Aurora Borealis
23 August 2018 CFA Institute Journal Review

Financial Market Frictions and Diversification (Digest Summary)

  1. Aditya Jadhav, CFA

In periods of stressed financial markets, firms tend to diversify their operations in areas that have negative correlations with their current activities. The authors find empirical evidence that firms increase diversification by reallocating capital across segments and during M&As, recessions, and depressions. Diversifying mergers are expected to be more appealing than focused mergers during these times, with more stock mergers instead of cash mergers.

How Is This Research Useful to Practitioners?

The authors review research conducted on financial market frictions and diversification efforts by firms, and they attempt to verify the relationship between investment and M&A diversification by firms with respect to the availability of external capital. They state multiple factors contribute to this phenomenon, mainly

•        reduction of cash flows from existing operating activities;

•        lower opportunity cost of diversification; and

•        inability of smaller, less diversified corporates to obtain capital to invest in diversified operations.

This study is useful for practitioners working in various segments of the financial services industry. From this research, corporate finance practitioners may understand typical investing patterns followed by their peers. It could be used to extrapolate and forecast possible investment diversifications in order to mitigate risks in stressed financial markets. According to the authors, investment diversification is most feasible during times of high market frictions because of lower costs associated with diversification using internal capital owing to external market conditions (the spillover effects of stressed markets). A large conglomerate may diversify into newer areas using internal capital generated from cash flows of other operations in a period of recessions for a few basic reasons, such as the following:

  • a lack of fresh investment into current operations owing to generally lower aggregate demand for products;
  • lower cost of internal borrowing vis-à-vis borrowing from the market; and
  • possibility of acquiring smaller, ailing firms (because of recession-hit markets) at lower than replacement costs.

Investment banking and investment management professionals could use the research to map out potential periods to evaluate diversifying or consolidating investment activities. It can also be used in connection with the current research on merger waves to predict structural changes in corporate investment diversification. With the authors’ findings about negatively correlated industries, investment bankers could realize possible areas for clients to diversify or help clients consolidate their investment activities, whereas investment managers could streamline their investments activities toward firms that have tried to replicate the models specified in the article (i.e., investments in negative correlation industries).

How Did the Authors Conduct This Research?

The authors use multiple datasets for this study. To understand the rationale of their research, one must first understand their objective. They measure investment diversification by non-financial corporates into newer operation areas in association with external capital availability. To do so, they use a vector autoregressive model, with which they attempt to measure the average diversification of firms over a 40-year period with respect to external capital availability.

To measure external capital availability, the authors use the TED (Treasury–eurodollar) spread as a proxy. The TED spread is the difference between the risk-free, three-month Treasury bill and the three-month LIBOR, a measure subject to credit risk, denominated in US dollars. A higher spread is indicative of greater market friction or lower external capital availability. To visualize investment diversification, the authors use the Herfindahl–Hirschman Index (HHI) in two forms: the reciprocal of HHI assets, which measures investment concentration in a particular segment under the Standard Industrial Classification (SIC), and the reciprocal of HHI sales, which is a proxy to measure cash flows accrued in a particular segment under the SIC.

The change in the average number of segments when compared with the TED gives the measure of aggregate diversification of corporates with respect to changes in external capital availability.

Abstractor’s Viewpoint

The authors provide solid evidence that non-financial firms tend to diversify into operations with negative financial correlations during the time of stressed financial markets. Their findings could be further tested by other researchers to verify these findings in other geographies.

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