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During the 1980s, many diversified firms reduced their diversification by refocusing. This study examined whether this refocusing created market value for the companies involved. It is shown that refocusing announcements are associated with significant, positive abnormal returns, which implies that firm diversification levels prior to refocusing were higher than optimal.
During the 1980s, many diversified firms reduced their diversification by refocusing on their core businesses; several studies provide statistical evidence for this contention (Lichtenberg, 1990; Markides, 1990; Williams, Paez, & Sanders, 1988). My previous research, (Markides, 1990) identified these refocusing firms as having high diversification and poor profitability relative to their industry counterparts and suggested that the reason they refocused was that they had diversified beyond their optimal diversification limits. By refocusing on their core businesses, these firms are moving back, closer to their optimal diversification levels. This statement in turn implies that refocusing helps these firms improve their profitability and market value (cf. Hoskisson & Turk, 1990: 470). The reported research tested this prediction empirically, My purpose was to determine whether the market value of firms that refocus increases. I examined 45 firms using event-study methodology to assess the stock market reaction surrounding their refocusing announcements. In an efficient capital market, the effects of such announcements reflect the long-term consequences of refocusing. This effect may not prove to be accurate, but it will be unbiased--neither too high nor too low on the average. In this study, I expected the refocusing-announcement effect to be positive and statistically significant.
THEORETICAL CONSIDERATIONS
A LIMIT TO DIVERSIFICATION
Intuitively, it would seem that in a world in which transaction costs are not assumed to be unimportant, there must be a limit to how much a firm can grow in size. For instance, managerial diseconomies of scale may lead to U-shaped average cost curves, which limit size (cf. Keren & Levhari, 1983). Were this not the case, the world would be dominated by a single megafirm.(1)
The issue of such a size limit has been the subject of several debates in economics (e.g., Calvo & Wellisz, 1978; Mueller, 1987: 26-29; Williamson, 1967). Depending on the specific assumptions they have used, various models have provided different answers. Here, I was only concerned with overdiversification as one limitation on the efficient size...