation of diversification strategy is the management of strategic human capital. Professional knowledge and resource is important especially in emerging markets. Because of the large imperfections in capital, products, and managerial talent, emerging markets usually have no market data, nonexistent or poorly developed distribution systems, relatively few communication channels (Arnold et al. 2012).

One of the key resources of firm operations is process-related knowledge such as technological and operational know-how. Firms that learn these knowledge quickly

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and effectively will create value for their businesses (Guillén 2000). Hence, institutional knowledge and resource is important in emerging markets.

Knowledge and information are factors in human capital of a firm. Human capital is competencies, tacit experience, and overall knowledge-base of individuals in an organization (Bontis and Serenko 2009). Human capital in a firm is thus a source of critical competitive advantage. Human capital is a set of knowledge and skills that develop through education, training, and various experiences (Coleman 1988; Coff 2002). Individuals accumulate ability and knowledge from education and experience.

For organizations, experience in industries or learning from other firms provide the related knowledge of operating strategy and best practices in the industry. Human capital of a firm is a bundle of human capital of each members in that firm, such as employee, managers etc. This study discusses the role of human capital in product diversification. As previously highlighted, product diversification is one of strategic decisions in firms. This study focuses on discussion of how human capital of decision makers in firms influence firm performance.

The key person of decision making in firms usually is top manager. Top managers are responsible for soliciting feedback and making the executive decisions for the firms, communicating this decision to others, and monitoring strategy adoption (Simon 1987). However, the strategic decisions related to large amounts of organizational resources and implement through appropriate means. Top managers sometimes cannot handle the complexity in the process of strategic decision making.

There are cognitive limits to information processing by individual managers (Shrivastava and Grant 1985). Therefore, top managers usually search relevant information or suggestion from others. Beside top management, board of directors and block shareholders also has influence on firm decision making. Board and

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shareholders are not engaged in the day to day operations. In comparison to managers, directors and shareholders exercise relatively little independent influence over the firm’s strategic direction (Westphal and Fredrickson 2001). The support from the board of directors and shareholders are critical in the functioning of a firm. Prior research has looked at the role of board’s experience in firm’s strategic decision making. However, limited prior research has looked at the experience of block shareholders as a source of advice and information. Drawing on prior research on learning from experience and others’ knowledge (Carpenter and Westphal 2001; Johnson et al. 2013; Platt and Platt 2012; Wu et al. 2013), I argue that the experience of the board of directors and block shareholders influence firms’ strategy, especially firm decisions related to diversification.

The board of directors is appointed to oversee the activities of firms and to give managers some advice on day to day affairs. One of the tasks served by the board of directors is to provide advice and consultation to managers on matters related to firm operations, which means that one of the role of the board is involvement in strategy formulation (Salancik and Pfeffer 1980; Hoitash 2011; Nicholson and Kiel 2007; Carpenter and Westphal 2001). There is growing discussion on how boards add value to the firms. Researchers found that boards can add value by reviewing key firm decisions, providing advice in the strategy formulation process, consulting for the management, and even bringing key information about industry contacts (Nicholson and Kiel 2004; Daily et al. 2003; Golden and Zajac 2001).

Boards affect firm diversification not only by directly influencing the formulation of diversification strategy but also via indirect influence through their role as “sounding boards for management” (McNulty and Pettigrew 1996; Westphal and Fredrickson 2001; Jensen and Zajac 2004). Board of director is the bridge

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between the firm and industry. Directors are expected to bring access to important resource outside the firm, as channels of communication between the firm and the environment, and then help firm in strategy formulation (Haynes and Hillman 2010).

When boards deal with complex strategic decision making tasks, they will rely upon their own knowledge which related to business environment (Carpenter and Westphal 2001). Directors usually build their related knowledge from experience in similar roles. Nicholson and Kiel (2004) address that director increase firm performance by using their intellectual capital. A bundle of intellectual of director is also known as board capital. Board capital support directors executive their role in firm operation and influence firms’ behavior. Based on board capital theory, the assessment of board ability in the form of board capital is an important issue (Tian et al. 2011). The major components of board capital are directors’ human capital and social capital (Johnson et al. 2013). Boards’ human capital is a part of board capital and is a popular issue in corporate governance research. Human capital of directors refers to the skills and experiences that individual directors bring to the decision-making process. To influence the decision making process, they bring knowledge of industry and specific task. Board expertise in a domain area and familiar with specific events through prior top management experience, such as being CEO (Johnson et al. 2013).

Therefore, directors’ knowledge of industry and its business environment is critical for firm operations. Directors accumulate industry knowledge and gain information of competitors from their experience through appointment by other companies or from prior top management experience.

As for block shareholders, shareholder activism provides a channel for shareholders to closely monitor and provide advice to management, which can be helpful in the promotion of firms’ long-term performance (Gillan and Starks 2000).

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Shareholders are firms’ primary stakeholders and who are owners of the firm (O'Rourke 2003). As owners of the firm, shareholders care about the performance and profitability. The power and influence of shareholders in firm operation is significant.

Shareholders usually monitor and affect firm strategy by shareholder activists.

Shareholder activism is defined as shareholders influence on firms’ behavior by claiming their power as owners of firms. Shareholders play their monitor and advise role of firm business activities through both formal and informal activisms. Formal shareholder activism refers to public attempts to influence the firm, through public shareholder proposals, actions in the annual meetings, active lobbying of votes, and attempts to change the stock price by buying and selling stocks. Informal activism attempts are not publicly visible, but take place behind the scenes, through actions such as corporate engagement, and private negotiations and dialogue with managers (O'Rourke 2003; Nordén and Strand 2011). Colpan et al. (2011) address that the characteristic preferences of shareholders have influence on product diversification and then impact firm performance. According to learning theory, experienced investors accumulate investment knowledge and make better investment decisions (Korniotis and Kumar 2011). The knowledge from their investment experience is helpful in their industry evaluation and market predictions (Delios and Henisz 2003; Tuschke et al. 2014). With this knowledge, block shareholders can potentially provide valuable advice to managers about market and industry trends, which is valuable for making diversification related strategic decisions.