Corporate Diversification and Long-run Performance of SEO Firms --Evidence from Taiwan-- Jeng-Ren Chiou Ming-Yuan Li Ting-Kai Chou Chao-Ya Wan

Outline 1. Introduction 2. Hypothesis Development 3. Data and Empirical Design 4. Empirical Results Analysis 5. Conclusions

Introduction  A large and growing literature examines the consequences of corporate diversification.  diversified firms sell at a discount relative to focused firms.  stock prices tend to fall when firms announce focus- decreasing corporate actions.  The prior evidence suggests that the costs of corporate diversification exceed the benefits.

Introduction  Recent papers try to identify some of the costs of diversification by examining the investment patterns of diversified firms.  Scharfstein (1998)  Rajan, Servaes and Zingales (2000)  Cross-subsidization phenomenon  A conglomerate firm always invest more in weak division than their stand-alone industry peers.  diversified firms would invest more in relatively poorer projects than focused firms

Introduction  There is little empirical work that directly identifies the benefits of diversification.  Lewellen (1971) - coinsurance effects increase a diversified firms’ debt capacity relative to the aggregate debt capacity of its individual divisions as stand-alone firms.  Williamson (1975), Stein (1997), Lamont (1997) and Shin and Stulz (1998) - internal capital market and efficiently allocating cash across divisions.

Research Objective  We try to provide evidence on the potential benefits associated with corporate diversification  examine the effect of diversification on subsequent performance following the equity issues.  The direction of relationship between diversification and post-SEO performance is unclear.

Hypotheses Development  Internal capital market hypothesis  In diversified firms, profitable product lines can allocate much needed capital to negative cash flow businesses.  There may also be positive synergies between the lines of businesses of the issuing firms.  Under the assumptions of efficient internal capital markets and/or synergies, we would expect a positive relationship between diversification and post-SEO long run performance.

Hypotheses Development  Resource misallocation hypothesis  Berger and Ofek (1995) provide an exposition on how corporate diversification can decrease firm value.  There may be a higher propensity for the misallocation of capital across business segments through inefficient cross-subsidization in a diversified firm.  Rajan, Servaes, and Zingales (2000)  Scharfstein and Stein (2000).  We expect a negative relationship between diversification and post-SEO long run performance.

Data  Seasoned equity offerings on the Taiwan Securities Exchange over  exclude financial companies and firms without complete data.  A total of 386 equity issues remain after our selection criteria. Number of SEOs issued in the period 1995 to 2002 on the Taiwan Securities Exchange507 Less: utilities and financial firms(54) Less: missing data on stock returns within 3 years after the SEO(35) Number of firms conducting SEO with complete returns in the sample period418 Less: missing data on diversification calculation-related variables(12) Less: missing data on regression control variables(20) Sample 386 Sample Selection

Sample Distribution by Year  Most of the offerings occur in the periods.  Due to the economic recession in Taiwan capital markets, only five offerings conducted in 2001.

Sample Distribution by Industry  The SEO sample varies by industry from 143 offerings in the electronics classification to 1 offering from automobile industry.

Methodology  Buy-and-Hold Abnormal Returns (BHAR)  BHAR represents the monthly compounding return for issuing firm from a buy and hold strategy, adjusted by the holding period return on the benchmark during the corresponding period.  size-matched portfolio  B/M-matched portfolio  size-and-B/M-matched portfolio

Methodology  Measure of Diversification (1)  Herfindahl index (HINDEX) - reflects the degree to which the sales of a firm are concentrated within its divisions.  The variable HINDEX equals 1 for all single- segment firms and is less than 1 for multiple- segment firms.  Smaller levels of HINDEX correspond to less industry focus and greater diversification.

Methodology  Measure of Diversification (2)  Diversification Dummy (DIV) - identify whether a firm has multiple segments or not.  The DIV equals 1 if the firm has multiple segments, and 0 otherwise.

MeanStd.Q1MedianQ3 Number of Segments Rev.-based Herfindahl Index Offering price (NT$) Issue Size (million NT$) Total assets (billion NT$) Market value (billion NT$) Book-to-market ratio Age Hot market R&D expense ratio (%) Tobin Q Subsequent SEO activity Debt ratio Return on assets (%) Cash flow/total assets (%) We find that SEO issuers, on average, have two segments. The mean Herfindahl index is The mean gross proceeds are million NT dollars or US$ million. Compared with other developed capital market like the U.S., and Japan, gross proceed for Taiwan SEOs are much smaller. Empirical Results -Summary Statistics of SEOs-

Empirical Results -Post-SEO Long-run Performance-  Taiwan SEO firms don’t exhibit long run under-performance  The result is robust to various benchmarks

Single firms (N=136) Multi-Segments firms (N=250) Single-Segment firms vs. Multi-Segments firms MeanMedianMeanMedian Diff. in Mean Diff. in Median Number of segments *** Rev.-based Herfindahl Index *** Offering price (NT$) * Issue Size (million NT$) Total assets (billion NT$) ** Market value (billion NT$) Book-to-market ratio Age *** Hot market ** R&D expense ratio (%) ** Tobin Q ** Subsequent SEO activity Debt ratio Tech industry Empirical Results -Summary Stat. by Issuer- Type- Relative to focused issuers, the diversified issuers have lower offering price and R&D intensity, but have longer listing history and larger assets amounts.

Univariate Comparisons The 3-year period buy-and-hold abnormal returns for single-segment SEO firms show significant underperformance phenomenon. The result is robust to various benchmarks including size-matched, B/M matched, and size-and-B/M matched portfolios. However, the post-issue buy-and-hold abnormal returns for multiple- segment SEO firms show significant outperformance. The result is also robust to various benchmarks. A test that the mean post-issue performance for single- and multiple-segment issuers are equal is rejected at 1% level.

Regression Results 1.The coefficient on HINDEX is negative and highly significant. Since increases in HINDEX represent increases in focus, it appears that equity-issue conducted by more focused firms occur more negative long-run performance. 2.The result supports the internal capital market hypothesis.

Regression Results -Endogeneity Consideration- 1.Campa and Kedia (2002) suggests that firms that choose to diversify are not a random sample of firms. If this case, the estimation results using OLS will be biased. 2.We attempt to use simultaneous equation for model 1 to control for the endogeneity, and use Heckman’s (1979) two stage procedure to control for the self-selection of firms that diversify. 3.The empirical results show that there still exists a significant positive relationship between diversification and post-issue performance.

Summary  This paper is the first to examine the effect of corporate diversification on the equity issue performance.  We find that equity issues by diversified firm results in better subsequent stock price performance than equity issues by comparable focused firms.  These findings are consistent with the hypothesis that diversification improve the efficiency of internal capital-allocation process.

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