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INVESTOR RECOGNITION OF CORPORATE INTERNATIONAL DIVERSIFICATION TAMIR AGMON AND DONALD R, LESSARD* IN THE PRESENCE OF BARRIERS to portfolio capital flows, multinational firms (MNCs) have an advantage relative to single-country firms because of their ability to diversify internationally. This financial advantage—the result of financial market imperfections—compliments the advantages MNCs derive from imperfections in real goods and factor markets and represents an additional motive for multinational expansion,' This paper argues that such barriers do exist and provides empirical support for the diversification motive by showing that investors appear to recognize the extent of multinational diversification of a sample of U,S, firms listed on the New York Stock Exchange,



The benefits of international diversification at the investor level are well documented (e.g., [3], [8], and [16]). However, the mere presence of less than perfect correlations among company earnings and/or asset values in various countries is insufficient to establish that international diversification is relevant at the corporate level. Two further conditions must be satisfied: 1) there must exist greater barriers or costs to portfolio capital flows than to capital flows forming part of the direct investment package; and 2) investors must recognize that MNCs provide a diversification opportunity which otherwise is not available. If there were no barriers to international capital flows, and if capital markets were uniformly well developed, investors would diversify their portfolio holdings internationally and required rates of return on securities (projects) would reflect only their contributions to the risk of a fully diversified world portfolio. Under such circumstances, diversification at the firm level would be of no consequence •Senior Lecturer, Tel Aviv University, and Associate Professor, Sloan School of Management, M,I,T, This paper was written while Dr, Agmon was a Visiting Professor at the Sloan School, We would like to thank Michael Adler, Fischer Black, Dennis Logue, James Paddock, Robert Pindyck, Alan Rugman and Marshall Blume, a reviewer for this Journal, for helpful comments and Alex Henry for computational assistance, 1, It is generally acknowledged that in order to justify foreign investment, the multinational corporation must have some advantage relative to local firms in the countries in which it invests which allows it to overcome the costs imposed by cultural and geographical distance not borne by local firms. Most economists have argued that the primary sources of advantages of MNCs relative to local firms are imperfections in markets for products and factors of production, generally excluding capital. Reviews of the theory of foreign investment are provided by Dunning [2], Kindleberger [7], Ragazzi [13], and Stevens [17], The benefits of international diversification were introduced into the literature by Grubel [3], Ragazzi [13] and Rugman [14] extend them to FDI,



The Journal of Finance

and the required rate of return on a particular project would be the same whether it was undertaken by an MNC or a local firm.^ II.


In order to verify the existence of a diversification motive for multinational expansion by corporations, we seek to determine if the two conditions cited above are true. In the case of the first condition, we observe that there are numerous examples of barriers to portfolio flows which are or have been more stringent than those applying to direct investment flows.^ Further, the flexibility of the MNC in shifting revenue-producing resources among its operating units suggests that even when barriers are nominally the same, direct investment flows will be freer than portfolio flows,** Although these observations are not conclusive, they lend substantial support to the first condition. We concentrate on the second condition, whether investors appear to recognize the diversification opportunities provided by MNC shares. We do this by investigating the share price behavior of a sample of U.S.-based MNCs. Direct measures of the existence and magnitude of the diversification motive based on the pattern of MNC expansion are avoided since the diversification motive coexists with motives resulting from imperfections in product and real factor markets. As a result, in many cases it is consistent with the same patterns of expansion explained by alternative hypotheses and cannot be isolated empirically.^ For example, the foreign investment "balance sheet" of the United States, characterized by a preponderance of outward FDI and inward foreign portfolio investment (FPI), has been explained in terms of real goods and factor market relationships, but the same pattern is consistent with the argument outlined above. The U.S, investor, seeking diversification but facing relatively less efficient capital markets abroad and barriers imposed by legal restrictions as well as by a lack of previous foreign investment experience, would prefer to diversify by purchasing shares of U.S.-based MNCs which include claims on foreign operations while 2, Myers [12] provides a clear argument for this case in reference to the domestic conglomerates. Others, including Lewellyn [10] and Hughes, Logue and Sweeney [5], have argued that diversification at the corporate level is advantageous since it increases a firm's debt capacity. However, this conclusion has been questioned on the grounds that when a firm which has outstanding debt diversifies, it increases the value of the debt and thus reduces the value of equity. See for example Higgins and Schall [4], 3, These may include formal "border" barriers such as the U,S, IET, formal internal barriers such as SEC registration requirements, informal border barriers resulting from investor tradition and/or lack of information, and informal internal barriers which would include relatively undeveloped or inefficient domestic capital markets, 4, Foreign direct investment often involves transfers of intangible factors of production such as technology or managerial skills. To the extent that these real transfers are not paid for in cash, they are accompanied by financial transfers, usually of a risk-bearing nature since the eventual payment for the factors involved is contingent on future outcomes. Clearly, such inward transfers are not captured by controls over financial flows. Remittances of profits from these transferred resources often will not be restricted and even if they are, the MNC has a number of options for bypassing such restrictions, especially transfer pricing of goods and factors of production, 5, This problem has plagued most empirical research on the motivation for multinational expansion. For a critical review of these studies, see Stevens [17],

Investor Recognition of Corporate International Diversification


non-U.S, investors, to whom the U.S, market appears quite open and efficient, would diversify by purchasing shares in U.S, firms. Direct measures based on the risk adjusted performance of the shares of multinational firms relative to singlecountry firms suffer from similar drawbacks,* III,



Since the shares of U.S.-based MNCs represent claims on foreign as well as domestic activities, one would expect share price movements to reflect this fact. If prices behave as if the market does not distinguish between firms with different degrees of international involvement, one would have to conclude that as far as the American equity market is concerned, international diversification of activities does not matter. On the other hand, if the movements of share prices indicate that the market perceives international corporations as different than those less internationally inclined, this evidence, in combination with evidence of barriers to capital flows, lends support to the view that the M N C s ability to diversify internationally is an advantage. The Relationship Between Share-Price Behavior and the Extent of International Involvement

Fluctuations in share prices reflect events (i,e,, new information) which change expectations of the future cash flows of corporations or the mechanism by which these future cash flows are capitalized by investors in the market. For purposes of exposition, it is useful to classify fluctuations within a single economy as those resulting from three arbitrarily defined types of effects—those which affect virtually all stocks (although perhaps to a different degree), those which affect certain groups of stocks such as industries, and those specific to single stocks. The first type of effect is the main component of the systematic risk which cannot be eliminated by diversification. Thus the most important relationships between returns on securities can be described in terms of a "market model": ^•. = »j + PjK. + -^j,


where Rj, is the return on security y (a random variable) in period /, R^, is the return on the market index, aj and /?,. are parameters for security J, and" e, is a random variable with a zero mean, and Cov(e,,€p = 0, Cov(R.,i) = 0. ^ Internationally, the structure of returns appears to be more complex. Returns on securities within each domestic market appear to be reasonably well described by the market model, but they are related internationally through a world factor,^ In 6, This approach faces the same empirical difficulties as tests of the capital asset pricing model in the domestic context as well as the as yet unresolved issue of specifying an appropriate international capital asset pricing model. For a review of the first set of issues, see Jensen [6], for the second Agmon [I], and Solnik [15], Hughes, Logue, and Sweeney [5] raise a series of interesting issues in this regard, 7, Agmon [1], Lessard [8], and Solnik [15] explore the international structure of returns. All conclude that country elements are very strong and industry elements of little importance. However, they do not accept a common definition of the worid market factor nor do they resolve whether price changes of individual stocks are directly related to the worid factor or are related only indirectly through the respective domestic market factors.


The Journal of Finance

this case the interdependence of changes in the prices of securities in the international market can be summarized in terms of an "international market model": f^j>. = Âťj + PjkR>c + yjK + '^j


where R^ is the return on security J from country k, and where time subscripts were dropped for simplicity, R,^ is the return on the country k market factor, and R^ is the return on the world market excluding country k (i.e. the rest of the world). If we view an international firm as a collection of activities in different countries, then the return on its traded shares can be described as: Rj=oij+^Wj,Pj^R,+ yjR^ + ij


(= 1

where the R^ represent the market factors for each of the N countries in which firm j generates proportion w, of its revenues (2/^/= 0- Equation (3) implies a direct relationship between the international composition of the firm's activities and the pattern of the price changes of its shares. Unfortunately such a complex relationship would be difficult to test due to the lack of necessary data and the need for a more specific and explicit international valuation model. In this section we take a more modest and preliminary step. We test the proposition that securities of firms with relatively large international operations are more closely related to the rest of the world market factor and less to their home country factor than shares of firms which are essentially domestic. We expect this since non-U,S, activities should be reflected by a dependence on the rest of the world factor and the appropriate country factors, but not by dependence on the U.S, country factor. Therefore, the higher the proportion of non-U,S, activities, the lower the dependence on the U,S, country factor. Further, since the rest of the world factor by construction does not reflect U,S, activities, it should become more important as non-U,S, activities increase. Thus an examination of the relationship between security price changes and the domestic and the rest of the world factors, controlling for the degree of international involvement, provides a partial and indirect test of whether the international composition of a firm's operations is reflected in the market behavior of its securities.* Thus the return on the shares of a U,S,-based MNC may be thought of as arising from the following relationship: Rjs = <^j + PjsKs + yjsK + %-


where ,R,^ = return on the share of the yth corporation with a proportion s of non-U.S, sales, R^, the return of the NYSE index, and R^ the return of the rest of the world index, defined to be orthogonal to R^,. 8, It should be emphasized that our analysis is restricted to determining the impact of degree of a firm's intemationai involvement on the relationship of its stock's movements with general domestic and world market effects. It does not encompass tests of the relationship between the stock'sriskinessand average retum over time, Hughes, Logue, and Sweeney [5] interpret similar results as showing that stocks>are priced internationally rather than domestically. While this is an attractive hypothesis, this interpretation can be questioned on several grounds.

Investor Recognition of Corporate International Diversification


We test the hypothesis that /8y^ is a decreasing function of s, and that y^ is an increasing function of s. Empirical Results In order to test the hypothesis that security returns reflect the international composition of a firm's activities, monthly returns (ending stock price plus cash dividend, divided by the previous price) for 168 months from January 1959 to October 1972, and an estimate of the proportion of a firm's revenue from non-U.S, sources were obtained for a sample of 217 U,S. firms. The firms were then ranked according to the degree of international activity and grouped in deciles in order to reduce the influence of differences other than the extent of international activity. The composite return series for the resultant portfolios (about 20 stocks were included in each one) were regressed on the indexes for the U.S. stock market and the rest of the world,' To obtain the latter, the Capital International world index was regressed on to the New York Stock Exchange index and the residuals of this regression were defined as the "rest of the world" stock market index. The results of this regression are presented in Table 1 below. The data presented in Table 1 shows that those portfolios with a high degree of international involvement, measured by proportion of sales outside the U.S., have TABLE 1 DEPENDENCE OF MONTHLY RETURNS ON U , S , AND WORLD INDEXES


No, 1 2 3 4 窶「 5

6 7 8

9 10

Proportion of Sales Outside the U,S, (%) 1-7 7-10 10-13 13-17 17-21 21-25 25-28 29-35

35^2 43-62



Std, Er,


of fi

Y (world)

Std, Er, of y


1,04 1,06 ,98 ,82 ,98 ,98 ,82 ,99 ,86 ,88

,03 ,03 ,03 ,03 ,03 ,03 ,03 ,03 ,03 ,03

,16 -,11 ,13 ,56 ,18 ,20 ,50 ,30 ,59 ,60

,09 ,10 ,08 ,08 ,10 ,10 ,09 ,10 ,10 ,09

,898 ,884 ,894 ,861 ,866 ,856 ,853 ,872 ,820 ,864

9, The monthly holding period returns for individual stocks are from the CRSP monthly file, the U,S, index is a market-value weighted index for the New York Stock Exchange also from the CRSP file, and the world market index is the Capital International World index, a market-value weighted index of the major securities listed on the 18 most important national stock markets. The foreign activity measures, proportion of sales generated outside of the U,S,, were taken from Standard and Poor's The Outlook (August 13, 1973), The ideal measure of foreign activity would be proportion of total market value represented by non-U,S, operations, sales, etc. However, for obvious reasons this number is not available窶馬or is it known by the firms in question. Other measures such as assets, employees, or profits appear to be even further from the ideal than sales. The international distribution of profits, for example, is arbitrary since it depends on transfer prices, overhead allocations, and various accounting conventions regarding recognition of foreign activities. However, the grouping procedure employed should alleviate some of the problems associated with the foreign activity measure.


The Journal of Finance

relatively high y's, the coefficient relating the changes in the share price to the rest of the world index (not including the U.S.). Moreover, the higher the level of international involvement, the more statistically significant is the y coefficient. Similarly, the j8 coefficient relating the returns on each of the portfolios to the U.S. index are much higher for those portfolios with little international involvement.'" This evidence supports the hypothesis that the market recognizes the geographically diversified nature of the U.S.-based international corporations as well as the extent of their international involvement. These results, however, are only indicative since they do not show whether the observed differences in /8's and y's are statistically significant. Further, although the grouping of stocks into portfolios is useful for isolating the impact of the extent of international activity, it does not lend itself easily to such a test. Therefore, we performed a two-stage regression on individual stock data to test the relationship between firm's national dependence (/8) and international dependence (yy) on its degree of international involvement. In the first stage, E and y were determined for each of the 217 securities using equation (4). In the second stage the ^^'s and y^'s were related to IS, the international sales ratio, in two separate equations: (5a) j






The evidence presented in Table 1 suggests that bj will be negative and that bj will be positive." A summary of the two-stage regression is presented in Table 2 below: TABLE 2 U.S. AND WORLD DEPENDENCE AS A FUNCTION OF INTERNATIONAL


bj (U.S. dependence)

bj (world dependence)

-.010 T statistic -3.98 f statistic (1,215) 15.91 i?-squared .069

.012 T statistic 4.42 f statistic (1,215) 19.52 /{-squared .083

Both bj and bj have the expected sign and are statistically significant at a 5 percent level. 10. Similar relationships hold when the 14-year period was split into two seven-year periods. 11. A and fj are regression coefficients themselves and hence are measured with error. However, to the extent that this error is uncorrelated with IS, it will not bias the estimates of b and b' but will reduce the (-statistics.

Investor Recognition of Corporate International Diversification IV.



The results support the hypothesis that U.S. investors recognize the international composition of the activities of U.S.-based corporations. This is only a first step towards a specification of the relationship between real corporate variables, such as the international distribution of operations, and capital market variables, such as changes in share prices. However, when coupled with the observation that MNCs often can diversify internationally at a lower cost than portfolio investors, it suggests that the diversification motive should be given more serious consideration than has been the case to date. REFERENCES 1. T. Agmon. "The Relations Among Equity Markets: A Study of Share Price Co-Movements in the U.S., U.K., Germany and Japan," The Journal of Finance (September 1972). 2. J. H. Dunning. "The Determinants of International Production", Oxford Economic Papers (January 1973). 3. H. G. Grubel. "Internationally Diversified Portfolios", The American Economic Review (December 1968). 4. R. C. Higgins and L. D. Schall. "Corporate Bankruptcy and Conglomerate Merger", Journal of Finance (March 1975). 5. J. S. Hughes, D. E. Logue, and R. J. Sweeney. "Corporate International Diversification and Market Assigned Measures of Risk and Diversification", Journal of Financial and Quantitative Analysis (November 1975). 6. M. J. Jensen. "The Foundations and Current State of Capital Market Theory", in M. J. Jensen, ed.. Studies in the Theory of Capital Markets (Praeger, 1972). 7. C. P. Kindleberger. American Business Abroad: Six Lectures on Direct Investment (Yale University Press, 1969). 8. D. R. Lessard. "World, Country and Industry Relationships in Equity Returns: Implications for Risk Reduction Through International Diversification", Financial Analysts Journal (Jan./Feb. 1976). 9. . "The Structure of Returns and Gains from International Diversification", in Elton and Gruber, eds.. International Capital Markets (North-Holland, 1976). 10. W. G. Lewellyn. "A Pure Financial Rationale for the Conglomerate Merger", Journal of Finance (May 1971). 11. H. M. Markowitz. "Portfolio Selection", The Journal of Finance (March 1952). 12. S. C. Myers. "Procedures for Capital Budgeting Under Uncertainty", Industrial Management Review (Spring 1968). 13. G. Ragazzi. "Theories of the Determinants of Direct Foreign Investment", IMF Staff Papers (July 1973). 14. A. R. Rugman. "Motives for Foreign Investment: The Market Imperfections and Risk Diversification Hypothesis", Journat of World Trade Law (September/October 1975). 15. B. H. Solnik. European Capital Markets (Heath Lexington Books, 1973). 16. . "Why Not Diversify Internationally?" Financial Analysts Journal (July 1974). 17. G. V. G. Stevens. "The Determinants of Investment", from J. H. Dunning, Economic Analysis and the Multinational Enterprise (Allen and Unwin, 1974).

Agmon article