Global Diversification: Does it really add value? Evidence from China

By Emma Black (Portfolio Manager at Tier One Capital) 23 April 2013

Paper Co-Authors: Michael Guo, Xiaofei Xing, Angelos Doukas 

Journal: European Financial Management

Since the seminal work of Markowitz in the fifties, academics and practitioners alike have debated the value of diversification. Defined as the spreading of risk, diversification was recommended to be accessible to investors through the combination of assets that do not move in perfect harmony with one another into one portfolio (i.e. they exhibit less than perfect positive correlation), meaning that an investor can benefit from combining two stocks, for example Apple with Wal-Mart, to the extent that they do not move in the same way as each other and can thus offset one another’s movements. The benefits of diversification have been shown to be optimally gained with approximately thirty stocks held within a portfolio of equities, while research has promoted further diversification of risk through the inclusion of different asset classes into the overall held position. In recent times, we have seen diversification sought not just across industries, but across countries. Diversification has mimicked globalisation and has spread investor portfolios onto a global scale. This has been directly achieved with new financial products such as Exchange Traded Funds (ETFs) as well as indirectly being offered to investors who hold the assets of a domestic firm that has internationally expanded its operations to achieve multinationality. While diversification has undoubtedly long-benefitted firms in the EU and US via increased integration, the emerging markets of Brazil, Russia, India and China (commonly referred to as the BRIC economies) have been relative latecomers in regards to diversifying both investors positions as well as firm operations. In our latest research, we have focussed upon the Chinese market and whether or not global investment, and in turn global diversification, is both a wise strategic move as well as a profitable one.

Contextually, China has rapidly emerged onto the global socio-economic landscape since the turn of the century. Globalisation and financial market integration has led China to become a central and integral part of the world’s economic landscape, igniting much Western political concern. Political encouragement from the top in China has bolstered Chinese CEOs to acquire cross-border targets with menacing speed with the primary intention of boosting both the technological advancement and subsequent economic growth of the domestic state. There have been a number of political reforms that have vastly shaped the Chinese economy and have served as the building blocks of this marked stance to outward investment. Primarily, the economic reform of 1978 changed the direction of Chinese economic policy such that the economy has dramatically grown over the past three decades to become the second-largest economy in the world, valued at a staggering £5.8 trillion. During this time, domestic companies such as Lenovo have grown substantially, moving into the international arena capitalising upon exchange rate movements while competing with dominant western brands such as Hewlett-Packard. In 2011, cross-border investments via merger activity rose by 96% when backed by private-equity, raising their value to $12.3 billion from $6.3 billion during 2010. It is clear that China has begun its shopping spree.

However, this transition for Chinese firms to move beyond the domestic economy has been no easy feat. Cross-border transactions emanating from China have triggered western curiosity and fear is widespread over what lies ahead for Western firms following the exchange of control for major international brands, such as IBM and Volvo, to the East. The office of President Obama in the US has openly criticised trade practices with China, with the New York Times reporting that the Committee on Foreign Investment into the US should ‘block any mergers and acquisitions involving the Chinese companies and American businesses’ due to national security concerns. Political radars have responded by honing in on cross-border M&A transactions involving the People’s Republic of China, particularly given that many acquisitions involve the purchase of targets within the energy, industrials or technological sectors. For example, Swedish government officials strongly opposed the now-completed sale of Volvo to the Chinese car manufacturer Geely under the fear of the potential outflow of intellectual property to the East, resulting in the deal being referred to the European Commission on anti-trust grounds (Breaking News, 2010).

Given this debate, we focus in our paper upon the performance of Chinese acquiring firms, distinguishing between whether the target is a domestic or foreign entity in order to ascertain whether cross-border transactions are creating value for Chinese bidders. We define value creation in terms of shareholder wealth – such that a deal is deemed to create value for the bidder if statistically significant wealth gains are created in either the short-term or long-term. The short-term results indicate that domestic transactions generate 2.76% announcement returns while cross-border deals neither gain nor lose, with an undecided market response. These results therefore indicate that in the Chinese market, domestic acquirers outperform those firms that acquire overseas by 2.45% on average at the time of deal announcement. Additionally, the short-term analysis reveals that Chinese bidders do earn further abnormal returns but only when purchasing domestically within the energy, industrials and materials sectors, and not when purchasing targets in these sectors from foreign markets.

Over the long-term, domestic acquirers generate long-term wealth losses of -7.98% while cross-border acquirers fail to generate any meaningful wealth effect on the whole. After controlling for firm size we find that small acquirers have a much higher loss than larger acquirers for domestic mergers, but there is no difference in the performance for small cross-border acquirers. However, when we control for the size of the firms, we find that there is a high positive long-run over-performance of large cross-border acquirers. On average, these firms generate long-term wealth gains of 22.39%. This superior performance is also shown to be 29.81% higher than the performance of domestic large acquirers. This result suggests that there is a financial benefit for Chinese acquirers of “going-out” of the domestic economy but only when the Chinese firm is in the top 30% of firms when ranked by market capitalisation, largest to smallest. The evidence indicates that large Chinese firms that “go-out” can generate significantly higher returns, relative to those which “stay-in”, if the firm is sufficiently large enough.

Additional evidence in the paper indicates that there has been a significant increase in the volume of cross-border investment via M&A activity emanating from China, growing over time within key sectors such as energy and high-technology, suggesting that the Dragon is at last waking up. There is certainly a key motivation to acquire intangible assets abroad, such as technology, patents and knowledge, which will all seek to improve and bolster China’s ascension to become an unquestionable superpower, and with more deals rumoured on the market, it certainly looks an area to watch. However, the widespread fear to Chinese takeovers amid concern over a loss of resources to the East, most certainly is unsupported in this work.