ELSEMER Journal of Financial Economics 37 (1995) 67-87

Corporate focus and stock returns

Robert Comment*‘a*b, Gregg A. Jarrell”
a University of Rochester, Rochester, NY 14627, USA
“Ofice of Economic Analysis, U.S. Securities and Exchange Commission,
Washington, DC 20549, USA

(Received May 1991;final version received December 1993)

Abstract

Greater corporate focus is consistent with shareholder wealth maximization. Dis-

economies of scopein the 1980sare confirmed by a trend towards focus or specialization,
a positive relation between stock returns and focus increases,and the failure of diversified
firms to exploit financial economies of scope(coinsurance of debt or reliance on internal
capital markets). Large focused firms were less likely to be subject to hostile takeover
attempts than were other firms, but diversified firms were distinguished in the 1980s
mostly by being relatively active participants, as both buyers and sellers,in the market for
corporate control.

Key words: Diversification; Business segment; Leverage; Internal capital market; Take-
over
JEL class@cations: G32; G34

1. Introduction

Conventional wisdom holds that economies of scope have been reversed in

the 1980s.Managers are now advised to eschewdiversification and to shrink the

*Corresponding author.
The Bradley Policy Research Center, William E. Simon Graduate School of BusinessAdministra-
tion, University of Rochester, provided support for this research. This research was presented at
SUNY Buffalo, the University of Chicago, the University of Rochester, and the 1992 ASSA and
WEA meetings. Special thanks to our discussants Steven Kaplan, Michael Rozeff, and Karen
Wruck. Any opinions expressed are those of the authors, not those of the Securities and Exchange
Commission or its staff.

0304-405X/95/.$07.000 1995 Elsevier Science S.A. All rights reserved

SSDI 0304405X9400777 X
68 R. Comment, G.A. JarrrN/ Journal of’ Financial Economics 37 (1995) 67-87

far-flung enterprises that resulted from past diversification strategies. In their

public statements, managers are apt to say that they want to concentrate on
a core business,and they are likely to rationalize mergers and growth strategies,
as well as divestitures and restructuring, as reflecting a strategy of specialization.
This view marks a change from the steady increase in diversification since the
1950sand from the several theoretical justifications for diversification that have
been advanced, including (i) managerial economies of scale, (ii) economies of
scopein production and marketing, and (iii) financial synergiessuch as earnings
smoothing and the efficiencies that arise with an internal capital market. The
new emphasis on specialization is consistent with Jensen(1988) who argues that
corporate diversification programs exemplify the theory that managers of firms
with unused borrowing power and large free cash flows are more likely to
undertake low-benefit or even value-destroying investments. Similarly, Meyer,
Milgrom, and Roberts (1992) argue that failing businessescan have too-ready
accessto cross-subsidies when they are part of a diversified firm.
Our findings show a steady trend toward greater focus during the 1980s.We
find that 55.7% of exchange-listed firms had a single business segment in 1988,
compared to 38.1% in 1979,with other measuresshowing smaller proportionate
increases.Perhaps more important, the trend toward greater focus is associated
with greater shareholder wealth. This relation is not trivial in economic magni-
tude. A change of 0.1 in the absolute value of a revenue-based Herfindahl index
of focus is associated with a stock return of about 4%, and changes this large
occur about one year in ten. Adding or subtracting one business segment is
associated with a return of about 5%, and changes this large occur about one
year in eight.
We show that diversified firms do not take advantage of some of the underly-
ing efficiencies thought to motivate diversification. We consider whether diversi-
fication (1) permits a greater use of debt (because the coinsurance of debt
reduces default rates), (2) permits a substitution of intersegment cash transfers
for arms-length transactions (because transaction costs are lower in internal
capital markets than in external capital markets), or (3) increasesthe likelihood
of takeover because (conversely) these intersegment transfers accommodate
a waste of free cash flow. We find that debt does not increase systematically with
diversification and that diversified firms do not rely any less on external capital
market transactions. There is someevidence that diversification does make firms
more likely to be takeover targets.
We have several reservations about these results. First, much of the trend in
focus stems from sample turnover rather than from same-firm changes. Turn-
over was unusually high in the 1980s and new firms had higher focus than
departing firms, but we still observe increases in focus on a same-firm basis for
old-line firms (in the sample at the start of the decade).Second, our regression
estimates of the wealth effects of focus are only reliably positive when an
accounting measure of performance is included in the regression. Their inclusion
 R. Comment. G.A. JarreNIJournal of Financial Economics 37 (199.5) 67-87 69

could impart an upward bias to the effect of focus even after controlling, as we
do, for the wealth effectsof acquisitions and divestitures. Third, our exclusion of
part-year returns (following the last accounting disclosure) for delisted com-
panies could impart a downward bias. We tend to exclude the stock returns of
acquisition targets, which are typically positive, as well as post-takeover changes
in focus, which Bhagat, Shleifer, and Vishny (1990) find to be positive. Finally,
weakness in our proxy measures of focus could explain the apparent failure of
diversified firms to exploit financial efficiencies. Our measures of focus are
validated, however, by evidence that the effects of corporate diversification on
risk parallel the well-known effects of portfolio diversification on risk. More-
over, our measuresof focus correlate well with frequency of participation in the
market for corporate control: 22.8% of the most diversified firms participated in
large acquisitions or divestitures each year versusjust 3.4% of pure-play firms.
We discuss our sample and focus measures in Section 2. In Section 3 we
present empirical evidence on the trend toward focus over the 198Os,while
Section 4 covers the relation between changes in focus and stock returns.
Participation in the market for corporate control is covered in Section 5,
reliance on external capital markets is covered in Section 6, and the effect of
focus on leverage and risk is covered in Section 7. Our conclusions appear in
Section 8.

2. Measuring focus

Business-segmentdata is available from Compustat as of fiscal years ending

June 1978, and our data stop with years ending October 1989. We restrict our
attention to NYSE- and ASE-listed firms (about two thousand per year) because
most unlisted firms report just one line of business each year. Although not
reported here, average focus also increased among unlisted firms. Focus can
change as a company divests or acquires assets,or directs its capital spending
into new businesses,and it can shift over time due to divergent growth rates for
the industries in which a company participates. We measure the change in focus
over one-year intervals, aggregating across underlying events. This is necessary
becausesegment data is reported annually, but appropriate also if focus-chang-
ing events tend to be heterogeneous or unannounced. In addition, judging from
their public statements, top managers have come to view focus as a policy
objective in and of itself. Our analysis of the wealth effects of undifferentiated
changes in focus fills a void on either score.
Our use of segment-reporting data means that we rely on managers to define
what constitutes a distinct business at their firms, subject to accounting stan-
dards and the demands of Wall Street analysts. An alternative source of
information on focus is the Census Bureau’s data on employment at indi-
vidual plants and establishments, which require the use of standard industry
70 R. Comment, G.A. Jarrelll Journal of Financial Economies37 (1995) 67-87

classification (SIC) codes to combine establishments into business segments.

These data have the advantage of being available for privately-held firms.
Liebeskind and Opler (1992) analyze an extension of these data maintained by
TRINET Inc., and find that average focus increased during the 1980sfor both
public and private firms. The trend was identified by Lichtenberg (1991), also
using Compustat data, although he attributes it to shifts in reporting tastes.
Managerial discretion is limited by the Financial Accounting Standards Board,
which requires separate accounting for any segment amounting to more than
10% of the consolidated firm’s sales, operating profits, or assets.What discre-
tion remains will affect some measures of focus more than others. Herfindahl
indexes give disproportionately small weight to the smaller segmentsthat may
or may not be reported, and our results hold for these measuresas well as for the
number of segments.
We use Compustat business-segmentdata to calculate five different measures
of focus: (1) the proportion of firms reporting just one segment,(2) the number
of segments reported by management, (3) the number of four-digit SIC codes
assigned by Compustat, (4) a revenue-basedHertindahl index, and (5) an asset-
based Herfindahl index. Compustat assignsas many as two four-digit SIC codes
to each segment. A revenue-based Herfindahl index, Fjt, reflects the degree to
which revenues are concentrated in just a few of a company’s businesssegments.
It is calculated across Nj, segmentsfor thejth firm in fiscal year t as the sum of
the squares of each segment i’s revenue as a proportion of total revenue:

where Xijt is the revenue attributable to a segment. An asset-basedindex is

calculated in the same way using the book value of the identifiable assetsof the
segment. Segment revenue is defined to exclude intercompany sales, interest,
nonoperating income, equity in earnings of unconsolidated subsidiaries, other
income, rental income, gain on sale of securities or fixed assets,discontinued
operations, excise taxes, and royalty income. We calculate changes in focus as
first differences in Fj,.

3. Trend in focus

There is evidence of a trend toward diversification in American companies

over the period 1950-1970. Ravenscraft and Scherer (1987) report that the
proportion of manufacturing industry acquisitions that the Federal Trade
Commission (FTC) characterizes as purely conglomerate in nature rose from
5% of total assetsacquired in 1950-55, to 18% in 1956-63, to 36% in 1964-72,
and fell to 32% in 1973-77. Also, the 471 companies in the FTC’s Line of
 R. Comment, G.A. JarrelllJournal of Financial Economics 37 (1995) 67-87 71

Business Survey increased their average number of lines from under three in
1950 to over sevenin 1975,while the top 200 companies increased their average
number of lines from 4.8 to 10.9.This trend suggeststhat meaningful economies
of scope existed through the 1960s.
Another explanation for corporate diversification is that antitrust restraints
could have channeled growth by domestic firms in the direction of diversifica-
tion (see,for example, Baker, 1992; Matsusaka, 1992).In 1982, the U.S. Justice
Department issued new lenient antitrust guidelines for mergers, essentially
acknowledging a trend in court decisions, and this relaxation could have
contributed to greater focus. Weighing against this story is the fact that corpo-
rate diversification is common in other jurisdictions, such as Japan and Korea,
and White (1988) says that the relaxation did not result in any rush of mergers
among competitors, as one would expect from the lifting of a binding constraint.
Table la documents the average level of focus each year from 1978to 1989for
exchange-listed firms. All measuresshow an increase in focus during this period,
with the largest proportionate increase seen in the proportion of firms with
a single segment, which increased by one-half from 38.1% in 1979 to 55.7% in
1988. (We do not have data for all firms in 1978 or 1989.)The number of SIC
codes assigned by Compustat turns out to average five-thirds of the number of

Table la
Average level of focus among exchange-listed firms covered by Compustat, by year, for focus
measured by the percentage of firms reporting a single business segment, the number of segments
reported, the number of four-digit SIC codes assigned by Compustat, and by asset-based and
revenue-based Herhndahl indexes
- -
Percent Revenue-
with Number of Number of Asset-based based
Fiscal years Number one segments SIC codes Herhndahl Herfindahl
ending in: of firms segment reported assigned index index

1978” 1,703 36.2 2.59 4.17 0.684 0.683

1979 2,008 38.1 2.53 4.09 0.698 0.696
1980 2,~ 38.8 2.50 4.08 0.703 0.701
1981 1,991 40.2 2.45 4.03 0.709 0.707
1982 1,959 40.9 2.42 3.98 0.713 0.715
1983 1,963 41.8 2.38 3.91 0.716 0.721
1984 1,934 43.4 2.30 3.78 0.730 0.731
1985 1,917 46.0 2.20 3.63 0.745 0.748
1986 1,938 50.3 2.08 3.46 0.768 0.769
1987 2,038 53.6 2.00 3.32 0.786 0.788
1988 2,085 55.7 1.94 3.23 0.797 0.800
1989” 557 63.9 1.72 2.95 0.832 0.840

“Our data cover fiscal years ending June 1978through October 1989,so not all firms are included in
years 1978 and 1989.
12 R. Comment, G.A. Jarrelll Journal of Financial Economics 37 (1995) 67L5’7

Table 1b
Comparison of average focus levels in 1979 and 1988 for all firms that were exchange-listed at any
time during 1979-88 and covered by Compustat in either year, by whether firms are in the sample
both years (constant composition) or just one of the years (varying composition), measuring focus by
a revenue-based Herfindahl index

Number Mean

1979 1988 1979 1988 Change T-stat.

.____-. - ..______~
Constant composition 1,272 1,272 0.691 0.744 0.052 8.21
Varying composition 777 638 0.717 0.915 0.198 15.70

Table lc
Average same-firm change in focus over the sample period, by endpoints of the longest period over
which the change can be measured, beginning with 1979and ending with 1988,with focus measured
by a revenue-based Hetlkdahl index, for all exchange-listed Compustat firms

Last year of measurement interval

First year
of inmrval 1980 1981 1982 1983 1984 1985 1986 1987 1988

1979 0.009 0.024 0.024 0.029” 0.057” 0.051” 0.026 0.073” 0.045”
1980 -0.003 -0.021 -0.009 -0.002 -0.017 -0.043 -0.016 -0.018
1981 0.016 0.016 0.015 - 0.029 - 0.009 0.024 -0.014
1982 - 0.029’ 0.013 0.057 0.009 -0.044 -0.019
1983 -0.006 -0.000 -0.051” 0.009 -0.020”
1984 0.007 0.033 0.013 -0.014
1985 0.010 -0.017 0.006
1986 0.003 -0.006
1987 - 0.005

“Reliably different from zero at 5% level for two-tail test.

segmentsreported by management, and both of these focus measuresincreased

by about one-fifth. The two Herfmdahl indexes increased by about one-seventh.
We find that the average level of focus in 1979 is reliably different from the
average in 1988 using a revenue-based Herfindahl index (even though this
measure shows the smallest proportionate increase of the five). The test is
performed in Table lb for two mutually-exclusive groups. The constant-com-
position group includes firms that had Compustat data for the entire period. For
this group, average focus increased from 0.691 to 0.744 (t-statistic of 8.21). The
varying-composition group includes firms that arrived or departed during the
period, and here average focus increased from 0.717 to 0.915 (t-statistic of 15.7).
While arriving firms had relatively high focus and departing firms exhibited
 R. Comment, G.A. JarrelllJournal of Financial Economics 37 (1995) 67-87 13

typical focus levels, the contribution of sample turnover to a trend in focus was
probably not attributable to this fact alone, as it is likely that arriving firms have
always had high focus levels. In the 198Os,however, this tendency combined
with an unusually high rate of turnover to yield a trend. Exchange-listed firms
were delisted due to takeovers at an average annual rate of 4.6% per year from
1980-89 compared to 1.5% per year from 1940-79.’
More-desegregated tests are reported in Table lc. Here, we measure the focus
change for each firm using the longest interval possible within our sample
period, and report averages for groups of firms with common starting and
ending years. All the groups with reliably-positive focus changes had 1979
starting dates (firms in the sample from the start), and none of these groups had
negative average changes. In contrast, none of the groups with post-1979
starting dates had average changesthat were reliably positive. Consequently, the
trend in focus holds for individual firms and is not entirely an artifact of a shift in
sample composition.

4. Wealth effect of focus

The existing evidence on the relation between focus and economic perfor-
mance is inconclusive. Copeland and Weston (1979)cite several studies that find
that the stock-price performance of conglomerate firms dominated that of
mutual funds in the 1960sand early 1970s.In contrast, event studies comparing
buyer stock returns in related versus diversifying acquisitions generally attribute
a small penalty to diversification (see,for example, Eckbo, 1985;Sicherman and
Pettway, 1987;Merck, Shleifer, and Vishny, 1990;Kaplan and Weisbach, 1992).
There is also an extensive literature on the correlation between levels of focus
and accounting-based measures of performance. Chatterjee and Wernerfelt
(1991) review this literature and find no consensus conclusion.
A number of studies consider the effects of focus on Tobin’s 4, the ratio of
a firm’s market value to the cost of replacing its assets.Teece(1982) argues that
firms diversify in order to exploit excesscapacity in some input factor, parti-
cularly management skills. If an input is imperfectly marketable, rents can
accrue to the firm that employs it. These rents are then capitalized in the firm’s
stock price, thereby increasing q. Wernerfelt and Montgomery (1988) and Lang
and Stulz (1993) find a positive correlation between levels of focus and q. Our

r We calculate these annual takeover rates as the number of exchange-listed firms delisted each year
with CRSP delisting codes in the range 200-399, divided by the total number of listed firms as of the
start of the year. This overstates the takeover rate somewhat because some transactions coded as
exchanges (300-399) are reorganizations, not acquisitions. We believe the true takeover rate for
thesefirms in the 1980swas 4.2% per year (Table 4) based on our mergers and acquisitions database,
which begins in 1975.
14 R. Comment, G.A. Jarrelll Journal of Financial Economies37 11995) 67-87

0.08

4.06
-24 -22 -20 -18 -16 -14 -12 -10 -6 4 4 -2 0 2 4 6
MOlltbllddVOtOBndOfpkrlYWOf~

..... . . ____-

Fig. 1. Event-study showing the average wealth effect of focus changes for three groups of firms
segmented by the direction of focus change. The sample consists of fiscal years in the period
1978-1989 for exchange-listed firms. Plotted points represent, for each group of firms, the average
month-by-month value of a %l initial investment in the firm lessthe corresponding month-by-month
value of a $1 initial investment in the CRSP equally-weighted market portfolio. Month zero is
defined as the last month of the fiscal year of the change in focus. Focus is measured by a Herhndahl
index definedon revenue. There are 5,088fiscal-years with increases in the Herfmdabf index, 4,469
with decreases,and 7,056 with no change.

evidence (in Table 3) that asset turnover is higher at diversified firms suggests
that book values will be marked to market more frequently at diversified firms,
which could reduce 4 (as conventionally measured) and thus cause a positive
correlation between focus and 4.
Before turning to our regression tests of the relation between focus changes
and stock returns, we use Fig. 1 to illustrate that our main conclusions hold on
average. Fig. 1 is constructed by forming three groups according to the direction
of the change in focus as measured by the revenue-based Herfindahl index, and
shows cumulative net-of-market wealth relatives in event time, from 30 months
before the last month of the year in which the focus change is measured (month
zero of the bottom axis) to three months after. To get the running value of a $1
initial investment, we compute wealth relatives (one plus the monthly return) for
each firm and cumulate these multiplicatively to refIect reinvestment. Each
month, the corresponding wealth relative for the market portfolio is subtracted
and the resulting net wealth relatives are then averaged and plotted. In ef%ct,the
only factor for which explicitly control is the general market return, with beta
 R. Comment, G.A. JarrelllJournal of Financial Economics 37 (1995) 67-87 15

assumedequal to unity. The best average performance is seen among the firms
experiencing increasesin focus, and the worst performance occurs for firms that
decreasedtheir focus. The difference in net return over 34 months between the
focus-increaseand the focus-decreasegroups is 7.4%. The statistical significance
of the relation between focus and stock performance is established more reliably
in the multivariate regression tests reported below, but a comparison of group
means is possible with the data in Fig. 1. Based on wealth relatives as of month
3 (three months after the end of the fiscal year of the change in focus), the average
for the focus-increase group (mean = 0.024, n = 5,088) is statistically signifi-
cantly greater (t-statistic 4.11) than the average for the focus-decreasegroup
(mean = - 0.050, n = 4,469).
Our formal analysis correlates fiscal-year changes in focus with both same-
year stock returns and prior-year returns, using a multivariate, pooled, time-
series cross-sectional regression covering about two thousand exchange-listed
firms per year. We replicate our analysis using prior-year returns becausefocus
changes could be announced or anticipated in the year before they take effect.
Fiscal-year returns are compound CRSP monthly returns, including dividends.
We get net-of-market estimates of wealth changes by including in our regres-
sions the average return of (1) all exchange-listed firms in the market and (2) all
other exchange-listed firms in the same industry, less the market average. The
net-of-market industry return is set to zero if less than three other companies
have the same SIC code. Industry classifications are based on the two-digit SIC
code of a firm’s primary business segment reported by CRSP.
We control for fiscal-year changes in total revenue, total assets,and earnings
from continuing operations in the expectation that the wealth effectsof changes
in focus are secondary to the effects of operating performance. To render these
accounting measurescomparable across firms and time, we denominate annual
dollar amounts as fractions of the beginning market value of common stock.
We control for the wealth effects of large acquisitions and divestitures by
including dummy variables defined on (1) firm-years with acquisitions valued at
$100 million or more and acquisitions of exchange-listed firms of any size,
(2) divestitures valued at $100 million, and (3) firm-years with both types of
events. The acquisition and divestiture data come from IDD Information
Servicesand cover transactions announced in the period 1980-90. Information
on acquisitions of exchange-listed firms comes from our proprietary mergers
and acquisitions (M&A) database, which is derived from various keyword
searchesof the Dow Jones News/Retrieval database,as well as from inspection of
the Wall Street Journal Index and Commerce Clearing House’s Capital Changes
Reporter (the original source for CRSP delisting codes).
Table 2 reports regression results for same-year returns and prior-year re-
turns using four different measuresof focus. Change in focus is reliably positively
associated with same-year and prior-year stock returns for every measure of
focus. Using the revenue-based Herfindahl index, the sum of the estimates for
R. Comment, G.A. Jurrelil Journal of’ Financial Economics 37 (1995) 67-87

‘.

, -
c

i
:
,
Change in total revenue 0.03 0.05 0.03 0.05 0.03 0.05 0.03 0.05
(6.95) (14.9) (6.93) (15.1) (6.97) (15.1) (7.08) (15.2)
Change in total assets 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
(11.7) (13.0) (11.7) (13.1) (11.7) (13.0) (11.8) (13.1)
Change in earnings 0.06 1.35 0.06 1.35 0.06 1.35 0.06 1.35
(1.41) (31.5) (1.44) (31.5) (1.43) (31.5) (1.39) (31.5)
Dummy for acquisitions (only) 0.02 0.01 0.02 0.01 0.02 0.01 0.02 0.01
(1.01) (0.64) (0.98) (0.64) (1.W (0.68) (1.W (0.W
Dummy for divestitures (only) 0.02 0.13 0.02 0.13 0.02 0.13 0.02 0.13
(0.75) (5.49) (0.78) (5.39) (0.80) (5.46) (0.73) (5.44)
Dummy for both in same year 0.00 0.02 0.00 0.02 0.00 0.03 0.00 0.03
(0.02) (0.52) (0.02) (0.51) (0.06) (0.59) (0.06) (0.61)
R-square 0.267 0.330 0.267 0.330 0.267 0.330 0.267 0.331
N 16,565 17,135 16,562 17,132 16,565 17,135 16,565 17,135

Each of the four panels uses a different measure of focus (OLS estimates pooling firm-years, t-statistics in parenthesis). Dummy variables indicate years
with large divestitures or acquisitions.
78 R. Comment, G.A. Jarrelll Journal of Financial Economics 37 (1995) 67-87

the two years indicates that an increase in focus of 0.1 is associated with an
additional stock return of 4.3% (2.9O/ in the same year and 1.4% in the prior
year). Similarly, an increase in the asset-basedHerfindahl index of 0.1 yields
a 3.5% increase in wealth over two years; a reduction of one in the number of
SIC codes assigned by Compustat (indicating higher focus) yields a 3% increase,
and a reduction of one in the number of segments yields a 5% increase.
Divestitures (with no acquisition in the same year) are associated with an
additional stock return of 13% in the same year and 15% over two years, while
acquisitions are associated with average returns that are positive but not
reliably greater than zero, whether or not they are accompanied by divestitures
in the same year. These gains are larger than those reported in event studies,
perhaps because our transactions are larger or because our return interval is
longer.
These estimates of the wealth effectsof focus could be biased upward by our
inclusion of accounting-based measuresof performance if measurement error in
the accounting variables is negatively correlated with change in focus. In fact,
our coefficient estimates for focus change are only reliably positive in regressions
that include one or another of these accounting measures.In particular, divesti-
tures have a tendency to generate both an increase in focus and a negative
measurement error in the change in revenue (amounting to the revenue of the
divested operation over the post-divestiture part of the fiscal year). Algebraic-
ally, this implies an upward bias in our estimated wealth effect of focus, as focus
increases tend to be observed in those fiscal years (with divestitures) when the
measured change in revenue underpredicts the stock return. Another way of
stating this is that, based on a multitude of event studies, we know that sellers of
corporate assets tend to capture the gains from trade. If these transactions
incidentally increase focus for sellers (or reduce it for buyers) on average, then
our wealth effect is preordained to some degree. This upward bias is mitigated
by our inclusion of dummy variables for fiscal years with significant acquisitions
and divestitures, and our reported estimate is otherwise robust, but this bias
nevertheless implies that the wealth effects of focus changes might be smaller
than we estimate.
Our estimates are essentially unchanged when we exclude firm-years with
acquisitions or divestitures instead of introducing dummy variables for these
events, and unchanged when we include these casesbut allow the intercept and
focus estimates to differ in fiscal years with these events. Our data on acquisi-
tions and divestitures are limited to transactions exceeding $100 million in
value, and smaller transactions could matter for small firms, but our estimate is
more positive when we include just large firms (the one-quarter of our sample of
firm-years for which a firm’s market value of common stock exceeds $500
million), and remains reliably positive among large firms when we omit all three
of the accounting-based measures of performance. In other unreported regres-
sions, estimates of a positive relation between wealth changesand focus changes
 R. Comment, G.A. Jarrell/Journal of Financial Economics 37 (199.5) 67-87 19

do not differ materially when regressions like those in Table 2 are replicated
for various subsets of the sample (i.e., by survivorship, firm-size quartile,
half-decade, by initial focus level, or by the direction of the change in focus).
Because stock returns are correlated with total revenue, another kind of
spurious correlation could arise when we use a revenue-basedHerfindahl index
to measure focus. Both wealth and a revenue-based Herfindahl index of focus
will tend to increase when the primary segment does surprisingly well, inflating
our estimate of a (positive) causal relation between them. An offsetting negative
bias arises when surprising performance occurs in ancillary segments instead,
but the net effect could be positive. This problem also arises with a Herfindahl
index based on assets(becauseassetschange with earnings and earnings affect
realized returns), but the number of segmentsand the number of SIC codes are
less likely to change with surprising financial performance, and our conclusions
do not depend on the measure of focus we use. Moreover, the problem only
applies to same-year returns, not prior-year returns.

5. Focus and M&A activity

Table 3 reports frequency statistics to see whether diversified firms were

relatively likely to participate in the market for corporate control in the 1980sas
buyers or sellers of assets and subsidiaries. Our data on acquisitions and
divestitures are described in Section 4. Large divestitures occurred during 2.8%
of all firm-years, and large acquisitions during 4.9% of all firm-years, based on
all exchange-listed firms for fiscal years beginning 1980-89. These frequencies
exhibit a pattern when the sample is broken down by the level of diversification
at the beginning of the year. Firms with just one segment divested in 0.8% of
their years, those reporting five segmentsdivested in 6.7%, and firms reporting
six or more segmentsdivested in 12.7% of their firm-years. Confirming this, the
acquisition frequency exhibits the samepattern as the divestiture frequency: the
corresponding values are 2.7%, 10.9%, and 13.5%. This is not just a size effect.
Frequencies are uniformly higher for large firms, but association with focus
persists. Large firms with just one segment divested in 2.6% of their firm-years,
those reporting five segmentsdivested in 11.5%, and those reporting six or more
segmentsdivested in 18.8% of their firm-years, with corresponding acquisition
frequencies of 8.6%, 17.5%, and 20.5%. Table 3 also shows that both divesti-
tures and acquisitions were more frequent during the second half of the 1980s
than during the first half, approximately doubling for each category of focus.
If diversification is inefficient, diversified firms should have been likely take-
over targets in the 1980s.Table 3 reports the frequency with which diversified
and focused firms were the targets of unsolicited merger proposals or un-
negotiated tender offers, and the frequency with which they were successfully
acquired. We get this information from our M&A database (described earlier).
Table 3
Percentageof firms involved in the market for corporate control per year in the period 1980-1990, by the level of focus at the start of the year (measuring
focus as the number of segmentsreported) for all exchange-listed firms, for those with market values of equity exceeding $500 million at the start of the
year, and for two time periods

Subgroup of firm-years where initial capitalization exceeds

All exchange-listed firms $500 million
-
% %
Number of Firm- % % % hostile % Firm- % % % hostile %
segments years sellers buyers either offers bought years sellers buyers offers bought
___. -__-
8,880 0.8 2.7 3.4 3.0 4.6 1,647 2.6 8.6 10.6 1.8 1.7
2 3,548 1.9 3.4 4.9 2.7 4.3 709 6.5 10.4 15.1 1.8 2.8
3 3241 3.7 6.2 9.3 3.4 4.2 1,058 8.4 13.7 20.2 2.0 2.4
4 2,048 5.8 8.4 12.9 3.2 3.2 908 10.5 15.6 23.3 3.2 2.6
5 1,015 6.7 10.9 16.3 3.4 3.2 486 11.5 17.5 26.5 2.7 2.5
6-10 764 12.7 13.5 22.8 3.3 3.4 464 18.8 20.5 33.8 3.2 2.8
Total 19,516 2.8 4.9 7.1 3.1 4.2 5,272 7.9 12.9 39.1 2.3 2.3
..__--. __.
 Subgroup of fiscal years beginning l/80-12/84 Subgroup of fiscal years beginning l/SS-1 l/89
~ ~__..~ ~~~ __ ..-~-
% %
Number of Firm- % % % hostile % Firm- % % % hostile %
segments years sellers buyers either offers bought years sellers buyers either offers bought
~~ ~___
1 3,956 0.3 1.9 2.1 1.9 4.1 4,924 1.3 3.4 4.4 3.8 4.9
2 1,819 0.6 2.1 2.6 1.8 4.2 1,749 3.3 4.7 7.3 3.7 4.4
3 1,743 1.4 3.7 5.0 2.2 3.9 1,498 6.3 9.1 14.2 4.7 4.6
4 1,189 2.5 5.9 8.1 2.1 3.0 859 10.2 11.9 19.7 4.8 3.5
5 623 3.2 8.8 11.2 2.7 2.9 392 12.2 14.3 24.2 4.6 3.6
6-10 491 9.2 11.0 17.3 3.1 3.5 273 19.0 17.9 32.6 3.7 3.3
Total 9,821 1.4 3.6 4.8 2.1 3.8 9,695 4.2 6.1 9.4 4.1 4.6

Sellers include firms with divestitures exceeding %lOOmillion in value. Buyers had a purchase exceeding $100 million or acquired an exchange-listed firm of
any size. Either is less than the sum of buyers and sellers because some firms are both buyers and sellers in the same fiscal year. Hostile ofJers are firms that
received unsolicited merger proposals or unnegotiated tender offers, without regard to success. Bought firms are those that are successfully acquired or
merged, without regard to friendliness.
82 R. Commenr, G.A. JarrellJ Journal qf Financial Economics 37 (1995) 67-87

We define targets without regard to outcome, so that not all targets are
acquired. Announcements of merger agreementsand negotiated tender offers do
not qualify a firm as a target because we want the target category to include
instances where public pressure (including share acquisition by arbitragers) is
brought to bear on management prior to the conclusion of merger negotiations.
Acquisitions are defined without regard to how the firm is put into play, so that
not all acquisitions are classified as targets. In Table 3, the column for targets is
labeled as ‘% hostile offers’ and the column for successfulacquisitions is labeled
as ‘% bought’.
Exchange-listed firms were targeted at a rate of 3.1% per year and successfully
acquired at a rate of 4.2% per year. Focused firms were more likely to be
acquired (4.6% for single-segment firms compared to 3.4% for six or more
segments).There was little difference, however, in the frequency in which firms
were targeted (3.0% for pure-play firms compared to 3.3% for six or more
segments).Among large firms, diversification increased the likelihood of receiv-
ing an unnegotiated takeover offer. Large, pure-play firms were targeted in 1.8%
of all firm-years, while large firms reporting six or more segmentswere targeted
in 3.2% of all firm-years. It seems that large, focused firms were relatively
immune from hostile takeover attempts during the 1980s.

6. Focus and internal capital markets

Williamson (1986) argues that internal capital markets can dominate external
capital markets by allowing a better allocation of capital across competing uses,
better sharing of inside information, and better post-investment control. Man-
agers can broaden their internal capital market and gain these economies by
diversifying. Bhide (1990) suggests that improvements in the efficiency of
external capital markets in the 1980sshould then imply reductions in diversifica-
tion, helping to explain the trend toward focus during the 1980s.These argu-
ments imply that, by relying on inter-segment transfers of cash, diversified firms
can limit their overall reliance upon and interaction with external capital
markets.
We consider three measures of the degree of a firm’s reliance on external
capital markets. Two make use of data from flow-of-funds statements (from
Compustat) detailing the amount of cash that passesannually between a firm
and the capital market, both inflow and outflow. To make them comparable
across firms, these amounts are denominated as percentages of the value of
financial claims at the start of the year, calculated as the market value of equity
plus the book values of long-term debt, short-term debt, and preferred stock.
Cash inflow includes long-term borrowings and any proceeds from the sale of
common or preferred stock, but not the proceeds of asset sales which would
render this a proxy for assettransactions more than capital-market transactions.
 R. Comment, G.A. JarreN/Journal of Financial Economics 37 (1995) 67-87 a3

Table 4
Average financial ratios by level of focus, including the average annual cash inflow or cash outflow
between the firm and external capital markets as percentages of initial financial liabilities, debt as
a percentage of financial liabilities, and short-term debt as a percentage of total debt, with focus
measured as the number of reported segments and as a Herhndahl index defined on revenue, for
exchange-listed firms in the period 1978-1989

Short-term Debt
Number of Number of Cash Cash debt as a as a %
segments firm-years inflow outflow % of debt liabilities

1 8,930 10.1 8.9 26.8 33.5

2 3,697 9.8 9.2 23.6 34.3
3 3,369 9.5 9.0 22.1 34.3
4 2,230 8.6 9.3 21.9 33.9
S-10 1,963 9.5 10.2 20.5 38.2

Short-term Debt
Revenue Number of Cash Cash debt as a as a %
Herfindahl firm-years inflow outflow % of debt liabilities

1 8,943 10.1 8.9 26.8 33.5

0.750-0.999 1,548 10.7 9.3 25.8 38.4
0.50&0.749 4,477 9.4 9.1 22.3 34.2
0.250-0.499 4,582 9.0 9.5 21.5 33.7
0.250 639 9.0 9.8 18.9 39.8

Cash outflow includes payments of interest and principal on debt, cash divi-
dends on preferred and common, and security repurchases.The third measure of
reliance on external capital markets, the percentage of debt that is due to be
repaid within the next fiscal year, indicates proximity to renegotiation.
Table 4 shows that cash inflow does fall with diversification, but only from
10.1% for single-segment firms to 9.5% for firms reporting five or more seg-
ments. Meanwhile, cash outflow increasesfrom 8.9% to 10.2% for these groups,
so these two measuresshow small and contradictory effects.The third measure
likewise shows little insulation from external capital markets, although the
percentage of debt that is due in a year does decreasefrom an average of 26.8%
for single-segment firms to 20.5% for firms reporting five or more segments.
Elsewhere in Table 4, only small differencesare observed when the subgrouping
is based on a revenue-basedHerfindahl index instead of the number of reported
segments,and the patterns across groups are not generally uniform. On average,
diversification does not appear to result in a meaningful substitution of in-house
transactions for arms-length transactions. The economic benefits to a firm from
having an internal capital market thus do not seemto include a reduction in its
reliance on the external capital market, although there could be other benefits.
84 R. Comment, G.A. Jarrelll Journal of Financial Economics 37 11995) 67- 87

7. Focus, leverage, and risk

Combining businessesthat have imperfectly-correlated earnings streams re-

duces the variability of earnings for the combination. Lower risk is probably not
valuable per se to shareholders, who can diversify on personal account by
holding portfolios of stocks. The ability of investors to diversify on personal
account has probably increased in recent years due to reductions in transactions
costs and growth in the mutual fund industry, and this could have reduced the
rationale for corporate-level diversification. Levy (1991) argues that the ability
of shareholders and financial intermediaries to construct portfolios of choice can
be diminished by corporate-level diversification. For example, the combination
of U.S. Steel and Marathon Oil as USX reduced the investment opportunities
available to shareholders to just the shares of USX, while the recent split into
two classesof stock, steel and oil, restored to shareholders a choice in how they
apportion any investment between these two businesses,while preserving any
financial or operating synergies at the corporate level.
Reduced variability of earnings can lead to planning and operating advan-
tages for a firm, and can increase its debt capacity by reducing expected default
rates. This claim, usually attributed to Lewellen (1971), predicts that diversified
firms will use more debt by virtue of the reduction in default rates that comes
with diversification (coinsurance of corporate debt). Amihud and Lev (1981)
argue that managers benefit from the risk reduction associated with corporate
diversification becausethey suffer less employment risk. By reducing volatility,
corporate diversification can potentially increase firm value by cutting agency
costs. Stulz (1990) argues that greater cash flow volatility increases the agency
costs of managerial discretion, and hence reduces firm value. This reduction in
value occurs because the more volatile or uncertain are future cash flows, the
harder it is to identify and maintain an optimal capital structure that balances
the costs of overinvestment due to too little debt [Jensen’s (1986) free cash flow
problem] and the costs of underinvestment due to too much debt, as described
in Myers (1977).
As a rough test of whether diversification increases debt capacity or usage,
Table 4 reports average leverage (the book value of debt denominated as
a percentage of the sum of the market value of common stock and the book
values of debt and preferred stock) by focus subgroups. The average leverage
ratio lies in a range of 33-34% for all but three groups. It does rise to about
38-40% for the most-diversified group, based on either of the two measures of
focus that we use here, but it also reaches this level for the (high-focus) group
with revenue-based Hertmdahl indexes in the range of 0.75 to 0.99. The eco-
nomic significance of the difference is not large in any event. These results can be
interpreted to mean either that diversification does not increase debt capacity or
that managers of diversified firms do not choose to exploit their greater debt
capacity.
 R. Comment, G.A. Jarrell/Journal of Financial Economics 37 (1995) 67-87 85

Table 5
The dependence of risk on focus, leverage, size and industry, for exchange-listed firms in the period
19781988

Dependent variable

Beta Sigma

Constant 0.720 0.071

(30.3) (82.1)
Focus level - 0.027 0.005
( - 1.71) (9.37)
Log of firm size 0.055 - 0.006
(21.5) - 60.7)
Debt ratio 0.063 0.017
(3.19) (24.1)
R-square 0.113 0.320
N 19,952 19,953

Beta is the coefficient estimate from a market-model regression of the stock return on the return
on the CRSP value-weighted market portfolio, and sigma is the standard deviation of the residuals
from this regression, estimated using weekly returns during the fiscal year. A total of 26 indus-
try dummy variables are included but their coefficients are not shown. Focus leuel is the rev-
enue-based Hertindahl index, debt ratio is the book value of long-term debt and preferred stock
divided by the same plus the market value of equity, and log o~jirm size is the market value of
common stock (in $ millions), each defined as of the start of the fiscal year (OLS regressions,
t-statistics in parentheses).

Finally, we document whether diversification affects systematic risk (beta)

or firm-specific risk (sigma). Table 5 presents pooled time-series cross-sec-
tional ordinary least squares regressions of risk levels on various explana-
tory variables measured as of the beginning of the risk-measurement period,
including focus level, firm size (market value of equity), debt/equity ratio
(the ratio of book value of long-term debt and preferred stock to the sum of
the same plus the market value of equity), and industry factors (26 dummy
variables for the most common two-digit SIC codes, the coefficients of which
are not reported). Beta is computed using a single-factor market model based
on a year’s worth of weekly returns and sigma is the standard deviation of
the residuals from this regression. We find that sigma increaseswith the level of
focus as is expected from the effectsof diversification, but that there is no reliable
relation between equity beta and focus. A firm’s overall beta should be a
weighted average of the betas of its individual businesses,and thus unrelated to
focus, so Table 5 holds no surprises.
86 R. Comment, G.A. Jarrelll Journal of Financial Economics 37 1199.5) 67-87

8. Conclusion

The 1980s witnessed a reversal among American public firms of an earlier

trend toward diversification. We find that the increase in focus measured across
exchange-listed firms during the 1978-89 period is consistent with shareholder
wealth maximization, implying that focus increased in the 1980sin part because
economies of scope were negative on balance during the decade.This conclusion
gains further support from our finding that some commonly-cited economies of
scope go unrealized: corporate debt is not a meaningfully greater proportion of
capital when debt payments are coinsured by diverse cash flows, and transac-
tions in external capital markets are no less prevalent when internal capital
markets are made available or enhanced through corporate diversification.
While there is some evidence that large, focused firms were relatively immune
from takeover attempts during the 1980s consistent with economies of scope,
focus had a much more pronounced effect on rates of participation in the market
for corporate control in that diversified firms were much more active than
focused firms as buyers and sellers of corporate assets.

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