International Journal of Management Vo

International Journal of Management Vol. 29 No. 4 Dec 2012 531

The Effects of International Diversification on Firm Performance: An Empirical Study across Twelve European Countries Alfredo M. Bobillo University of Valladolid, Spain

Felix López-Iturriaga University of Valladolid, Spain

Fernando Tejerina-Gaite University of Valladolid, Spain

The relationship between international diversification and firm performance is a binomial that has led to many investigations leading to mixed results, in some cases there is a positive relationship, in others no significant relationship or even negative. In this paper we try to find the possible reasons why these results occur. The international diversification is assessed by the ratio of exports to total turnover. Besides, we extend the research to the different performance that industrial and service firms could have, bearing in mind, too, if their business culture base originates from civil law or common law countries. Based on a sample of 1721 firms from twelve European countries, we compare this relationship for the 2000-2009 period. The empirical results obtained show a stronger ID-performance positive relationship in service firms than in industrial ones. Those firms with a culture based on civil law systems (bank oriented financial system) will have greater flexibility to counteract the negative relationship between ID and performance, than those firms with culture based on common law systems (capital market oriented system).

Introduction Accessing foreign markets is becoming a more and more attractive option for firms. International diversification (ID) is a stabilisation procedure for the firm’s sales and also a way of reducing the risks derived from the reduction in demand on the domestic market. Likewise, the presence of a firm on the global market entails greater derived risks, mainly due to the greater uncertainty and commitment of resources entailed by this action. It also represents a challenge to improve their competitiveness in their fight with local firms (Lucas, 1993; Bowen & Wersema, 2005). The degree of internationalisation is also contemplated as a pre-condition for the firm to become more financially successful (Annavarjula & Beldona, 2000; Ruigrok & Wagner, 2003).

Consequently, by way of international expansion, firms seek a way of improving their long-term financial profitability, extending diversification in general (Graham et al. 2002; Campa & Kedia, 2002) and diversification via foreign markets in particular (Kotabe et al., 2002; Lu & Beamish, 2004). However, the efficiency of these actions is frequently questioned. Nevertheless, the resource-based view of the firm, based on strategic management (Barney, 1991; Kogut & Zander, 1993) and the theory of internationalisation

 

 

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of foreign direct investments (Buckley & Casson, 1976; Hymer, 1976) indicate that the greater the involvement of a firm on international markets, the greater the possibility of exploiting its tangible and intangible assets in search of greater profitability.

In this context, faced with situations where there is a reduction in profit margins on domestic markets, firms seek to improve their profitability through international diversification. Therefore, the underlying question is to what extent does international diversification affect the company’s profitability? It is also worth asking what the ID- performance relationship is like and how it differs, regarding profile, in industrial and service firms. In this context, La Porta el al. (1997, 1998) point out that each country’s legal system is related to its financial system. In agreement with this idea, investors are the ones that provide the firms with funds for their growth, which means that the greater the legal protection, both of shareholders and of bondholders, the greater the certainty of exercising their ownership rights. Therefore, in those countries where the legal protection of investors is high (common law system), the capital markets are the most important source of funds that firms will use to finance their international expansion. However, in those countries where the protection of investors is weak (civil law system) the source providing the resources for the firm’s international expansion is the banking system.

The above arguments enable us to postulate that the international expansion of firms from countries where greater investor protection prevails (common law system) could be favoured more, compared with firms from countries with less investor protection (civil law system).

The remainder of the paper is organised as follows: Firstly, we present the literature and hypothesis about the relationship between ID and performance. Secondly, we show the study methodology. Thirdly, the results will be provided. And, finally, the conclusions will be discussed.

Literature and Hypothesis

International diversification becomes a growth strategy for a firm whose aim is to capture the opportunities offered by foreign markets (Capar & Kotabe, 2003). In this regard, the relationship between ID and a firm’s financial performance is a widely debated topic by researchers in the field of strategic management and international business. The internationalisation option offers firms different advantages related to economies of scale, scope and learning, derived from accessing foreign markets (Kogut, 1985; Ghoshal, 1987; Kim et al., 1989, 1993), at the same time as they can develop their main capabilities in different business segments and different geographic markets (Hamel, 1991). In other words, the aim is to extend these capabilities, which have previously been generated in the domestic markets, in the form of tangible and intangible assets abroad, in order to improve the firm’s financial performance (Hymer, 1976).

Similarly, accessing foreign markets offers firms the opportunity to integrate their activities across the national borders by marketing standardised products, rationalising production and allocating resources in a more efficient way (Kobrin, 1991). Likewise, the exploitation of the market imperfections and international transactions, through transfer

 

 

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prices, could represent another competitive advantage of international diversification, which would be reflected in a greater negotiating power for the firm. The above arguments enable us to venture a close relationship between ID and a firm’s financial performance, which for some researchers is linear and positive (Daniels & Bracker, 1989; Grant, 1987; Gomes & Ramaswamy, 1999; Geringer et al., 1989). Other studies have reached the conclusion that there is no relationship or that there is even a negative linear relationship (Shiddhartan & Lall, 1982; Kumar, 1984; Michel & Sacked, 1986; Collins, 1990; Denis et al., 2002). Finally, another approach has found a curvilinear relationship, in some cases U-shaped (Ruigrok & Wagner, 2003; Capar & Kotabe, 2003), inverted U-shaped (Hit et al., 1997; Ramaswany, 1993) or S-shaped (Contractor et al., 2003; Lu & Beamish, 2004; Chang & Wang, 2007).

The results of the above papers show that, although at moderate ID levels there are important benefits for firms, the transaction costs entailed by the internationalisation processes make the firms’ financial performance decrease, above all during the first stages, due to the increase of management costs involved by committing resources abroad.

The papers mentioned refer to industrial firms and one can question if these results could be extended to service firms. The reasons behind the internationalisation of the latter are basically the same as for industrial firms (labour costs, access to international markets, etc.), so service firms could benefit, just like industrial firms, from economies of scale at several stages of the value chain (Dunning, 1989) or from obtaining economies of scale in marketing activities (Campbell & Verbeke, 1994). However, these arguments assume that service firms, like industrial firms, incur fixed costs regardless of the results obtained (Katrishen & Scordis, 1998).

Despite the reasons given, it could be considered that the relationship between ID and a firm’s financial performance in service firms is different to the relationship for industrial firms. There are reasons, such as the greater regulation related to ownership, the preferences in local policies of national firms, the different tax treatment and employment rules for local companies (Feketekuty, 1988; Knight, 1999) that would affect service firms and not industrial firms, and which could represent a greater decline of profitability for service firms, above all, during the first stages of internationalisation. If we consider this argument, it can also be put forward that multinational service firms support an increase in costs due to the greater need to adapt the services to the local needs than industrial firms, based on cultural differences (Kapar & Kotabe, 2003). We can also point out that many services simultaneously require production and consumption (inseparability) which, in certain cases, requires the multinational firm to own a production subsidiary in the host country in order to be able to carry out its business (Boddewyn et al., 1986).

Consequently, greater investments are required for service firms to access foreign markets than for industrial firms, which makes it difficult for these firms to benefit more immediately from economies of scale, due to the high government costs incurred.

In short, due to the specific traits of service firms: intangibility, inseparability, heterogeneity and alterability of their outputs, we can pose the following hypothesis:

 

 

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H1: The relationship between ID and a firm’s financial performance in service firms (non- linear U-shaped) differs from the profile of industrial firms (non-linear S-shaped).

In the context of legal systems (civil law vs. common law) the regulations resulting from them can be expected to have an influence in different ways and to a different extent on the private relationships of the individuals. Therefore, according to Keizer (2008) the explanation of the reasons for the firms’ performance would have to be sought in the rules and regulations of those that govern them. Therefore, the legal system that reigns in each country may favour the negotiating power of firms when cancelling different contractual relationships. Thus, in the common law system, the cancellation of incomplete contracts would be facilitated by the judges’ flexibility to create laws and integrate any problem that was inexistent until then within the legal framework. Both systems maintain a high level of contractual development; however, they differ in effectiveness when enforcing the contractual regulations, giving rise to different levels of legal uncertainty. Thus, there must be a set of rules that will make the level of uncertainty decrease. From the financial viewpoint, this approach favours greater or lesser interventionism of the authorities in the economic activity of the citizens and the firms.

The arguments listed above have been used as the basis to structure bank-oriented or capital market-oriented financial systems, depending on the level of uncertainty entailed by executing the contractual agreements that arise from the economic-financial relationships.

On their part, the different specific economic activities of each firm may differ with respect to the financial services they require to execute them. Some activities will demand radical innovation and will need to be executed in a short period of time, whilst others will require a longer gestation period and an incremental innovation process that will lead to the firm obtaining a sustainable competitive advantage. In this scenario, the international diversification of the firm’s operations is associated with a long-term incremental resource commitment process and with a chain of successive innovations to improve the competitiveness of their products.

The main consequence of this proposal could give rise to the consideration that firms belonging to countries with corporate government systems, “outside systems”, characterised by a high liquidity of the capital market, a large number of listed firms, disperse ownership structure and active corporate control markets, would be in better or worse conditions to cope with international diversification activities than those firms with a culture based on “insider systems” where the number of listed firms is less, the ownership structure is more concentrated and the corporate control market is less active.

Thus, firms with capital market-oriented financial systems would manage those activities that entail a radical innovation better and whose management is carried out in the short term, whilst those activities, such as international diversification, which require long-term incremental investment, and that represent a high degree of supervision, would be better managed by firms originating from bank-oriented financial systems. The latter would be in a better position to obtain private benefits of control due to the greater ownership

 

 

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concentration, and to maintaining closer relationships with the financing supplier, which would favour the fight for improving performance in foreign markets.

With respect to the causal relationship between ownership concentration and firm performance, this is theoretically and empirically ambiguous. Studies such as those conducted by Pedersen & Thomsen (2003), Loderer & Martin (1997), Cho (1998), Himmelberg et al.(1999), Demsetz & Villalonga (2001), which apply simultaneous equations (contrasting with the studies that use ordinary least squares) do not reflect a significant relationship between ownership structure and firm performance. However, there is a certain consensus about the possible positive relationship between ownership concentration by insiders and firm performance.

The logical consequence of these arguments is that firms originating from countries with a civil law culture, due to the closer relationships between borrowers and lenders, and with a bank-oriented financial system, would have a greater volume of funds to cope with the underperformance difficulties during the first stages of the firm’s internationalisation process. Likewise, the greater ownership concentration in hands of the insiders would favour a positive impact on the firm’s performance.

In agreement with the premises set out above, the firms with culture based on the civil law system would recover in a shorter period of time from the difficulties caused by the first stages of international diversification and their performance would have a shorter reduction cycle.

Consequently, and based on this reasoning, we can put forward the following hypothesis:

H2: A non-linear (U-shaped) relationship between ID and performance could be expected in a longer time period in those firms whose culture is structured around common law systems than in those firms with a culture based on civil law).

Data and Methodology Data Our database consists of 8,959 observations from 1,721 firms from 12 countries between 2000 and 2009. According to La Porta et al. (1997 and 1998), we divide the countries into two main groups: those belonging to civil law systems and those belonging to common law systems. We also divide the sample into industrial firms and service firms according to the two-digit SIC code classification: industrial firms for SIC codes between 01 and 39 and service firms for SIC codes between 40 and 87. In Tables 1 and 2 we provide further information about the structure of the sample and some descriptive statistics:

Variables Our dependent variable is the firm’s performance (ROA) defined as the ratio between the EBITDA (Earnings before interests, taxes, depreciation and amortization) and total assets. We define four explanatory variables: ID is the degree of internationalisation and is calculated as the ratio between exports and total turnover; LEV is financial leverage defined as total debt to equity; SIZE is the log of total assets; and INTANG aims to

 

 

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measure the asset intangibility and is defined as the proportion of intangible assets over total assets.

Methodology We estimate the coefficients using a panel data method that combines observations from a number of firms over a 10-year period. The panel data methodology allows the control of the so-called unobservable constant heterogeneity –e.g. the specific characteristics of each firm that remain constant throughout time-.

Our model can be expressed with the following equation, where i refers to the firm, t the year, e

it is the random error and η

i is the fixed-effects term:

ROA it = α

i + β

1 ID

it + β

2 ID2

it + β

3 ID3

it + β

4 LEV

it + β

5 SIZE

it + β

6 INTANG

it + e

it + η

i

The thus-specified model was tested for the full sample and for each one of the two sub-samples into which we had divided the initial sample: common law firms, civil law firms, industrial firms and service firms (Table 3). In all the estimates we report the adjusted-R2 coefficient and the Hausman test. This test shows the importance of the fixed effect component –closely correlated with the remaining explanatory variables–, so that the within groups, the estimation method becomes necessary in order to deal with the constant unobservable heterogeneity.

Results As expressed in column 1 of Table 3, there seems to be a negative linear relationship between the firm’s performance and its degree of international diversification. This result poses the question of why firms undertake internationalisation processes when these processes translate into a loss of performance. One of the possible answers to that

Table 1: Distribution of the sample

Observations Firms Observations Firms France 1390 267 Belgium 244 47 Common law system 3,716 714 Germany 1488 286 Civil law system 5,243 1007 Denmark 314 60 Spain 254 49 Finland 205 39 Industrial firms 4,445 854 UK 2619 503 Service firms 4,514 867 Ireland 119 23 Italy 568 109 Holland 270 52 Poland 654 126 Sweden 834 160 TOTAL 8,959 1,721

 

 

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question consists in clarifying the firms’ performance according to the type of activity or the institutional-legal framework they operate in.

Thus, when the model is estimated in a different way for industrial firms and for service firms, the results change considerably.

Thus, in the case of industrial firms, we detect an S-shaped relationship, with a first decreasing section, a middle section when the performance increases as does the international diversification, and a final section when the relationship becomes negative again. On the contrary, in the case of service firms, there is a quadratic relationship, with a first negative relationship section that combines both variables and a second positive relationship section.

When the estimation is made in agreement with the legal system, a different pattern is also observed. Whilst, in both environments, the coefficients of ID, ID2 and ID3 are always significant, the relationship profile is different. In the civil law environment, an S-shaped relationship is observed, with an alternation of negative, positive and negative signs for different sections of the international diversification coefficient. On the other hand, in the common law environment, the relationship is U-shaped, so initially there is a negative effect of the ID on the firm’s performance, an effect which becomes positive later on.

Table 3: Baseline estimates

General Industrial Services Civil Common

ID -0.213*** -0.6994*** 0.0857 -0.2773*** -0.2052**

0.049 0.0742 0.0648 0.0600 0.0818

ID2 -0.045 0.7434*** -0.5442*** 0.3243** -0.3094*

0.116 0.1849 0.1525 0.1494 0.1878

ID3 0.017 -0.1122*** 0.2796*** -0.0894*** 0.2615**

0.080 0.1319 0.1037 0.1063 0.1254

LEV -0.001*** -0.0003*** -0.0001 -0.0003*** 0.0001

0.001 0.0001 0.0001 0.0001 0.0001

SIZE 0.003** -0.0006 0.0059** -0.0002 0.0068***

0.002 0.0024 0.0023 0.0022 0.0026

INTANG -0.032*** -0.0622*** 0.0007 -0.0250* -0.0353***

0.009 0.0133 0.0128 0.0137 0.0127

# obs 8959 4445 4514 5243 3716

Adj-R2 0.1264 0.1811 0.1173 0.0899 0.1118

F test 173.6*** 133.54*** 79.10*** 68.13*** 110.81 Hausman test 102.8*** 122.27*** 37.22*** 67.77*** 87.14

 

 

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If we now make the estimations, combining both criteria, we obtain the results obtained in Table 4. The first column shows that in industrial firms from civil law countries, there is a cubic S-shaped relationship, with three sections: a negative slope, a positive slope, and finally a third section with negative slope. However, industrial firms in common law countries show a U-shaped quadratic relationship, with an initially negative sign that becomes positive for sufficiently high internationalisation levels. Insofar as service firms are concerned, whilst in civil law countries their performance does not depend on the degree of international diversification, in common law countries we detect an inverted S-shaped cubic relationship, with an initially positive, then negative and finally positive sign.

Table 4: Additional estimates

Industrial Services

Civil Law Common Law Civil Common

ID -0.7026*** -0.6443*** -0.0202 0.1634*

0.0915 0.1263 0.0812 0.1079

ID2 0.9826*** 0.5288* -0.0960 -0.9342***

0.2309 0.3099 0.2008 0.2415

ID3 -0.6417*** -0.0614 -0.0668 0.5858***

0.1646 0.2206 0.1426 0.1575

LEV -0.0003*** -0.0007** -0.0005** 0.0002

0.0001 0.0003 0.0002 0.0001

SIZE 0.0013 -0.0053 -0.0011 0.0125***

0.0030 0.0040 0.0032 0.0034

INTANG -0.0781*** -0.0451** 0.0406** -0.0225

0.0182 0.0199 0.0206 0.0163

# obs 2880 1565 2363 2151

Adj-R2 0.1506 0.2352 0.0741 0.1813

F test 68.17*** 65.34*** 24.97*** 62.45***

Hausman test 69.16*** 40.00*** 72.27*** 93.74***

 

 

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Conclusions

The results obtained confirm the hypotheses put forward and show how the relationship between ID and performance differs, according to which economic activity sector they belong to and depending on whether their culture is associated with civil law or common law based legal systems.

Our empirical results can be summarised as follows. We find evidence that industrial firms have greater difficulties than service firms in reaching a positive relationship between ID and performance, due to the higher costs of adapting to the local needs and to the higher government costs they incur, either due to their nature (production-consumption) or to the greater investment required by their international diversification.

In the business culture context, the performance is different depending on whether the firm belongs to bank oriented financial systems or to capital market oriented financial systems. Those firms with a culture based on civil law systems (bank oriented financial system) will have greater flexibility to counteract the negative relationship between ID and performance in a shorter period of time during the first international diversification phases, than those firms with culture based on common law systems (capital market oriented financial system), due to the fact that the more distant borrower-lender relationships of the latter could represent a reduced contribution of funds to improve the firm’s performance more quickly.

Finally, we must point out the lack of significance in the relationship between ID and performance of service firms, both belonging to civil and to common law systems.

In short, the profile of the relationship between ID and performance varies significantly if the firms belong to different economic activity sectors and also depending on whether the business culture is based on civil or on common law systems.

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