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.