In their very inﬂuential article, Prahalad and Hamel (1990) deﬁne a ﬁrm’s core competence as ‘the collective learning in the organization, especially how to coordinate diverse production skills and integrate multiple streams of technologies.’ Such core competencies have many of the attributes of resources and capabilities described in Chapter 3 of this book: They are likely to be path dependent, causally ambiguous, and socially complex.
However, the existence of core competencies, per se, is a necessary, but not suﬃcient explanation of why ﬁrms will adopt a corporate diversiﬁ- cation strategy. Consider the following. Suppose a ﬁrm possesses a core competence, A, that can be applied in its current industry, I, but can also be valuably applied in a second industry, II. Since this single competence is valuable in both these industries, these industries are, by deﬁnition, strategically related (Markides and Williamson 1994).
However, what diﬀerent ways can this ﬁrm realize the value of its core competence, A, across these two industries I and II? One option, of course, would be for this ﬁrm to simply begin operations in industry II and then make sure that those inside this ﬁrm that are in charge of operating the business inside of industry II exploit competence A in doing so. Alterna- tively, this ﬁrm could acquire a ﬁrm that is currently operating in indus- try II, and by integrating this newly acquired business into its boundary, take advantage of competence A. Both these approaches to realizing the potential value of competence A in industry II adopt hierarchical forms of governance (Williamson 1975). And in both these cases, a ﬁrm can be said to be implementing a strategy of corporate diversiﬁcation.
However, hierarchy is not the only way this value can be realized. At least two alternatives present themselves. First, this ﬁrm could form an alliance with a ﬁrm currently operating in industry II, and realize the potential value of competence A this way. Alternatively, this ﬁrm could license its competence A to a ﬁrm currently operating in industry II. These inter- mediate and market forms of governance would enable a ﬁrm to realize the value of its core competence, but would not require a ﬁrm to actually change the mix of businesses it engages in within its own boundaries. That is, these ﬁrms would not necessarily have to implement a corporate diversiﬁcation strategy to realize the value of the core competence A.
It was Teece’s original (1982) insight that in order for it to be eco- nomically eﬃcient for a ﬁrm to operate multiple businesses within its boundary, not only must there be core competencies that can create value across these multiple businesses (although Teece did not use the term ‘core competence’—it had not yet been invented), but that the value of these core competencies could not be realized through intermediate or market forms of governance. Neither valuable core competencies nor market fail- ures, by themselves, were suﬃcient to explain the existence of diversiﬁed ﬁrms. However, together, they could explain these types of organizations.
Of course, Teece’s original argument (1982) was developed out of TCE, with its emphasis on transaction-speciﬁc investment and the threat of opportunism as primary determinants of a ﬁrm’s governance choices. However, in this case, TCE and resource-based theories are clearly comple- mentary. Transactions cost economics arguments suggest that high levels of transaction-speciﬁc investment lead to hierarchical governance. Resource- based theories suggest that exploiting core competencies that are path dependent, causally ambiguous, and socially complex will often require exchange partners to make high levels of transaction-speciﬁc investment. Thus, by bringing these two theories together, it follows that in order to exploit their core competencies, ﬁrms will often have to bring multiple businesses within their boundaries, that is, ﬁrms will need to implement corporate diversiﬁcation strategies.
A vast amount of empirical research has attempted to assess the valid- ity of these arguments. Currently, there is broad consensus that related diversiﬁcation (where a ﬁrm exploits a core competence in its diversiﬁca- tion eﬀorts) creates more economic value than unrelated diversiﬁcation (where a ﬁrm does not exploit a core competence in its diversiﬁcation eﬀorts) (Palich, Cardinal, and Miller 2000). This result is consistent with the RBT/TCE arguments presented here. After all, if a ﬁrm is not exploiting a core competence in its diversiﬁcation strategy, then it is not likely that transactions to implement its diversiﬁcation strategy would be subject to market failures, and thus, it is not likely that such transactions will need to be brought within the boundaries of a ﬁrm. If such transactions are brought within the boundaries of a ﬁrm, then the ineﬃciencies created will lead to low levels of performance. Thus, related diversiﬁers—where the exploitation of core competencies is more likely to lead to market failures— are likely to outperform unrelated diversiﬁers.
While there is broad consensus that related diversiﬁcation outper- forms unrelated diversiﬁcation, there is less consensus about whether diversiﬁcation—of any kind—outperforms no diversiﬁcation, a so-called focused or single business strategy. In their very inﬂuential papers, Lang and Stultz (1994) and Comment and Jarrell (1995) showed that diversiﬁed ﬁrms traded at a signiﬁcant discount compared to a portfolio of focused ﬁrms operating in the same industries as a diversiﬁed ﬁrm. This result sug- gested that, on average, diversiﬁcation—including diversiﬁcation designed to exploit core competencies—destroyed economic value. One explanation of this result was that the organizational costs of implementing corporate diversiﬁcation—including the cost of ineﬃcient internal capital markets (Gomes and Livdan 2004)—were simply greater than any value created by exploiting core competencies across multiple businesses.
A second group of scholars, including Campa and Kedia (2002), Villalonga (2004a, 2004b), and Miller (2004), showed that, controlling for a ﬁrm’s growth options in its current businesses, that corporate diversi- ﬁcation either did not destroy value or might even create value for its shareholders. Suppose, for example, a ﬁrm was generating signiﬁcant free cash ﬂow in a mature or declining business. In such industries, there are limited growth options and it might make sense for a ﬁrm to invest some of its free cash into business opportunities that have more signiﬁcant growth options. This would especially be the case if these growth options exploited one or more core competencies possessed by a ﬁrm (Miller 2004). Using a two-stage methodology, many of these authors were able to document either that diversiﬁcation did not destroy value, or that it, in fact, did create value for a ﬁrm’s shareholders.
However, even more recently, Mackey and Barney (2006) have shown that this diversiﬁcation premium literature is incomplete. In particular, when a ﬁrm with limited growth options generates free cash ﬂow, it has two broad options: First, it can use this cash to invest in new business activities (i.e. it can engage in related corporate diversiﬁcation) or, second, it can give this cash back to its shareholders, either in the form of a dividend or a stock buyback program. Employing the same two-stage methodology used by previous scholars, but simultaneously controlling both for the likelihood of a ﬁrm to diversify (because of limited growth options) and the likelihood of a ﬁrm to give cash back to its shareholders (through dividends or stock buybacks), Mackey and Barney (2006) ﬁnd that ﬁrms that only give cash back to their shareholders create economic value, ﬁrms that give cash back and diversify do not create or destroy value, and ﬁrms that just diversify destroy value. These results hold even if the level of strategic relatedness in the diversiﬁcation strategies used by a ﬁrm are controlled for. Once again, these results are consistent with the observation that the costs of diversiﬁcation may be greater than the beneﬁts created by exploiting a ﬁrm’s core competencies.
Source: Barney Jay B., Clark Delwyn N. (2007), Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press; Illustrated edition.