Is There an Association Between Corporate Governance and Firm

Diversification? An Empirical Study with Brazilian Companies

Wesley Mendes-da-Silva*
Federal University of Pernambuco
Recife PE, Brazil
Ervin L. Black
529 TNRB
Marriott School of Management
Brigham Young University
Provo, UT 84602
Abstract
The strategy adopted by a company can be understood as the result of mechanisms and
practices of corporate governance. In turn, the performance of a firm depends directly on the
decisions made by its administrators. However, managers can incorporate their own personal
interests in strategic decisions, creating a level of corporate diversification, according to the
operation of the corporate government. Thus, the objective of this study is to investigate,
empirically, if the structure of governance is different between focused and diversified firms
and, furthermore, if differences in corporate governance are associated with some loss of
value for the firm from the diversification. This study consists of a multiple cross section
extending from 1997 to 2001. Data from 176 companies with open capital listed on the So
Paulo Stock Exchange (Bovespa) were used, representing 14 industry segments. The results
of the multivariable analysis reveal that the size of the board of directors (InTAMC) and the
participation of the executives in the profit (profit sharing) of the company (PART) are
positively associated with the diversification of the firm (HPROD). Moreover, the companies
with private national capital (CNTR) appeared more diversified than those with government
capital; however it is important to recognize that these associations were not constant for the
entire length of the study period.
JEL: G34
Keywords: Corporate Governance, Firm diversification, Agency Problem, Brazilian Firms

August 31, 2004

Corresponding author: Finance Institute of Recife, Rua Antonio Valdevino Costa, 280/31/604Cordeiro Recife Pernambuco Brazil 52060040. Office:
+55 81 32291689, Email:mrwesley@bol.com.br . We express appreciation to Scott Tandberg for his research and
translation assistance. A prior version of this paper was presented during the 28th ANPAD Conference,
in Curitiba Paran Brazil, in portuguese language.

1. Introduction
Undoubtedly, the strategic alternatives chosen by the top administration will be, to a
large extent, responsible for the performance of the organization. In one influential study,
Jensen and Meckling (1976) discuss the Theory of Agency, which examines the relationship
between principals and agents, that is, between those directly affected by decisions and those
individuals who have actually been delegated the power to decide. Companies can have their
own strategic interests to achieve superior performance. However, the power to make
decisions is allocated to the executives, who are hired by the owners through the board of
directors, which has the principal purpose of representing the owners before the executives.
In this view, there are several necessary factors for the company to achieve superior
performance: (a) technical competence of the chosen executives to direct the activities of the
company, (b) aligning the interests of the executives with the interests of the corporation, (c)
the adequacy of the corporate governance structure to direct the relationship between the
principals (shareholders) and the agents (executives).
The strategic decision to diversify the operations of a company could then be initiated
by the actual interests of the corporation or as an attempt to satisfy the desires and personal
needs of the executives who are given the power to make the decisions. Several studies, such
as those of Lang and Stulz (1994), Berger and Ofek (1996), and Servaes (1996) suggest that
diversified firms suffer a substantial discounting in their value in comparison to the ascribed
value of companies with more concentrated operations. This type of association between
diversification and the discounted value of a company is consistent with two hypotheses.
First, diversification could be associated with the structure of inefficient governance, which
allows managers to maintain privileged positions in the administration of the company
(entrenchment), receiving private benefits paid for by the shareholders (private benefits).
Second, diversified firms can utilize excellent structures of governance, especially
divestment, if the transaction costs associated with the failure of the adopted diversification
were greater than the costs of operating in a more concentrated way.

Using data from the period of 1997 to 2001, from 176 industrial companies listed on
the So Paulo Stock Exchange (Bovespa), the objective of this study is to empirically study
the existence of relationships between corporate governance structures and diversification
strategies that can reduce the value of the firm.

Specifically, the study investigates if

governance structures are significantly different between focused and diversified companies,
and if these differences are consistent with the explanation of agency costs from
diversification.
The results of multivariable analysis reveal that the structure of governance is
sensitive to the level of diversification, which is consistent with the explanation of agency
diversification. Thus, the size of the board of directors (InTAMC), and the independence of
the chairman (INDPR) are positively associated with the diversification of the firm. In
companies with executive profit sharing (PART), higher levels of diversification are noted,
with an associated discounting in the value of the firm (Tobins Q) resulting from the
diversification. Besides this introduction, this essay includes five more sections. Section 2
examines the theory about relationships between performance and business strategy. Section
3 discusses the importance that governance mechanisms can exert on the adoption of
diversification strategies. Section 4 details the methodology used in the study. Soon after, the
results of the study are revealed and discussed in section 5. Finally, in section 6, the final
conclusions are presented.
2. Performance and Business Strategy
A companys strategy consists of the set of competitive changes and commercial
moves that the managers execute to achieve the best company performance. The strategy is
part of the management game to strengthen the position of the organization in the market,
promote client satisfaction, and reach performance objectives. Without a strategy, a manager
has no predetermined route to follow; he or she has not map and no unified plan of action to
lead to the desired results (THOMPSON and STRICKLAND III, 2000, p. 1).

To Hitt, Ireland and Hoskisson (2002, p. 31), a significant amount of the debate
regarding strategy revolves around strategies on an operational level and the competitive
dynamics associated with its use, that is, business strategies. When a company decides to
diversify its activities beyond a single industry and begins to operate in several industries, it
is adopting a strategy of diversification on a corporate level, a subject examined in this study.
Similar to strategies on an operational level, corporate-level strategies allow a company to
adapt to the current conditions of its external environment.
Formal strategic planning systems play an essential role in evaluating activities and
overcoming uncertainties in the environment by the administration. Interest is growing in
assuring that a business has adequate strategies, and that these strategies are collated with
corporate performance.

Although there are differences between organizations, almost

invariably, this process is aimed at performance results, both for the shareholders and the
financial community. In light of this idea, financial performance is understood as a function
of the strategies that a business implements through its administration.
For Rappaport (1998, p. 395-418), the approach of evaluating strategic planning
through conventional accounting doesnt clarify whether strategic planning will create value
for the shareholder. However, Certo and Peter (1993, p. 275) draw attention to the function
of feedback, which the financial area uses to guide the decisions of upper management. As
such, one cannot disregard the usefulness of measuring financial performance to make
corrections in the strategic positioning of a company.

2.1 The Role and the Strategy of Diversification

In a company with a single business, the management must deal with only one
industry setting and understand how to compete in it successfully. In a diversified company,
however, management must create strategic plans for several businesses, which compete in
multiple industry settings. The task of developing the corporate strategy of a diversified
company involves the steps summarized in Figure 1.
Figure 1: The Strategy Development Process for a Diversified Company
Decide on
changes to be
made to
position
company in
chosen
industries for
diversification

Action taken to
maximize
performance of
company after
diversification

Achieve
benefits and
transform them
into
competitive
advantages

Evaluate profit
prospects of
each business
unit in order to
allocate
resources

Source: Adapted from Thompson and Strickland III (2000).

The final step in the process of creating a strategy for a diversified company involves
evaluating the levels of financial performance reached with the adoption of the particular
strategic positioning, with the performance being the determining factor in positioning
corrections. In this work, the concept of strategy that will be used for the categories of
strategic diversification is derived from the influential work of Rumelt (1974, p. 10).
Diversification can then be seen as a function of managements decisions, which are
determinants of the future of the company and a cause of coordination, planning, and control
problems for upper management; in other words, it can be seen as strategy.
In this study, Rumelt (1974) tested the effectiveness of every one of the
diversification strategies and concluded that the Dominant Products and the Related Products
are excellent strategies; the data indicated that a relationship existed between high-level
strategies and financial performance. In diversified companies, each business unit chooses a
business-level strategy to implement so as to compete effectively and achieve above-average
returns, creating value. On the other hand, diversified firms should also choose a strategy
that carefully considers the decisions and administration of their businesses. Accordingly,

corporate-level strategy is an attempt to obtain a competitive advantage through the decisions

and administration of a collection of businesses that compete in diverse product industries or
markets (Hitt, Ireland, and Hoskisson, 2002, p. 232).
The firms that seek a low-diversification position concentrate their efforts on one
single business or on one dominant business. A firm is classified as a single business when
the revenue generated by the dominant business accounts for greater than 95% of total sales
(Rumelt, 1974, p. 10). Dominant businesses are firms that generate between 70% to 95% of
their total sales within a single category. Finally, firms with more than 30% of their sales
outside of a dominant business, and with their businesses somewhat related, can call their
company related diversified. Since more direct links exist between businesses, it is called
related. In cases where only a few links exist between businesses, the company is classified
as a related-unrelated mix, or a linked-related firm (Rumelt, 1974).
Companies pursue diversification strategies for a variety of reasons.

There are

incentives, resources, and administrative motives to diversify. The incentives to diversify

come as much from the external environment as from the internal environment of the
company. Often, diversification is implemented to avoid the loss of value by the firm.
External incentives to diversify include antitrust regulations and fiscal laws. Internal
incentives include under-performance, uncertain future cash flows, and overall reduction of
risk for the firm. The current study will fundamentally examine the internal incentives.
For Rumelt (1974), high performance eliminates the necessity for increased
diversification. Similarly, poor performance can create an incentive to diversify. Thus, firms
with low-levels of performance frequently take on greater risk (WISEMAN and GOMEZMEJIA, 1998, p. 133-153). Correspondingly, Chang and Thomas (1989, p. 271-284) found
evidence that low returns are associated with greater levels of diversification.

Poor

performance can lead to greater diversification, especially in the availability of resources to

pursue this goal.

Figure 1 presents in schematic form the incentives, resources, and

administrative motives to diversify a firm. On the other hand, a series of low returns after

additional diversification can reduce the degree to which the strategy is implemented.
Following this line of reasoning, Palich, Cardinal, and Miller (2000, p. 155-174) suggest that
an overall curvilinear relationship can exist between diversification and performance. Later,
Mendes-da-Silva (2004) tested the existence of a quadratic relationship between the
diversification level of industrial companies listed on the So Paulo Stock Exchange
(Bovespa) and Tobins Q index and found no significant association.
Figure 1 Reasons, Incentives, and Resources for Diversification
Economies of scale
Activity sharing
Transfer of Competencies
Market Power (related diversification)
Block competitors through multipoint
Reasons to improve strategic competitiveness
competition
Vertical integration
Financial economies (unrelated
diversification)
Effective allocation of internal capital
Business restructuring
Antitrust regulation
Fiscal legislation
Poor performance
Incentives and Resources with Neutral Effects
Uncertain future cash flows
on Strategic Competitiveness
Reduction in risk for the firm
Tangible resources
Intangible resources
Diversification of risk of administrative jobs
Administrative Motives (Reduction of value)
Increased administrative compensation
Source: Adapted from Hitt, Ireland, and Hoskisson (2002, p. 238)

Alternatively, from Gibbs (1992, p. 15), the value of a firm is maximized at the point
where the marginal return from additional diversification is zero. However, some managers
with free cash flows continue to diversify beyond the effective point, and they can destroy
shareholder value.

This approach, however, supports Palich, Cardinal, and Millers

argument, which proposes that the relationship between diversification and the value of the
firm is illustrated by an inverted U.

Extending beyond this point, Hitt, Ireland, and

Hoskisson (2002, p. 262) contend that the greater the incentives and the more flexible the
resources, the greater will be the level of expected diversification.

3. Corporate governance and the strategy of diversification

Reasons to diversify can exist even if incentives and resources are insufficient. A
reduction in administrative risk, that is, the risk of management job loss and the desire for
greater compensation, can be a motive for diversification initiatives (Cannela Jr. and Monroe,
1997, p. 213-237). A corporate strategy to diversify the lines of production of a firm can
maximize the competitive strategy, increasing its returns, which satisfies the interests of both
the owners and the executives.

However, the executives can diversify a firm with the

principal objective of mitigating their own employment risk. Additionally, they may even act
complacently in relation to the free cash flows generated from the positive net present value
of investments within the current product lines of the firm. To Gray and Cannela Jr. (1997, p.
517-540), diversification also offers benefits to the executives of which the stock holders do
not benefit.

Diversification and firm size are highly correlated, and as size increases,

executive compensation also increases.

As such, the executive directors of a company can initiate diversification programs for
different reasons; the principal reasons can be to reduce personal employment risk and for
other personal benefits. One type of personal benefit resulting from diversification could be
future career prospects. Thus, a manager can obtain non-financial benefits by diversifying a
company. Power, prestige, and social status are examples of non-financial benefits. Social
status depends on how well known an executive is within the different settings and business
lines (Anderson et al., 2000). Accordingly, the perception of power, prestige, and social
status can persuade an executive to diversify the activities of a company. As an organization
grows, it can tend to become more complex from an organizational point of view. In this
situation, an executive can feel a greater need to be entrenched in his or her position via
diversification, making the turnover of the executive very costly. In this way, diversification
can be seen as a result of the agency problem administrated by the firm (Hoskisson and Turk,
1990).

Large firms possess more complex administration, requiring greater abilities from
administrators, translating into greater compensation.

This differentiated level of

compensation can persuade an executive to implement higher levels of diversification, which

can compromise the financial performance of the firm. In this situation, the mechanisms of
corporate governance fill an essential role.

In this context, the board of directors, the

oversight of the shareholders, as well as the market itself have the power to limit superdiversification tendencies (Hoskisson and Hitt, 1990). Furthermore, the shareholders can
reduce their risk by diversifying their investment holdings. This contrasts with the managers
who do not have the opportunity to formulate a diverse portfolio of firms to mitigate their
employment risk. Thus, top executives may choose a level of diversification that maximizes
the size of the firm and, consequently the compensation that they receive, while reducing the
risk to their jobs.
Additionally, Palich, Cardinal, and Miller (2000, p. 158) understand that
diversification can occur for reasons besides performance maximization This theory
recognizes that increasing diversification may not be associated with concomitant increases
in performance, at least not through the entire relevant continuum. In situations where the
governing mechanisms are not sufficiently strong to control the executives decisions,
managers can diversify the firm to the point that the company fails to earn even average
returns (Hoskisson and Turk, 1990, p. 459-477).
In summary, the governing mechanisms should discourage this type of executive
action, which essentially seeks administrative gains, relegating corporate objectives to
secondary status, capable of significantly affecting the financial performance of the firm.
However, the implementation of these governing mechanisms creates agency costs (Sharma,
1997).

These costs consist of the sum of the incentive costs (such as executive profit

sharing), monitoring, implementation, and individual financial damages, all incurred by the
principal (Jensen and Meckling, 1976). The level of diversification that can be expected to
result in the greatest positive effect on performance (strategic competitiveness and above-

10

average earnings) is based partially on the form in which the interaction between resources,
administrative motives, and incentives affect the strategic diversification positioning. In
other words, the governing mechanisms are preponderant to the level and the type of
diversification to be adopted.
Strategies of diversification can increase the competitiveness of a firm and contribute
to greater financial returns.

Diversification should be measured by the mechanisms of

governance because the managers also have motives to make a firm grow excessively
through diversification. Moreover, in the last few years, the ownership of many modern
corporations has often been transferred to institutional investors, which, in Smiths (1996)
view, are a powerful governing mechanism. Denis, Denis and Sarin (1997, p. 135-160), in a
study that involved diversification, agency problems, and the market value of companies,
concluded that diversification is associated with reduced firm value, which is consistent with
the work of Berger and Ofek (1996, p. 39-65), Lang and Stulz (1994, p. 1248-1280), Servaes
(1996, p. 1201-1225) and Rogers (2001, p. 1-32), and even found a negative correlation
between diversification and turnover of upper executives of a company.
However, no studies exist that substantiate this association with evidence from the
Brazilian market. As a company grows, it tends to break up ownership, reducing ownership
concentration. To Hoskisson, Johnson, and Moesel (1994), diluted ownership creates weak
monitoring of administrative decisions.

A result of weak monitoring can be the

diversification of the firms product lines beyond the ideal point for the stockholders, as
explained by Palich, Cardinal, and Miller (2000). An inverse association would then exist
between ownership concentration and diversification since greater levels of monitoring could
motivate executives to avoid strategies that do no create value for the stockholder.
Besides ownership concentration, the majority source of capital for the firm can
influence the strategies implemented to create value for the stockholder. Thus, in a stateowned company, political interests can have greater weight than the financial performance of
the company, when compared to a private company (Volpin, 2002). Furthermore, a widely-

11

defended view is that a board of directors composed of a significantly-high percentage of

upper executives tends to result in relatively weak monitoring and control of administrative
decisions (Beatty and Zajac, 1994). On the other hand, there are studies, such as those of
Baghat and Black (1999 and 2002) and Medes-da-Silva, Moraes and Rocha (2004) that do
not attest to the effectiveness of an independent board of directors in relation to the
monitoring of executives, with the latter study created from Brazilian market data. The
following are the details of the procedures used to create the set of companies studied, in
addition to the variables involved in the study.

4. Methodology
4.1 Sample, data, and variables
In May of 2001, there were 459 companies listed on the So Paulo Stock Exchange,
of which 289 had data available on the Economatica database. In order to develop this
study, all manufacturing companies with data available for at least three of the five years
studied (1997 to 2001) were included, resulting in a total of 176 industrial (manufacturing)
companies with open capital. Companies with 14 different industrial segments were included
in the set, which are listed in Table 1. The data was collected from the Economatica
database and the Annual Report Information (ARI) that companies send annually to the
Comisso de Valores Mobiliarios (CVM).

Accordingly, the performance, corporate

governance, and strategy of product diversification variables were obtained as described in

the Appendix. After the collection and tabulation of the data, outliers were identified, which
can distort the results of the study. After identifying the outliers, they were removed from the
database, as recommended by Hair et al. (1998).

12

Table 1Occurrence of Participating Companies of the Study by Economic Sector

Sector

Occurrence
Percentage
Chemical
27
15,3
Textile
26
14,8
Siderurgy and Metallurgy
24
13,6
Vehicles and Parts
18
10,2
Food and Drink Sector
15
8,5
Electronics
11
6,3
Construction
11
6,3
Industrial Machine Sector
10
5,7
Others
10
5,7
Paper and Cellulose
8
4,5
Electric Energy
6
3,4
Mining
4
2,3
Oil and Gas
3
1,7
Non-metallic Minerals
3
1,7
Total
176
100
Source: Developed by the author with data from the study (2004)

A maximum limit of 10% of the valid observations was established as the limit for the
quantity of observations selected. This way, the normal distribution of the data was assured
following the procedure described by Hair et al. (1998), which proposes that the Z score for
each occurrence distribution, calculated with equation [1], should remain in the interval of 2.58 to +2.58.
skewness
[1]
6
N
where skewness is the value of the asymmetry statistic of the probability distribution of one
z skewness =

variable, and N represents the size of the sample.

5. Empirical Results
Table 2 presents the results of t-test for the equality of product concentration averages
(HPOD), which compares values related to the set of companies which maintained the
chairman of the board of directors independent from the management to those that did not
maintain independence of the chairman (INDPR) and finally those companies that granted
profit sharing to their executives with companies that dont grant profit sharing (PART).

13

Table 2 Result of T-Test for the Equality of Average of the Product Concentration
Index (HPROD) Following the Independence of the Chairman of the Board of Directors
(INDPR) and the Profit Sharing of the Executives in the Company (PART)

Governance
Average
Standard 95% confidence interval
t
gl
Sig.
Variables
difference
error of
Inferior
Superior
INDPR
-2,770 490,000 0,006
-607,432
219,322
-1038,361 -176,503
PART
-4,927 486,000 0,000 -1086,659
220,552
-1520,014 -653,305
Source: Developed by the author with data from the study (2004)
Note: this table presents the results of test t for the equality of the average of product concentration,
On the first line of Table 2, at the 1% level, the difference in product diversification is
significant based on the independence of the chairman of the board of directors (t = -2.770;
Sig < 0.01), which is illustrated on Graph 1. That is, the governance structures that included
chairmen of the board that did not simultaneously belong to executive management
(independents), presented lower levels of product concentration.

Graph 1 Product Concentration Based on the Independence of the Chairman of the

Board of Directors
12000

ndice H de Concentrao dos Produtos

10000

8000

6000
4000

2000

No Independente

-2000

Independente
1997

1999
1998

2001
2000

Ano

Source: Created by the author with data from the study (2004)

This result indicates that product diversification in companies with an independent

chairman of the board is greater than when the governing structure includes a nonindependent chairman of the board. Similarly, the second line of Table 2 shows that
companies which adopt profit sharing as a means to encourage executives also had a lower

14

average product concentration than those that did not offer this compensation to their
executives (t = -4.927; Sig. < 0.01). This is illustrated in Graph 2.

Graph 2 Product Concentration Based on Executive Profit Sharing

12000

ndice H de Concentrao dos Produtos

10000

8000

6000

4000

2000
Participao dos CEO
0

no

-2000

sim
1997

1998

1999

2000

2001

Ano

Source: Created by the author with data from the study (2004)

On the other hand, Graph 3 illustrates the evolution of the chairman of the board of directors
from 1997 to 2001 in the set of companies studied. In contrast to the expectation that with
increasing significance of good corporate governing practices, there would be a gradual
increase in the independence of the board (which would perhaps contribute to better
monitoring of executives, consequently reducing the probability of super-diversification), the
proportion of companies that maintained an independent chairman of the board fell from
53.3% in 1997, to 48.2%, a drop of approximately 10%.

Independent Chairman

Graph 3 Evolution of the Independence of the Chairman of the Board of Directors

60%

53.30%

52.60%

51.70%

50%

47.60%

48.20%

2000

2001

40%
30%
20%
10%
0%
1997

1998

1999

Time

Source: Created by the author with data from the study (2004)

15

5.1 Multivariable Analysis

Table 3 presents the multiple regression results, with the product concentration index
(HPROD) as the dependent variable. As shown, at the 1% level of significance, three
variables are considered significant in the HPROD illustrative model. First, the size of the
board of directors, lnTAMC ( 3 = -971.73; t = -3.52), was negatively associated with product
concentration. This result suggests that the greater the number of members on the board of
directors, the greater the product diversification implemented by the company will be.

Table 3 Estimated Parameters for the Multiple Regression Model

Independent
Variables

Non-Standardized
Coefficients

Standardized
Coefficients

Sig.

Adjusted R

B
Standard Error
Beta
(Constant)
7278.571
1103.577
6.595
0.000
0.126
INDPR
-280.031
259.307
-0.058
-1.080
0.281
INDCO
-2.386
8.328
-0.016
-0.286
0.775
-971.735
275.333
-0.188
-3.529
0.000
lnTAMC
711.874
173.023
0.184
4.114
0.000
CNTR
-11161.214
217.986
-0.238
5.327
0.000
PART
HPROD
-0.036
0.040
-0.042
-0.898
0.370
lnTAMF
-126.543
77.411
-0.081
-1.635
0.103
148.056
74.252
0.087
1.994
0.047
ANO
Source: Developed by the author with data from the study (2004). N = 659.
HPROD
Note: Statistical software SPSS Version 12.0. Enter method. Dependent variable HPROD,
independent and dependent variable are defined in the appendix. Durbin-Watson statistic: 2.049

Second, the type of stockholder control (CNTR) had a positive sign for the regression
coefficient ( 4 = 711.874; t = 4.114), which suggests that, on average, companies with a
higher level of product concentration have government capital, while companies with private
domestic capital demonstrated a lower degree of diversification. Third, profit sharing by the
executive directors was negatively correlated with product concentration ( 5 = -1161.214; t =
-5.327), which reveals that, in companies in which executives have profit sharing, less
concentration and greater product diversification were observed. This supports the idea that
in companies which incur the agency cost of profit sharing, there is a greater tendency toward
corporate diversification. On the 5% level of statistical significance, the YEAR variable ( 9

16

= 148.056; t = 1.994; Sig < 0.05) was relevant in explaining the behavior of the product
concentration index.
Thus, it was shown that on average, companies generally concentrated their product
set over time, or in 1997 companies were more diversified than in 2001. Notably, the model
did not reach an expressive value for the adjusted correlation coefficient, which suggests that
only 12.6% of the variance of HPROD were explained. Correspondingly, the Durbin-Watson
statistic (2.049) was greater than R, which, in Granger and Newbolds (1974) view, provides
sufficient support to believe that this is not a spurious regression. Considering the estimated
parameters, the most important variable in understanding the behavior of the product
concentration index, based on the tested model, is the sources of the companys capital
(CNTR).
Additionally, in order to verify which independent variables best explained the
behavior of product concentration; multiple regression was run by the stepwise method, with
the results illustrated in Table 4. Accordingly, the same variables which were significant in
Table 4 composed the illustrative model.

The size of the board (lnTAMC) variable

contributed most to the model, and the signs of the regression coefficients were the same as
those obtained in Enter-method multivariable test, which are found in Table 3.

Table 4 Estimated Parameters for the Multiple Regression Model

Non-Standardized
Standardized
Adjusted
t
Sig.
Coefficients
Coefficients
R
B
Standard Error
Beta
(Constant)
6870.165
441.784
15.551 0.000
0.049
1
lnTAMC
-1165.313
234.827
-0.225
-4.962 0.000
(Constant)
7395.165
445.854
16.587 0.000
0.091
2
lnTAMC
-1127.953
229.692
-0.218
-4.911 0.000
PART
-1026.853
216.694
-0.210
-4.739 0.000
(Constant)
6196.309
542.458
11.423 0.000
0.116
lnTAMC
-1233.685
228.195
-0.238
-5.406 0.000
3
PART
-1080.158
214.118
-0.221
5.045 0.000
CNTR
643.878
170.702
0.166
3.772 0.000
(Constant)
5675.175
600.597
9.449 0.000
0.122
lnTAMC
-1206.900
227.857
-0.233
-5.297 0.000
4
PART
-1064.902
213.566
-0.218
-4.986 0.000
CNTR
646.756
170.160
0.167
3.801 0.000
ANO
147.507
73.998
0.087
1.993 0.047
Source: Developed by the author with data from the study (2004). N = 688.
HPRODit = 0 + 1INDPRit + 2 INDCOit + 3 ln TAMCit + 4CNTRit + 5 PARTit + 6 HPODit + 7 ln TAMFit + 8 ANOit + it
Models

Independent
Variables

17
Note: Statistical software SPSS Version 12.0. StepWise method. Dependent variable HPROD, independent and
dependent variables are defined in the appendix. Durbin-Watson statistic: 2.085.

In order to verify the existence of relationships between corporate governance and

product diversification variables with company performance, Table 5 presents the regression
results with the dependent performance variables.

The first line contains the estimated

parameters for the proxy value of the firm, Tobins Q index. Four variables were significant
in explaining the behavior of the independent variable.

Thus, the independence of the

chairman of the board of directors (INDPR), on the 1% level, had a positive regression
coefficient ( 1 = 0.196; t = 4.155), indicating that, on average, companies whose chairmen
did not participate simultaneously in executive management had better performance in terms
of value created for the stockholder. This supports the idea that when the governing structure
includes independent members of the board of directors, there is better monitoring of the
executives, resulting in greater corporate performance.
It is important to note that, in the opinion of Dutra and Saito (2002), Brazilian boards
of directors are strongly dominated by people who are connected to executive management,
which compromises the monitoring of the executives. Besides this, throughout the world, the
importance of members of board of directors, individually and collectively, has been
intensely evaluated with a greater level of formalization (Byrne and Brown, 1997; Conger,
Finegold, and Lawler, 1998). As such, the demand for greater responsibility of the board has
led to actions such as: diversification of the backgrounds of the members of the board, as well
as the strengthening of the system of accounting controls.
Also on the 1% level of significance, the voting power concentration (HPOD) was
positively correlated with Tobins Q, suggesting that companies with greater voting power
concentration, on average, create greater value for the shareholder than those with more
diluted power. The size of the firm (lnTAMF) was also positively correlated with the proxy
value of the firm ( 7 = 0.034; t = 2.414). And, supporting the expectation that more
diversified firms suffer a drop in value relative to more concentrated firms, the product

18

concentration index, HPROD, at the 10% level of significance, was positively correlated with
Tobins Q. This agrees with the results obtained by Lang and Stulz (1994), Berger and Ofek
(1996), Servaes (1996), and also Denis, Denis, and Sarin (1997).

Table 5 Estimated Parameters for the Complete Mulivariate Regression Model

Non-standardized
Standardarized
coefficients
coefficients
Standard
B
Beta
Error
(Constant)
-.440
.217
.196
.047
.256
INDPR
INDCO
.002
.002
.068
LNTAMC
-.070
.050
-.082
CNTR
.015
.030
.025
Q
PART
-.027
.040
-.034
2.071E-05
.000
.150
HPOD
.034
.014
.135
lnTAMF
YEAR
.017
.013
.062
1.546E-05
.000
.098
HPROD
(Constant)
-46.013
16.575
INDPR
-5.594
3.734
-.085
INDCO
.079
.120
.039
LNTAMC
7.447
4.048
.106
CNTR
1.699
2.519
.033
CVEND
PART
.472
3.239
.007
HPOD
-.001
.001
-.050
2.458
1.125
.116
lnTAMF
2.037
1.075
.088
YEAR
HPROD
.001
.001
.040
(Constant)
-165.942
38.253
-24.712
8.573
-.164
INDPR
INDCO
-.045
.275
-.010
24.146
9.316
.148
lnTAMC
CNTR
3.983
5.719
.033
RPL
PART
11.692
7.411
.077
HPOD
.000
.001
-.011
6.720
2.559
.138
lnTAMF
6.000
2.442
.114
YEAR
HPROD
.001
.002
.039
(Constant)
-21.392
4.626
-2.763
1.025
-.148
INDPR
INDCO
-.052
.033
-.091
4.230
1.100
.211
lnTAMC
CNTR
.896
.685
.060
ROA
PART
.280
.890
.015
.000
.000
-.125
HPOD
1.148
.306
.190
lnTAMF
1.065
.292
.163
YEAR
HPROD
.000
.000
.047
Source: Created by the author with data from the study (2004)
Dependent
variables

Independent
variables

t
-2.026
4.155
1.072
-1.380
0.488
-0.656
2.869
2.414
1.242
1.855
-2.776
-1.498
0.663
1.840
0.674
0.146
-1.014
2.186
1.895
0.798
-4.338
-2.883
-0.165
2.592
0.696
1.578
-0.221
2.626
2.457
0.788
-4.625
-2.696
-1.580
3.845
1.307
0.315
-2.609
3.754
3.643
0.986

Adjusted
R

DW

Sig.

0.125

1.884

0.034

2.026

0.061

1.994

0.145

1.934

.044
.000
.284
.168
.626
.512
.004
.016
.215
.064
.006
.135
.507
.066
.500
.884
.311
.029
.059
.425
.000
.004
.869
.010
.487
.115
.825
.009
.014
.431
.000
.007
.115
.000
.192
.753
.009
.000
.000
.325

DFit = 0 + 1 INDPR it + 2 INDCO it + 3 ln TAMC it + 4 CNTR it + 5 PART it + 6 HPOD it + 7 ln TAMF it + 8 ANO it + 9 HPROD + it

Note: DF represents the performance of the firm. Dependent variables are expressed by Q, CVEND, RPL, and
ROA. Statistical software SPSS version 12.0. Method Enter. N = 678. The independent and dependent
variables are defined in the Appendix. ***Significant to 1%; **Significant to 5%; *Significant to 10%.

19

One can validly note that the correlation coefficient, adjusted R, did not reach
expressive values for the independent variables considered in this study. On the other hand,
for the four performance variables, the Durbin-Watson statistic was greater than the adjusted
R, suggesting that the regression was not spurious. The best adjustment of the proposed
model was return on total assets, ROA, with an R of 0.145. For this last variable, the
independence of the chairman of the board (INDPR) had a negative regression coefficient (1
= -2,763; t = -2,696), indicating that, on average, in companies whose chairman was
independent of management, return on assets was notably lower, in contrast to the model for
Tobins Q index.

6. Final Considerations
Strategic decisions made by upper management are the basis for the firm achieving
higher performance. However, executives may incorporate their own personal interest in the
strategic decisions. A result of this would be the super-diversification of the operations of the
firm. As such, effective systems of governance should represent the corporate interests
before the executive management by prioritizing the creation of value for the stockholder.
Thus, in companies where the governance structure is not effective, a drop in firm value can
occur as a result of excessive diversification.
This study contributes to better understanding the associations between governance
structures and diversification strategies.

Based on data from 1997 to 2001, from 176

manufacturing companies listed on the So Paulo Stock Exchange, the study examined
associations between corporate governance and diversification strategies, and also these two
sets of variables with four financial performance variables.
With a basis in the conceptual and operational definitions of the average equality
variables used in this study, the principal results of the study are the following. First, the
results of the bi-variable test indicate the existence of a significant positive association
between the product diversification level and the independence of the chairman of the board

20

of directors. This is evidence of one of the consequences of the adoption of governance

structures that exercise greater disciplining power over the executives, one of the agency
costs. Also, a significant positive association was seen between the granting of company
profit sharing and the level of product diversification since companies that choose this type of
executive compensation experience greater diversification of their product portfolio.
Second, the regression analysis suggests with statistical significance that the larger the
board of directors, the greater will be the level of product diversification. Another result is
that, similar to the bi-variable test, executive profit sharing is positively related to the
diversification of the company. The majority capital source was shown to be important in
understanding diversification behavior, since private national companies chose greater
diversification levels than state (government-owned) companies. The regression analysis
also showed a reduction in the level of diversification over the study period.
The size of the firm and the independence of the chairman of the board of directors
were positively related to the value of the company, while more diversified companies
obtained lower values for Tobins Q index, which suggests that companies suffer a drop in
value from the level of product diversification.

Although this study was limited to

manufacturing companies listed on the So Paulo Stock Exchange (Bovespa) in a given

period of time, limiting the generalization of the results, some aspects can be cited as objects
for future studies:

Perform a study utilizing different proxies and time periods than those used in this
study;

Verify the existence of ideal levels of firm diversification;

Analyze the impacts of diversification on the operational performance of the firm.

21

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24

AppendixDescription of Variables Involved in the Study

Variable

Description

Financial performance variable

CVEND

Rate of revenue growth per year, calculated by [(Salest+1) (Salest)] / Salest

Tobins Q index, measure of market value of a company is calculated by the

relation between the market value of a company and the reposition value of its
assets. This indicator reveals the aggregate wealth by the market as an indication of
its performance. If Tobins Q is greater than 1.0, it indicates that the market value
of the company exceeds the reposition value of its assets. It would then be the Chung e Pruitt
consequence of the creation of value for the stockholders, based on the investment (1994)
capacity to remunerate the capital of the owners. On the other hand, when Tobins
Q is less than 1.0, the companys liquidation value would not be sufficient to meet
the total cost of repositioning the assets of the company.

Return on total assets in year t. It is expressed by the ratio between company profit Anderson
i and the book value of the total assets in the same period.
et al. (2000)

ROA
ROE
INDPR

INDCO

Corporate governance variable

Conceptual
Bhagat e Black
(1999)

lnTAMC

Return on equity in year t. It is expressed by the ratio between company profit i and
the book value of its equity in the same period.
Diatomic variable that expresses the independence of the chairman of the board of
directors of a company. The value of the variable = 1 if the chairman of the board
of directors doesnt simultaneously occupy a position in executive management
(independent) and, value = 0 in the alternative case (non-independent).
Proxy that measures the degree of independence of the chairman of the board of
directors. It is expressed by the fraction of the total number of members of the
board of directors that is independent, that is, the percentage of the board that
doesnt simultaneously belong to executive management in year t.
Natural logarithm of the number of members of the board of directors of a company
i, in year t.

Anderson
et al. (2000)
Bhagat &
Black (2002)
Bhagat e Black
(2002)
Bhagat e Black
(2002)

CNTR

Politomic variable that expresses the type of stockholder control of a company.

Value = 1 when a company is a foreign holding; value = 2 when a company is
private domestic; value = 3 when a company is foreign; value = 4 when a company Volpin (2002)
is a domestic holding; value = 5 when a company is a state-owned holding; value =
6 when a company is state owned.

PART

Diatomic variable that expresses the profit sharing of the executives in the
company. Value = 1 if the executives have profit sharing, and value = 0 in the Volpin (2002)
contrary case.
Index of the voting power concentration under control of the three main
stockholders. Calculated with the following equation:
2

Hoskisson,
Johnson e
where Pi is the number of common shares of a company i in the control of a Moesel (1994)
determined shareholder, and P represents the total quantity of common shares of the
company.
HPOD =

HPOD

i =1

Pi
100
P

Index of the realized-sales concentration of the three main products of a company i.

Calculated with the following equation:

HPROD =

pi
100
p

Anderson

**

HPROD

LnTAMF

Size of the firm i expressed by the natural logarithm of the total assets of a company Bhagat e Black
in year t.
(2002)

YEAR

Politomic variable that expresses the year of the data of a company i. Value = 1 for
1997; value = 2 for 1998; value = 3 for 1999; value = 4 for 2000; value = 5 for
2001.

i =1

where pi is the value of sales made of a product, and p is the total value of sales of a et al. (2000)
company i in year t.

Source: Economtica Souce: Comisso de Valores Mobilirios (The Brazilian SEC) * Control variable
**Diversification variable