Economics

1. Introduction In the last decade, corporate diversification across industries has attracted a great deal of attention by financial economists and management scholars. Research on the diversification discount such as Berger and Ofek (1995) and Lang and Stulz (1994) shows that diversified U.S. firms trade at a significant discount relative to specialized firms. Active debate is still going on as to whether diversification itself is responsible for the discount (Martin and Sayrak, 2003). Recent studies such as Campa and Kedia (2002) and Villalonga (2004a) suggest that, once the endogeneity of diversification status is accounted for, diversification is not detrimental to firm value. Nevertheless, the fact that a staggering number of U.S. firms have divested unrelated businesses to refocus on the areas of their core strength suggests that managing a large diversified corporation successfully is not an easy task (Markides, 1995; Comment and Jarrell, 1995). Organizational economists provide a number of reasons to suspect that large complex organizations like diversified firms might underperform small rivals organized more simply (e.g. Milgrom and Roberts, 1988; Rotemberg and Saloner, 1994; Scharfstein and Stein, 2000). The wave of corporate refocusing appears to have hit the other side of the Pacific in the late 1990s. Nowadays, the business press is full of articles reporting Japanese companies, even those long considered the bluest of blue, actively slashing unprofitable businesses. As Figure 1 illustrates, the number of publicly announced divestitures in Japan indeed increased dramatically in the wake of corporate restructuring wave in the late 1990s. However, the diversification strategy of Japanese firms was once espoused as economically sound by many observers. For instance, in an influential Harvard Business Review article, Prahalad and Hamel (1990) drew heavily on Japanese companies to illustrate the importance of nurturing a firm’s core competence to sustain growth without risking financial health. Why then the large wave of divestitures' What went wrong' Unfortunately, 1 researchers do not have ready answers to these questions because evidence on the Japanese firm’s diversification is limited in supply. In response, this article contributes to increasing our knowledge on corporate diversification, performance, and restructuring in Japan based on a longitudinal sample of 142 largest manufacturers. Our analysis proceeds in three steps to this end. First, we document the long-term development of the sample firms’ diversification in 1973-1998 to understand basic facts about corporate diversification in Japan. Second, we investigate the link between diversification and performance in the largest manufacturers over the 25-year period. Because corporate restructuring is generally triggered by poor firm performance, a negative association between diversification and performance is expected if diversification failures were at least partly responsible for the rise of restructuring wave. Third, we shed direct light on the relationship between diversification and restructuring in the late 1990s by studying factors inducing firms to exit businesses through divestitures. We perform these analyses with emphasis on inter-business relatedness. It is often argued that, for diversification to create value, the firm must keep the relatedness (coherence) of its businesses high. For testing this hypothesis, we follow Lemelin (1982) and Fan and Lang (2000) who used the Input-Output (IO) table describing inter-industry commodity flows to measure relatedness. We are not the first to use the IO table for studying the Japanese firm’s diversification. Claessens et al. (2003) employed Fan and Lang’s (2000) relatedness indices to study diversification in Japan and eight other Asian economies. However, they measured relatedness based on the 2-digit IO table for the U.S. economy. In this article, we use the Japanese IO table with a finer industry classification to develop three indices, each measuring a different facet of business relatedness: the similarity of production technologies, similarity of human capital requirement, and opportunities for vertical transactions. This study complements the small but growing literature on diversification in Japan including the seminal studies by Goto (1981) and Yoshihara et al. (1981) who examined the 2 diversification strategy of the largest industrial firms as we do here. They identified a steady increase in diversification from the late 1950s to early 1970s. Yoshihara et al. (1981) also found out that most of their sample firms confined diversification to industries that were related to their main business. Itoh (2002) notes that one of the three stylized facts about the Japanese diversification is that Japanese firms tend to diversify into more related businesses than U.S. firms.1 Financial economists have shown that diversified firms trade at a discount in Japan as they do in the United States (Lins and Servaes, 1999; Hiramoto, 2002; Nakano et al., 2004). Nevertheless, Yasuki (1995) and Miyajima and Inagaki (2003) found that the average degree of diversification in the largest industrial firms continued to increase in the 1980s and 1990s. However, a recent study by the Ministry of Economy, Trade, and Industry (2005) covering a wide spectrum of firm size distribution shows that the average degree of diversification in the manufacturing sector declined by the early 2000s.2 Miyajima and Inagaki (2003) also note that some of their sample firms decreased diversification after the mid 1990s, auguring the arrival of refocusing wave to Japan. Our findings are summarized as follows. Consistent with earlier evidence, the average degree of diversification in our sample of the largest manufacturers continued to increase in 1973-1998. Despite this trend, their businesses relatedness measured in three different ways on average stayed constant, indicating that the diversification increase was not led by firms pursuing unrelated diversification. In aggregate, the diversification pattern of the largest Japanese manufacturers was remarkably stable during our study period. The stability of diversification strategy, however, was not brought about by its success because on