Sungyong Bruce Kogut, and Jae-Suk Yang. Forthcoming, Strategic Management Journal. Abstract The documented discount on globally diversified firms is often cited, but a correlation is not per se evidence that global diversification destroys firm value. Firms choose to globally diversify based on their firm attributes, some of which may be unobservable. Given these exogenous firm attributes, the decision to diversify globally is endogenous and self-selected. Using the same specifications save for the Heckman selection instrument, our results contradict past research that did not address endogeneity. We posit that the global premium should reflect the value of multinational operating flexibility. We use the 2008-2009 financial crisis as creating exogenous variation to permit a test for the positive change in firm valuation due to global diversification. During and after the 2008-2009 financial crisis, the premium associated with global diversification became larger and more significant than before the 2008-2009 financial crisis. The churn of subsidiaries entering and exiting countries increased during the crisis, pointing to the value of an operating flexibility to restructure the geography of the multinational network. In all, the results contradict past findings and finds evidence that operating flexibility is more valued during times of high volatility, thus generating the diversification premium.

1. Sungyong Chang, Bruce Kogut, Jae-SukYang
Columbia Business School, Columbia University
Academy of Mangement Conference
10 August 2015
Global Diversification Discount
and Its Discontents:
A Bit of Self-selection Makes
a World of Difference

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§ Motivation
§ Theory
§ Data and Methodology
§ Results
§ Conclusions
Table of Contents 2

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Global Diversification Discount
§ Industrial Diversification Discount (Berger and Ofek, 1995; Campa and
Kedia,2002;Villalonga 2004)
§ Denis, Denis, andYost (2002, Journal of Finance) found
evidence for a global diversification discount.
§ “Commentators today often extol the virtues, if not the competitive
necessity, of global diversification.… However,much like the situation
with conglomerates in the 1960s,we find no evidence that these global
diversification strategies have created shareholder value, on average.”
(Denis et al., 2002: p.1977)
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Research Questions
§ Methodological question
§ If we control the endogeneity of global diversification choice,do we
find the discount for global diversification?
§ Theoretical question
§ If we find a premium or discount,what is the rationale behind this
valuation effect?
§ We argue that operating flexibility from restructuring the global
subsidiary portfolio when a firm faced a shock of the financial crisis.
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§ Motivation
§ Theory
§ Data and Methodology
§ Results
§ Conclusions
Table of Contents 5

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Valuation Effect of Global Diversification (1)
Discount
§ (1) Liability of foreignness (Hymer,1960; Zaheer, 1994)
§ (2) Information asymmetry from complexity (Harris, Kreibel, and Raviv,1982;
Myerson, 1982)
§ (3) Monitoring cost:Costs increase in distance between
headquarters and subsidiary due to the difficulty to monitor
supports because of increased agency activities (Bodnar et al., 1999;
Kalnins and Lafontaine, 2013).
§ (4) Divisional politics leading to sub-optimal subsidization across
divisions (Meyer, Milgrom and Roberts, 1992;Rajan, Servaes,and Zingales, 2000)
§ (5) Managers’ incentive to adopt and maintain value-reducing
diversification (Jensen, 1986; Stulz, 1990)
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Valuation Effect of Global Diversification (2)
Premium
§ (1) Increasing operating flexibility (Kogut and Kulatilaka, 1994; 1998):
from shifting production to the country in which conditions
are more favorable.
§ (2) Exploiting firm specific assets (Caves,1971;Morck and Yeung, 1991):
internalization theory of synergy
§ (3) Satisfying investor preferences(Errunza and Senbet, 1981; 1984;Lessard,
1973):completes for the financial market for investors
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Summary on Costs and Benefits of Global
Diversification and Industrial Diversification
Global
Diversification
Industrial
Diversification
Costs
Liability of
Foreignness/Newness
o o
Information Asymmetry o o
Monitoring cost o o
Sub-­‐optimal subsidization o o
Managers’
incentive
for
value-­‐destroying
diversification o o
Benefit
Operating
flexibility o
(same activities) x
(different
activities)
Synergy creation
by
exploiting
assets o o
Completing financial
market
for
investors ∆
or x x
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Benefits from Operating Flexibility
(1) Incremental profit
From when a firm can flexibly
respond to changes in the state
variable by choosing globally
where to assign its activities
between two subsidiaries
located in countries X and Y.
(2) Option value
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Self-selectionin Global Diversification
§ As first argued in Shaver’s (1998) article on endogeneity in
foreign investment, the self-selection design is consistent with
a theoretical statement that the decision to invest overseas is
the product of the strategizing by managers to improve the
profitability of the firm.
§ Campa and Kedia (2002) found that the industry discount
disappeared or became milder once the econometric
specification accounted for selection.
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§ Motivation
§ Theory
§ Data and Methodology
§ Results
§ Conclusions
Table of Contents 11

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Data and Methodology (1)
§ Sample Selection (Following Denis et al., 2002)
§ The sample consists of all firms with data reported on the Compustat
Industry Segment database from 2005 to 2011.
§ We exclude
§ (1) utility (SIC 4900-4999) and financial firms (SIC codes 6000-6999),
§ (2) firms incorporated outside of the United States
§ (3) any industrial segment has sales less than $20 million
§ (4) sales of any business segment is not within one percent of total sales.
§ The final sample consists of 12,640 firm-years associated with 3,002
firms.
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Data and Methodology (2)
§ Measure of Diversification
§ Global Diversification (Dummy):More than or equal to one foreign
subsidiary (from the Orbis Database)
§ Industrial Diversification (Dummy):More than or equal to two
business segments (from Compustat)
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Data and Methodology (3)
§ ExcessValue
§ We estimate EVit (i represents firm id and t represents year) using the
industry multiplier approach described in Berger and Ofek (1995),
Campa and Kedia (2002), Denis et al.(2002).
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Actual market value
Imputed market value
Weighted by Sales
Median of (Market value to Sales ratio)

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Data and Methodology (4)
§ Control Variables
§ Market value,long-term debt, capital expenditure,EBIT,R&D,
advertising
§ Instrumental Variables
§ Percentage of industrially diversified firms in the industry
§ Percentage of sales of industrially diversified firms in the industry
§ Dummy takes 1 if the firm is listed on major exchange markets
(NYSE, Nasdaq,and AMEX)
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§ Estimation Methodology
§ (1) OLS
§ (2) Heckman’s two-step model
§ 1st Probit regression with firm characteristics and instrumental variables
§ 2nd Step OLS with Inverse Mills Ratios
Data and Methodology (4) 16
IDit* GIDit*

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Sample statistics 17

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§ Motivation
§ Theory
§ Data and Methodology
§ Results
§ Conclusions
Table of Contents 18

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Results (1) Valuation effect of global
diversification
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Self-selection correction flips the valuation effect
for global diversification.

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Results (2) First-stage Probit regression
Instrumental Variables:
According to the type of
diversification,different
characteristics affect the choice
on the diversification type.
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Results (3) Effect of Financial Crisis 21

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Results (4) 22
Global diversification premium
during the crisis

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Result (4) 23
Number of churns
reached the peak
during the crisis

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Results (5) 24
Larger net flow
to the less affected countries
than the others.

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Results (6) 25
Larger net flow
to the less affected countries
than the others.

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Country level analysis
Without controlling self-selection With controlling self-selection
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The self-selection correction flips the signs and changes
the size of valuation effects of many countries
Red:
Discount,
Blue:
Premium,
Yellow:
Insignificant,
White:
No
data

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§ Motivation
§ Theory
§ Data and Methodology
§ Results
§ Conclusions
Table of Contents 27

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Conclusions (1)
§ Our results show that selection effects matter for
understanding global diversification in three ways:
§ (1) reversing the finding of a global discount,
§ (2) proposing and supporting a theory of operating flexibility as the
explanation
§ (3) integrating the choice of diversification within a broader theory
of strategy and capability.
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Conclusions (2) Operating Flexibility and
Macroeconomic shock
§ Multinational firms benefited positively from a strategy to
diversify globally during a period of increased volatility and
macroeconomic uncertainty.
§ This is not luck.It is the operating flexibility gained through a
strategy to invest in a global network.
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Appendices 30

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Theory of Global Diversification
§ The two well-documented assumptions on global
diversification set out by Stephen Hymer 50 years ago.
§ (First) The“liability of foreignness”(Zaheer,1995).
§ (Second) An offsetting competitive advantage that can be transferred
from one country location to another at a cost that does not wither
away the benefits of the competitive asset (Caves, 1971; 1996, Morck
andYeung,1991).
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Firm characteristics 32

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Churn related findings 33