Efficient Corporate Diversification: Methods and Implications

This study develops and tests a measure of efficient corporate diversification (ECD) that compares the variability of a firm's revenues with the variability of a minimum-variance portfolio of businesses that maintain the same sales growth rate. According to ECD, which incorporates the exposure of a firm to business cycle fluctuations, a firm is considered more efficient the higher its ratio of minimum variance to the realized variance. The empirical results indicate that efficient diversifiers manage to reduce the variability of their returns without sacrificing profitability. Moreover, such firms have a more favorable trade-off between risk and return in the equity market. Further, efficient diversifiers are found to be less diversified as measured by the extent of operations in different SIC industries. Instead, they operate in related business segments that have differential responses to business cycle changes and thereby enjoy the benefits from related diversification while minimizing their operating risk.