Efficiency or bounded rationality? Drivers of firm diversification strategies in Vietnam

Abstract

Considering the case of diversified firms within a developing/transition country such as Vietnam, this paper investigates diversification relatedness while taking into account both firm-and industry-specific components. The high volatility of the dynamics of diversification observed in Vietnam suggests the hypothesis that firms decide to enter into new industries following a trial and error process, initiated by boundedly rational herding behaviours, i.e. firms follow the most commonly observed business combinations. Using a survivor-based (SB) measure of relatedness, we test the hypothesis of a boundedly rational behaviour. We find that both the probability of exit and the different performance measures (Return on sales and Total factor productivity) are not or are negatively correlated with SB-related diversification. This is in contrast to what has been observed in developed countries. However, using the SIC distance approach, we obtain the expected positive relationship between performance and relatedness in diversified firms. The conflicting result between these two relatedness indices therefore suggests there has been a trend in follow-up among inexperienced firms that imitate the direction and intensity of the diversification of dominating players within the industry (herd behaviour). However, diversified firms gain experience over time and choose more efficient business combinations in subsequent entries. When we use the classical SIC-based approach, we find that greater diversification raises profitability, but only to an optimum relatedness point, beyond which the positive effect fades away. To control for the endogeneity of diversification relatedness and the serial correlation in error terms, we adopt an instrumental-variable two-stage least-squares estimation approach (IV-2SLS) with GMM treatment.

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