States of the Economy and Geographic Investment Decisions

ABSTRACTWe examine the impact of economic conditions on firm performance after geographic expansions and divestures. We conjecture that different economy conditions during which a firm expands in and out of geographic territories affect the firm's ability to transform its resources into competitive edges. The difference in the ability of a firm to convert resources to advantages, in turn, leads to variations in operating performance subsequent to geographic expansions and divestures. We conduct empirical tests of our hypotheses using corporation self-disclosed segment data from 1979 to 2008 from COMPUSTAT. We find that, during weak economic cycles, geographic expansions result in sustained long-term profitability. Specifically, firms' geographic expansion decisions contribute 5.4% and 3.9% per year to industry-adjusted annual return on assets (ROA) over 4- and 5-year periods, respectively. On the other hand, geographic divestures enacted during a weak economy do not help improve firm performance. Moreover, both strong and weak economic conditions enhance performance of geographic expansion over two years but have no long-term effects. Finally, the state of the economy during which time geographic divesture takes place does not affect subsequent operating performance.JEL: F2, L1, L25KEYWORDS: Geographic Diversification and Divesture, Operating Performance, Resource-Based View(ProQuest: ... denotes formulae omitted.)INTRODUCTIONThe conjecture that major corporate investment decisions are highly influenced by market cycles has been studied extensively in the business literature. For example, Baker, Stein and Wurgler (2003) show that stock price has a huge impact on equity-dependent firms' investment decisions. Similarly, it is found that mergers and acquisitions (MA while in 2001, after the bubble burst, there were only half as much (Rhodes-Kropf and Viswanathan, 2004). Again, in 2006 and 2007 when stock indices hit new high in all major equity markets, a record number of mergers and acquisitions took place all over the world (finance.mapoftheworld.com). Interestingly, an adverse development in the stock market often triggers companies to scale down their operations as well. Such swamp into mergers and acquisitions in a good economy and the rush into divesture during economic downturn have been well documented in the business press. For instance, PWC' 2009 survey of US executives on divestiture activities revealed that 69% of the respondents planned similar or increased level of divestiture activity in 2010 after the market crash of 2008 and 2009. However, whether these investment decisions result in favorable financial returns has not been fully examined yet. The objective of the study is to empirically document the extent to which the economic cycle impacts firms' operating performance subsequent to an important corporate investment decision, namely geographic diversification and divesture.To examine the impact of different economic states on firms' geographic diversification decisions, we first classify the U.S. economic condition into three categories, strong, stable, and weak, based on the U.S. annual Gross Domestic Product (GDP) growth rate. We define an economy as "strong" when the annual U.S. GDP growth rate is above 4%, and "stable" when the annual GDP grown rate is between 2.5% and 4%; A "weak" economy is reached when the U.S. annual GDP growth is less than 2.5%. We, then, measure each firm's operating performance subsequent to its geographic diversification or divesture using 2-year, 3-year, 4-year, and 5-year average return on assets (ROA) and net profit margin (also known as return on sale, or ROS). …