Strategic Management Journal, Vol.

2, 327-343 (1981)

Corporate Economic Performance:

Diversification Strategy Versus Market
Structure
H. KURT CHRISTENSEN
Krannert Graduate School of Management, Purdue University, West Lafayette, Indiana
U.S.A.

CYNTHIA A. MONTGOMERY
Graduate School of Business Administration, The University of Michigan, Ann Arbor,
Michigan, U.S.A.

SUM MARY

This paper incorporates both diversification strategy and market structure variables in a study of
corporate economic performance. A subsample of 128 firms from Rumelt’s 1974 study was
updated and utilized to investigate the possibility that market structure variables might moderate
or confound the diversification/performance relationship he reported. Study results indicate that
performance differences could be demonstrated for some of Rumelt’s categories, but, across the
range of categories, a hypothesis of performance differences was rejected. As expected, categories
associated with distinctly high or distinctly low economic performance were also associated with
significant differences in a series of market structure variables.

Researchers from several disciplines have sought to identify factors which influence
corporate economic performance. Strategic management researchers have sought to
relate corporate economic performance to the major direction-setting decisions made
by the firm. For a new and growing firm, these decisions frequently relate to the degree
and manner in which its product line and served market should be extended. For an
older firm which wishes to continue to grow, the key decisions generally relate to the
degree and manner in which it should diversify into different businesses (Chandler,
1962; Scott, 1971).
Starting from a very different perspective, researchers in industrial organization
economics have been guided by a conceptual framework which examines possible
relationships among (1) the structure of the industry (or industries) in which the firm
operates, (2) the conduct of the firms within that industry, and (3) the level of economic
performance both of the individual firms and of their Associated industries. This effort
has yielded an extensive literature, much of which supports the proposition that firm
profits are strongly influenced by the structure of the market or markets in which the
firm operates (Scherer, 1970).
These two streams of research have developed in large measure independently of
each other. It is the purpose of the present research to incorporate both diversification
strategy and market structure variables in a study of corporate economic performance.
0143-2095/8 1/040327-17$0 1.70 Received 27 August 1980
0 1981 by John Wiley & Sons, Ltd. Revised 19 March 1981
328 H . Kurt Christensen and Cynthia A . Montgomery

OVERVIEW OF STUDY AND HYPOTHESES

The publication of Richard P. Rumelt’s book, Strategy, Structure, and Economic

Performance in 1974represented a watershed in the study of diversification strategy. In
that work, Rumelt made two major contributions. First, building on the earlier work of
Wrigley (1970), he developed a nine-category measure of diversification strategy.
Second, he demonstrated a statistical linkage between diversification strategy and
economic performance.
In assigning companies to a diversification strategy category, Rumelt utilized three
ratios, the latter two of which he developed specifically for his study:
1. Specialization ratio: ‘The proportion of a firm’s revenues that can be attributed
to its largest single business.’ (Rumelt, 1974:14)
2. Related ratio: ‘The proportion of a firm’s revenues attributable to its largest
group of related businesses.’ (Rumelt, 1974:16)
3. Vertical ratio: ‘The proportion of the firm’s revenues that arise from all by-
products, intermediate products, and end products of a vertically integrated
sequence of processing activities.’ (Rumelt, 1974:23)
By developing measures of relatedness and verticality, Rumelt overcame some of the
limitations both of Wrigley’s four-category scheme and of product-count measures
employed in industrial organization economics studies of diversification, (Rumelt’s
categories are defined in Appendix A.)
Utilizing the improved classification scheme and multiple measures of economic
performance, Rumelt found that seven of his nine diversification categories clustered
into high, medium and low performance groups. A summary of Rumelt’s findings
appears in Tables 1 and 2.
It is noteworthy that both categories classified as high performers diversified by
building on a single strength or resource associated with the original business
(constrained diversification). The low performers, on the other hand, reflected both
sides of the diversification spectrum. The unrelated passive firms are among the most
highly diversified in the study, while the dominant vertical firms were far less diversified.
Rumelt’s work has commonly been interpreted to mean that various diversification
profiles lead to varied performance levels. However, the correlational nature of
Rumelt’s results cannot support such conclusions, a caution Rumelt himself noted
(1 974: 156). Beyond the difficulty of establishing causality scientifically, the linkage has
not been examined rigorously for potential moderating or confounding effects. That is,
rival explanations for the observed linkage have not been ruled out. In particular,
research from industrial organization economics raises the possibility that market
structure variables account for some or all of the differences Rumelt observed between
diversification strategy and corporate economic performance.
The present study draws five rival explanations from industrial organization
economics for the observed relationship between diversification strategy and firm
performance. Most of these explanations are related to the firm’s environment, and
specifically to the characteristics of the markets in which they participate. These
potentially moderating or confounding variables are market share, market
concentration, market growth, market profitability and absolute firm size. Table 3
presents a summary of representative findings on the relationship between these
variables and firm or industry profitability.
Table 1. Financial characteristics of the strategic categories

Sales Earnings Earnings Relative Price/ Return Return Equity/ Internal Risk
growth growth per share standard earnings on on capital financing premium
growth deviation ratio capital equity ratio ratio ratio
of EPS

Est. category means:

Single 7.17-- 4.81--- 3.92-- 16.13- 14.60--- 10.81 13.20 0.781 0.580 0.378--
Dominant-vertical 7.42-- 7.34- 5.14- 22.79 15.68-- 8.24--- 10.18--- 0.724--- 0.662- 0.329---
Dominant-constrained 9.48 9.08 7.60 23.15 15.92 12.71+++ 14.91'' 0.807' 0.609-- 0.658"
Dominant-linked-unrelated 6.93 8.10 6.1 1 16.63 15.41 8.69 10.28 0.758 0.601 0.221 -
Related-constrained 9.62 10.39'' 8.56+++ 15.91-- 19.19'" 11.97+++ 14.11"' 0.800" 0.729 0.775"'
Related-linked 8.06 7.15 5.57 17.58 19.27'" 10.43 12.28 0.798 0.681 0.451
Unrelated-passive 6.10- 7.78 5.96 20.90 13.77-- 9.40 10.38- 0.830' 0.616 0.357-
Acquisitive-conglomerate 20.64'" 18.64'" 9.46' 39.28+++ 17.43 9.56 13.13 0.591--- 1.970'" 0.516
9
Est. overall mean 9.01 8.72 6.57 20.11 17.02 10.52 12.64 0.769 0.732 0.516
-2
Est. residual u 6.06 8.73 8.02 18.63 5.45 5.05 5.33 0.142 0.400 0.456
2
Partial R 2 (per cent) 20.00 11.41) 5.50 8.80 10.30 9.40 9.60 13.00 36.40 7.40
:
a
~ h
Sig. F,-ratio test 0.001 0.001 0.005 0.001 0.005 0.001 0.001 0.001 0.015 c,
- ~ 0
Sig. F,-ratio test - -
0.05 0.1 0.001 0.001 0.005 0.025 3
~~

The F-ratio was used to test the hypothesis that category effects were zero (all category means are equal). The F,-ratio was used to test the hypothesis that category effects are 2.
zero if the acquisitive-conglomerate category is excluded. The table shows the significance levels at which these hypotheses can be rejected.
Source: Richard Rumelt, Strategy, Structure, and Economics Performance, Harvard University Press, Cambridge, Massachusetts, 1974, p. 92. Reprinted by permission.
Estimated mean values of the Equity/Capital Ratio, Internal Financing Ratio, Price/Earnings Ratio, and Risk Premium Ratio are expressed as ratios. All others are expressed
as percentages. The plus or minus signs following an estimated category mean indicate that it differed significantly (' +' for a positive deviation, ' -' for a negative deviation) s2
from the overall mean (t-ratio test). One sign indicates a deviation significant at the 0.1 level, two signs indicate the 0.5 level, and three signs the 0.01 level.
Each of the performance variables is defined in Rumelt, 1974, pp. 168-70. 3
h
a

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330 H . Kurt Clwistensen and Cynthia A . Montgomery

Table 2. Strategy performance in Rumelt's study

Strategy performance

High Medium Low

Dominantconstrained Related-linked Dominant-vertical

Related-constrained Single Unrelated-passive
Acquisitive-
conglomerate

(Two of Rumelt's categories, dominant-linked and dominant-unrelated,

were not clearly associated with any cluster.)
Source: Richard Rumelt, Straregy, Structure, and Economic Performance,
Harvard University Press, Cambridge, Massachusetts, 1974, p. 94.
Reprinted by permission.

Table 3. A selected listing of research studies investigating the relationship between

firm or industry performance and market structure variables

Market Market Market Firm

share concentration growth size

Gutmann (1964)
53 firms +
Hall and Weiss (1 967)
341 firms + 4
Collins and Preston (1968)
20 2-digit, 21 3 4-digit
industries +
Miller ( 1 969)
106 minor IRS industries +
Shepherd (1972)
231 firms + + -
Gale ( 1972)
106 firms + + +
Bass (1973)
97 food firms + +
Meehan and Duchesneau ( I 973)
186 firms in 32 4-digit
industries i-
Rhoades (1973)
241 4-digit industries + +
Dalton and Penn (1976)
97 food firms + + - +
-
Patton (1976)
Firms in U.S. brewing
industry, 1952-1971 k
Bass, Cattin, and
Wittink (1978)
63 firms + *
+ indicates a positive correlation with performance
- indicates a negative correlation with performance
+ indicates mixed results; correlations in both directions
-
 Corporate Economic Performance 331

This study hypothesized that systematic differences in market structure variables

would be found across Rumelt’s strategy categories. In particular, it was expected that
Rumelt’s high performers would possess more favourable market characteristics (e.g.
higher market shares), and his low performers would possess less favourable market
characteristics (e.g. lower market shares) than other firms in the sample.
Specifically, it was expected that

A. Constrained diversijiers have larger weighted market share indices,‘ and

unrelated diversijiers have smaller weighted market share indices than other
firms in the sample.

This expectation is consistent with the types of diversification these firms have
pursued (narrow versus broad) and with the research which indicates that firms with
large market shares are better performers than firms with small market shares
(Shepherd, 1972; Bass, 1973; Buzzell et ul., 1975; Bass et al., 1978).

B. Constrained divers$ers are located in more highly concentrated markets, and

unrelateddiversijiersin less concentratedmarkets than otherfirms in the sumple.

It is reasonable to expect that some markets are more conducive to specialization

than others, and that, in turn, those markets will be more concentrated than markets
where specialization is not as advantageous. Alternatively, high market shares (which
by definition are more likely to occur in highly concentrated markets) could encourage
firms to maintain constrained product lines and to reap the advantages therein.
A positive relationship between market concentration and profitability has been
shown in many studies, including Collins and Preston (1968); Miller (1969); Gale
(1972), and Dalton and Penn (1976).

C. Constrained diversijiers’ markets are growlingfaster than those of other firms in

the sample, and unrelated divers$ers’ markets are growing slovivr than those of
other firms in the sample.

The expectation is in line with Bass’ ‘defensive diversification’ conclusion where growth
was found to be a significant correlate of success for firms with little diversification and
not a significant correlate for highly diversified firms (Bass e f ul., 1977:193).
Among others, the following work has shown a positive relationship between growth
of served markets and firm or industry profitability: Gutmann (1964); Rhoades (1973),
and Bass et al. (1978).

D. Constrained diversijiers are located in more profitable markets, and unrelated

diversifiers in less profitable markets than other firms in the sample.

The expectation that profitable firms will be located in profitable markets seems to be
intuitive, yet few rigorous studies have demonstrated this point. The Strategic Planning
Institute’s work with the PIMS database is probably the best known work leading to
this conclusion (Schoeffler, 1977). Additionally, in an extension to Strategy, Structure,

Variable definitions are given in Appendix B

332 H . Kurt Cliristensen and Cjntliia A . Monigomerj>

and Economic Performance, Rumelt reported that market profitability varied among
strategy categories, and that the profitability associated with constrained firms’
markets was higher than that associated with the markets of other types of diversifiers
(Rumelt, 1977).

E. On average, unrelated diversifiers are larger, and constvained-diversifiers are

smaller than other f i r m s in the sample.

This finding would be consistent with economists’ suggestion that non-maximization

of profits can result when large firm size leads to inefficiency, poor communication,
slow reaction time, etc.
Empirical research on the relationship between firm size and profitability has
produced conflicting results (for example, see Hall and Weiss, 1967; Shepherd, 1972;
Dalton and Penn, 1976; Bass et al., 1978). Hence, past evidence in support of this
hypothesis is not strong. However, because the relationship is problematic, its potential
influence should be evaluated.
Unless one or more of these’hypotheses can be rejected, one must admit the
possibility that the relationships Rumelt observed between diversification strategy and
performance were in some part due to differences in one or more of these structural
variables.

TIME FRAME A N D SAMPLE COMPOSITION

The present work focuses on the time frame from 1972-1977. The focus was guided by
the availability of market share data and necessitated the updating of Rumelt’s
classifications up to 1977. The updating process itself became an integral part of the
research, providing an opportunity to evaluate both the inter-rater reliability of
Rumelt’s 1974 classifications and the reproducibility of his results in a different time
frame.
Financial constraints related to the procurement of market share data’ prohibited
the study of firms in all ten of Rumelt’s strategy ~ a t e g o r i e sSelection
.~ among the ten
was based on the significance each category played in Rumelt’s overall conclusions (see
Table 2).
Both of the high performing categories (dominant-constrained and related-
constrained), and two of the medium performers (related-linked and single business)
were included. The selection of these categories, along with the dominant-linked,
allowed for a comparison between constrained and linked diversifiers. A choice
between the low performers led to a selection of the unrelated portfolio category which
included most of the firms which had previously been designated as unrelated-passives.
It was judged that unrelated portfolio firms would represent best the high end of the
diversification continuum (additionally, the selection decision was influenced by the
imprecision involved in determining the diversification status of vertically integrated
firms.)

* This study utilized the market share data of Economic Information Systems available through the
Lockheed Dialogue System. These data are subdivided by 4-digit S.I.C. category.
In 1977 Rumelt slightly revised his original classification system of nine strategy categories. A working
paper, ‘Diversity and profitability’ details this change.
 Corporute Economic Pc>rfhrr?iuncv 333

For classification decisions, this study made use of line-of-business data reported in
Securities and Exchange Commission Form 10-Ks and in company annual reports.
Regulations requiring companies to report some data at the line-of-business level were
put into effect between the time of Rumelt’s initial study and this study. Thus, more
refined data were available for this study.
Beginning with I39 Fortune 500 firms in these categories, five were eliminated due to
post- 1974 merger and acquisition activity; two were eliminated due to unreliability of
financial data; and four were eliminated due to strategy changes during the 1975-77
period.
Classifications for 125 of the remaining 128 firms matched Rumelt’s, and
classification changes were needed for the other three. The overall high degree of inter-
rater agreement between this study’s classifications and Rumelt’s suggests that his
category classification system is reliable. Commonly voiced fears that the system was
unreliable owing to its degree of dependence on qualitative judgements were not borne
out. Indeed, the availability of line-of-business data reduces the extent to which making
Rumelt-type strategy classifications is a judgemental process.
Furthermore, the line-of-business data reduced the amount of time needed to make
the classification decisions. In this capacity, they are a most useful facilitator of
strategic management research. The fact that their high level of aggregation makes
them unsuitable for some research questions (e.g. competitive strategy in a narrowly-
defined market) does not necessarily reduce their usefulness for making categorical
strategy classifications.

RESULTS

Performance by strategy category

The next step in the analysis was t o determine whether, for the new time period and
sample, significant differences in performance could be demonstrated across the
strategy categories (see Table 4.)
F-tests were used both in Rumelt’s research and in the present study to determine
whether there were statistically significant differences among the performance means
across the strategy categories. Rumelt (Table 1) haa found statistically significant
differences, thereby supporting his conclusion that diversification strategy and
performance were associated. In contrast, none of the overall F-ratios in Table 4
approaches significance at the 0.1 level.4 Therefore, there are no statistical grounds for
asserting that significant performance differences exist over the range of categories in
this sample.
This study, like Rumelt’s, utilized t-tests to compare individual category means to the
mean of the remainder of the sample. The results of the t-tests in Table 4 suggest some
agreement with Rumelt’s results. Measuring performance as return on invested capital,
unrelated-diversifiers clearly were less successful, and related-constrained diversifiers
were more successful than other firms in the sample. The dominantconstrained firms’
higher than average returns on assets and equity suggest that they, too, were better than

A significance level of 0.1 was selected to balance the likelihood of Type I and Type I1 errors. The precision
of estimates extracted from large scale economic surveys suggests that more exactness cannot be demanded
from the data at hand. Additionally, when attempting to reproduce previously stated results, care should be
taken to avoid unnecessary Type I1 (B) errors.
 w
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Table 4. Performance by strategy category

~~ ~~ ~~~ ~ - ~~ - ~~~ ~~ ~-
GSALESS GEPS ROIC ROA ROE ROCRR ROIC77 ROA77 ROE77 8
Est. category means e
Single (19)* 0.1703 0.0990 0.1 106 0.0555 0.1041 6.755-- 0.1180 0.0589 0.1 140-
6
<n
Dominant-constrained (13) 0.1467 0.1202 0.1353 0.0768'+ 0.1399" 10.546 0.1300 0.0779' + 0.1407
Dominant-linked (3) 0.1204- - 0.2735 0.1157 0.0831 ' 0.1489 4.195- - - 0.1515' + 0.0908 + + 0.1572' $
Related-constrained (39) 0.1416 0.1473 0.1297' 0.0614 0.1296 - 10.967' 0.1247 0.0672 0.1296 S'
Rela ted-linked (39) 0.1319 0.1484 0.1 174 0.0606 0.1090 9.598 0.1134 0.0600 0.1413 ,
b
Unrelated-portfolio (1 5 ) 0.1227 0.1489 0.1075-- 0.0725 0.1443' 7.500- 0.1298 0.0742 0.1354
%
0
Overall Mean 0.1407 0.1410 0.1208 0.0637 0.1185 9.317 0.1220 0.0662 0.1333
Sig. F-ratio 0.6676 0.7758 0.4860 0.4866 0.7033 0.2789 0.9573 0.6716 0.4844 8
The plus or minus signs following a category mean indicate that it differed significantly(' +' for a positive deviation, ' -' for a negative deviation) from the overall mean for the
2
other five categories. The I"-ratio was used to test the hypothesis that category effects were absent.
2
* Sample size.
+ =significant at the 0.1 level; + + =significant at the 0.05 level; + + + =significant at the 0.01 level.
1See Appendix B for definitions of column headings.
Table 5. Performance by strategy category with vertically integrated firms included
~ ~ ___ ~ ~~ ~~ ~

GSALESf GEPS ROIC ROA ROE ROCRR ROIC77 ROA77 ROE77

Est. category means

Single (19)* 0.1703 0.0990 0.1106 0.0555 0.1041 6.755- - 0.1180 0.0589 0.1 140
+ + +
Dominant-constrained (1 3) 0.1467 0.1202 0.1353 0.0768+ + + 0.1399' 10.546 0.1 300+ 0.0779+++ 0.1407'
+
Dominant-linked (3) 0.1204- - 0.2735' 0.1157 0.0831 0.1489 + 4.195-- 0.1515" 0.0908' + 0.1572' +

Relatedconstrained (39) 0.1416 0.1473 0.1297+++ 0.0614 0.1296 10.967'' 0.1247 0.0672 0.1296
Related-linked (39) 0.1319 0.1484 0.1174 0.0606 0.1090 9.598 0.1134 0.0600 0.1413"
Unrelated-portfolio (1 5 ) 0.1227 0.1489 0.1075 0.0725 0.1443 7.500- 0.1298 0.0742 0.1354
Vertical (3 1) 0.1730 + 0.0757- 0.0874--- 0.0451 - - - 0.0846- - 6.311-- 0.0957- - 0.0470 0.0969-- -
9
T
$
Overall Mean 0.1470 0.1282 0.1 143 0.0600 0.1119 8.731 0.1169 0.0625 0.1261
Sig. F-ratio 0.4490 0.4800 0.0165 0.0903 0.4664 0.0767 0.6616 0.2124 0.0295 $
* Sample size.
+ = significant at the 0.1 level; + + =significant at the 0.05 level; + + + =significant at the 0.01 level.
See hrpendix B for definitions of column headings.

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336 H . Kurt Christensen and Cynthia A . Montgomery

average performers. Additionally, the ROCRR risk measure, which divides average
ROIC by its standard deviation, indicates that unrelated firms as well as dominant-
linked and single business firms were riskier than other firms in the sample, while
relatedconstrained firms were less risky than others.
Although the t-tests indicate that Rumelt’s results were in some sense replicated here,
the lack of significant F-ratios in Table 4 cannot be dismissed lightly. The disparity in
overall significance (F-ratios) between this study’s results and Rumelt’s was puzzling
and unexpected. Various possible explanations for the difference were evaluated,
including an assessment of chronological/economic differences between the samples.
As important as these issues are, the examination indicated that it was not likely that
they would cause a differential impact across firms. Instead, the most likely explanation
appeared to be related to sample composition and the properties of the F-test.
When performance data for 3 1 vertically integrated firms were added to the analysis,
F-ratios for key performance variables became significant (ROIC, ROA, ROCRR) (see
Table 5.) Recalling that
Mean square between
F=
Mean square within
and noting that the vertically integrated firms were distinctly low performers in both
samples, suggests that the unusually poor performance of the vertically integrated firms
forced several of the F-ratios to significance. This finding demonstrates that the F-ratio
is sensitive to category extremes and indicates that one must be cautious to conclude
that significant differences exist across all or most categories when the analysis includes
an extreme group.
It is interesting to note, however, that the overall patterns from the t-tests in Tables 4
and 5 are similar, and basically in support of Rumelt’s findings. Constrained firms d o
appear to be the strongest performers in the sample, and the unrelated firms tend to be
the weakest. Considered in toto this information indicates that distinct categories of
performers can be identified, but, for any given variable, clear distinctions across the
range of firms are unlikely.

MARKET STRUCTURE VARIABLES

The next step in the analysis was to test for possible moderating or confounding effects
of the market structure variables. The F-test was again utilized to determine whether
statistically significant differences in market structure variables existed across the
sample. Table 6 presents strategy category means for several market structure
variables.Note that P R O F l , the weighted return on assets measure associated with the
firms’ markets, differed significantly across strategy categories. Additionally,
differences in the weighted market share variable approached significance (F-ratio =
0.1067).
Two individual categories displayed interesting and significant differences.
Unrelated portfolio firms were found to have lower market shares, to be positioned in
less profitable and less concentrated markets5and to be significantly smaller than other

It is interesting to note that it is not the 4-firm or 8-firm concentration levels that differ by strategy category.
Rather, it is the 20-firm and 50-firm levels. This suggests that the overall number of firms in a market and the
associated size of barriers to entry differ between some strategy categories.
Table 6. Strategy category means for firm-specific and market variables

SHARES PROF1 PROF2 CON1 CON2 CON3 CON4 GROW FSIZE

Est. category means

Single (1 9)* 0.0771 0.0596 0.1206 0.4489 0.5760 0.7218 0.8338 0.1 149 0.1138
Dominant-constrained (13) 0.0963 0.0658 0.1283 0.4367 0.5634 0.7224 0.8397 0.1206 0.1123
Dominant-linked (3) 0.1190 0.0545 0.1 141 0.4053 0.5292 0.6982 0.8260 0.1242 0.1152
Related-constrained (39) 0.0724 0.0693+++ 0.1343' + 0.4248 0.5691 0.7409 + 0.8604' 0.1276' o.iii4
Related-linked (39) 0.0729 0.0613 0.1244 0.4270 0.4270 0.5535 0.8423 0.1185 0.1110--
Unrelated-portfolio (15) 0.0242- - 0.0529- - - 0.1 144- - 0.4048 0.5258 0.6804- 0.8064- 0.1195 0.1141" 3
d
Overall mean 0.071 1 0.0629 0.1259 0.4275 0.5591 0.7199 0.8419 0.1212 0.1121 3
Sign F-ratio 0.1067 0.0714 0.2723 0.9617 0.9186 0.7058 0.5785 0.7718 0.2023 :
h.
i;'
* Sample size. 0
+ =significant at the 0.1 level; + + =significant at the 0.05 level; + + + =significant at the 0.01 level. 3
1 See Appendix B for definitions of column headings. s
R'

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338 H . Kurt Christensen and Cynthia A . Montgomery

firms in the sample. Related-constrained firms, on the other hand, were found to be in
more profitable, faster growing, and more highly concentrated markets than other
firms. Each of these findings was in the direction hypothesized except for firm
size.
Reviewing the hypotheses : significant market profitability differences (hypothesis D)
were found across the categories in the sample, while significant concentration
(hypothesis B) differences at the 20-firm and 50-firm levels were found for two strategy
categories.6 Significant market share (hypothesis A) and growth (hypothesis C)
differences were found for one category. A firm size (hypothesis E) difference was found
for one category in the opposite from expected direction. These results indicate that
differences in diversification strategy go beyond skeletal patterns of product linkages
and include the characteristics of the markets in which firms participate.

CONCLUSIONS AND IMPLICATIONS

The evidence presented here supports the view that performance differences exist
among some, though not all, of Rumelt’s categories. In turn, those differences appear to
be linked to characteristics of the markets in which the firms operate.
Rather than being viewed as a system for differentiating among a range of firms,
Rumelt’s category scheme can perhaps best be viewed as a means for distinguishing a
few distinct groups from other firms in general. The results of the t- and F-tests are
consistent with this interpretation. In particular, two distinct profiles emerge from this
work: one for the related-constrained, and the other for the unrelated portfolio
diversifiers. These firms are distinguished not only by their product linkages and
performance levels, but also by the characteristics of the markets in which they
participate.
E x post fucto research studies such as this one cannot support causal statements;
however, economic theory in conjunction with this research suggests that market
structure variables influence firm performance and diversification strategy. The
rationale behind the direction of the market structure-performance linkage has been
well-argued in the economics !i:arature. The direction of the influence between market
structure and strategy is based on the concept of defensive diversification (for example,
see Bass et al., 1977). This concept suggests that firms located in markets which
constrain their growth or profitability are the most likelycandidates for diversification.
Firms or businesses in ‘low opportunity’ markets are likely to find a similar lack of
opportunity in markets which they could enter through constrained diversification.
Therefore, they are more likely to pursue unrelated diversification.

Overall statements on performance and market structure differences are based on the sample of I28 firms
(i.e. not on the sample including the vertically integrated firms). Sales breakdown data were not available for
the vertically integrated firms, and in the interest of consistency it seems appropriate to compare market
structure differences from 128 firms to performance differences from the same rather than an expanded
sample. That the performance means of the unrelated portfolio firms were not significantly different in the
expanded sample should be noted, but evaluated with respect to the extremes presented by the vertically
integrated firms and the properties of the statistical tests employed. Compared to other non-extreme
categories (Table 4), the unrelated portfolio firms were lower than average performers. That perspective is
carried through in additional discussions.
 Corporate Economic Peuformance 339

Markets
/High profitability \,
,RO Growing '\
0 / High concentration '
A/'
'\
'*
Strategy Performance
Related-constrained High ROIC
Low accounting risk (ROCRR)
Figure 1. Proposed relationships among market structure, firm performance, and related-
constrained diversification strategies

These relationships are depicted in Figures 1 and 2. Figure 1 shows that related-
constrained firms tend to be high return, low accounting risk performers in part
because they operate in growing, highly concentrated, highly profitable markets. They
can achieve this level of performance while participating only in markets which enable
them to capitalize on their core strength (the dominant-constrained firms appear to
have a profile much like that of the related-constrained firms, although the linkages are
not statistically significant).

Markets
'Low profitability \
,
"
0concentration
LOW \
,

,/'
Low market shares '\
\
\
Y/ x
Strategy Performance
Unrelated-portfolio Low ROIC
High accounting risk (ROCRR)

Figure 2. Proposed relationships among market structure, firm performance, and unrelated-
portfolio diversification strategies

Figure 2 shows that unrelated-portfolio firms tend to be low return, high accounting
risk performers in part because they operate in highly fragmented, low profitability
markets.
This study's findings have important implications for practising managers. First,
following a strategy of constrained diversification is not sufficient to assure high
earnings. The constrained diversifiers appear to be more profitable in part because they
operated in very profitable, highly concentrated markets, and were able to acquire large
shares in those markets. These firms' above-average market shares also suggest that
they possess a sufficient level of the skills and resources critical to success in these high
opportunity markets-a condition which may have developed due to diversification
close to the original business. Successful performance is the outcome of market
opportunity combined with the capacity to take advantage of that opportunity. In
diversification planning, it is unwise to fail to analyse either.
Second, the rather uninspiring performance of unrelated-portfolio firms suggests the
dangers of inattention to market structure in entry decisions or of knowingly entering
highly fragmented, low profit markets. To the degree such markets are entered because
businesses can be purchased for attractive prices, a longer-run point of view is needed.
If these businesses are acquired because of unrealistic expectations of improving
340 H . Kurt Christensen und Cynthiu A . Montgomerj,

performance with new ownership, a hard look at market structure variables can lead to
more realistic assessments of turnaround potential.
However, the performance problems of the unrelated-portfolio firms may be deeper
than this: they may lack critical skills or resources needed to participate successfully in
faster growing, more concentrated markets. Additionally, the objectives and control
systems of unrelated-portfolio diversifiers may discourage the application of resources
to activities expected to yield high, but delayed, returns.
Of necessity, this study has left unanswered many questions about diversification
and corporate economic performance. In addition to the questions which emerge
directly from the findings of this study, there is a need to examine the management
systems, organizational structures and managerial styles conducive to a high level of
economic performance in diversified firms (Bettis, Hall and Prahalad, 1978). As the
separate research traditions that study corporate economic performance become
integrated, both research and managerial practice will be enriched.

APPENDIX A

Definitions of Rumelt’s categories

Single business: Any firm which derives 95 per cent or more of its revenues from one
business.
Dominant business: Any firm which derives 70-94 per cent of its revenues from its
largest single business.
Dominant firms were divided into four sub-classifications :
Dominant vertical: Any dominant firm with a high vertical ratio.
Dominant constrained: Any dominant firm which diversified by building on a single
strength or resource associated with the original business.
Dominant linked: Any dominant firm which diversified on the basis of one of several
strengths or resources. The particular strength lor resource varied across the
different businesses in the firm.
Dominant unrelated: Any dominant firm whose diversification activities are not
related to the dominant business.
Related business: Any firm deriving less than 70 per cent of its sales from a single
business and possessing a high relatedness ratio.
Related firms were divided into two sub-classifications :
Related constrained: Any related firm which diversified by building on a single
strength or resource associated with the original business.
Related linked: Any related firm which diversified on the basis of one of several
strengths or resources. The particular strength or resource varied across the
different businesses in the firm.
Unrelated business: Any firm deriving less than 70 per cent of its sales from a single
business and possessing lower relatedness ratios.
Unrelated firms were divided into two sub-classifications :
Multi-business: Any unrelated firm containing a few large unrelated businesses.
Unrelated-portfolio: Any unrelated firm containing many unrelated businesses.

Sources: Rumelt, 1974:9-32. The discussion of unrelated business categories is contained in Rumelt, 1977.
 Co p w u " Economic Pel:fiwmuncc 34 1

APPENDIX B

Definitions of performance measures used in the study

Name Defined as Prior use

-- -~ . _

GSALES
Sales growth Average per cent loox, - x, Ansoffet al., 1971
1973-1 977 change over period 7X,-

GEPS
Growth in earnings Average per cent 100 x, - x,
per common share change over period Nx,- Ansoff et a/.. 1971
1973-1977

ROIC, ROIC77
Return on invested Net income A. T. + interest Rumelt, 1974*
capital, average Shareholders' equity + L-T debt Bass, 1973*
1975-1977, 1977

ROA, ROA77
Return on assets Net income after taxes Rumelt, 1974*
average 1975-1977, Widely employed return
Total assets
1977 measure

ROE, ROE77
Return on equity Net income after taxes Rumelt, 1974*
average 1975-1977, Bk. value of shareholders' equity Widely employed return
1977 measure

ROCRR
Risk adjusted Average return on invested capital Rumelt. 1977
return, 1973-1977 s.d. of return on invested capital
~

* These authors also employed these measures in subsequent research.

(continued overleaf)
342 H . Kurt Christensen and Cynthia A . Montgomery

Definitions of market variables used in the study

~~~

Market variables

mij4 =the percentage of firm i’s total sales that

are in 4-digit market j

m i j 3=the percentage of firm i’s total sales that

are in 3-digit market j

SHARE
Weighted market share MS, =~ , m i j 4 M i j Mi,
= Firm i’s share
4-digit market j
Cmij4
PROF 1
Weighted industry ROA PI = Cjmij,ROAj ROA, = ROA associated
with 3-digit
Cm,,3 market j

PROF2
Weighted industry ROE P2 = Cjmij,ROEj ROE, = ROE associated
Ctnij3
with 3-digit
market j

CON I
Four-firm concentration CON, - 4 =Cjmij4conj.,-,
CON2
Eight-firm concentration
CON3
Twenty-firm concentration
CON4
Fifty-firm concentration

GROW
Growth of firm’s GR = C,rn,,,GR, GR, = annuity measure
markets, 1972-1976 of shipment
growth (in
dollars) in 4-
digit markets
FSIZE
Firm size 1
average 1975-1977 Log assets

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