For "sin" companies, diversification may make sense, study finds
June 8, 2006
Messod Daniel Beneish
BLOOMINGTON, Ind. -- Diversification, long derided as a poor strategy for companies seeking to maximize shareholder return, can actually help firms preserve their assets -- at least those companies threatened by litigation or regulation, according to a new study of tobacco company diversification activity led by Professor Messod Daniel Beneish of Indiana University's Kelley School of Business.
Beneish and his three co-authors are the first to suggest that diversification makes good business sense for certain types of companies -- those facing serious legal and political costs. For those companies, parking capital elsewhere in physical assets can keep it away from litigators and help shore up "political capital" as well.
Beneish, the Sam Frumer Professor of Accounting, conducted the research with Ivo Jansen, assistant professor at Georgetown University's McDonough School of Business; Nathan Stuart, assistant professor at the University of South Florida; and Melissa Lewis, a doctoral student at the Kelley School.
In the case of tobacco companies in particular, "diversification reduced the depth of their pockets, made them less attractive targets to politicians and private litigants, and extended tobacco firms' influence to a larger number of regulators," said Beneish, who examined 88 diversifying acquisitions by tobacco companies between 1963 and 1988.
Diversification usually doesn't make sense for companies. Extensive academic research has shown, among other things, that diversified firms trade at a discount, and that firms reversing prior diversifying activity achieve higher valuations. If investors want diversification, the thinking goes, it makes more sense to invest in separate companies than to invest in a conglomerate.
But diversification by so-called "sin companies" like those in the tobacco sector is a different story, Beneish said. It allowed companies such as Phillip Morris to acquire companies such as Kraft Foods as a way to funnel tobacco cash flows into businesses that litigants and politicians would be less likely to attack.
"The notion of building political capital is a motivation for diversification that's never been studied," added Beneish, a longtime smoker. "That is, diversification increases the number of legislative districts in which firms have operations, and thus firms' ability to influence a greater number of politicians. As well, diversification increases the number of employees (and ostensibly the number of unions representing these employees), making it more difficult for politicians to expropriate because a larger number of jobs -- and thus votes -- are at stake.
"This is, to my knowledge, the first economic study to show that diversification actually can create value."
Expropriation costs became a reality in 1998 with the Master Settlement Agreement requiring the six domestic tobacco producers to pay state governments $206 billion over a period of 25 years. Once expropriation became certain, tobacco companies began returning cash to shareholders in the way of dividends, Beneish's research found.
"Between 1963 and 1988, the average payment to shareholders through share purchases was $0.4 billion, in 2001 dollars," he said. "It increased to $3.5 billion in 2001 dollars between 1989 and 2003."
"The central conclusions of our research are that diversification created value in the tobacco industry by reducing the expected costs of expropriation, and that tobacco firms limited payouts to shareholders in the pre-settlement period because these could be construed as claim-diluting by politicians and private litigants," Beneish said.
"This study is the first to investigate expropriation costs as a diversification incentive," he added. Although it is based on a specific industry, which limits generalization, he conjectured that "firms with greater political capital are more likely to obtain favorable tariffs in import relief investigations, receive a favorable tax treatment or subsidy, receive greater regulatory protection from private litigation, and receive more favorable public assistance packages in cases of financial distress."
Beneish argues that what he calls "expropriation costs" have until now not been studied as an explanation of how sin businesses, such as tobacco firms, earn extra returns.