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School of Business | Department of Finance | Finance | 2016
Thesis number: 14335
Falling behind or catching up? The impact of conglomerates' capital allocation activeness on profitability
Author: Kaijalainen, Olli
Title: Falling behind or catching up? The impact of conglomerates' capital allocation activeness on profitability
Year: 2016  Language: eng
Department: Department of Finance
Academic subject: Finance
Index terms: rahoitus; financing; monialayritykset; conglomerate companies; investoinnit; investment; kannattavuus; profitability; pääoma; capital; menot; expenditure
Pages: 67
Key terms: Capital allocation; Capital allocation activeness; Internal capital market; Investment efficiency; Conglomerates; Profitability; Capital expenditure
Multi-business firms have developed more active approaches to capital expenditure allocation lately in response to ever more rapidly changing market and investment opportunities. Intriguingly, only two prior papers have studied the relation between capital allocation activeness and firm perfor- mance. Hall et al. (2012) show that more active conglomerates produce notably higher returns to their shareholders, whereas Guedj et al. (2009) demonstrate that passive firms obtain higher future profitability than their more active peers. These two papers both explain the performance difference with allocation (in)efficiency. In this paper, I study whether conglomerates allocating capital actively experience different future profitability than conglomerates following a more passive allocation strategy. Moreover, I scrutinize the underlying cause of the profitability differential, comparing the effect of on the one hand allocation efficiency and on the other hand past performance.

I collect a comprehensive sample of conglomerate firms listed in the U.S. between 2001 and 2014, especially taking advantage of their segment-level data. I construct three distinct measures of allo- cation activeness based on prior literature. I also construct two measures of allocation efficiency based on earlier literature as well as develop my own measure of allocation efficiency. To study the impact of allocation activeness on firm profitability, I divide the conglomerates into quintile portfo- lios based on their allocation activeness and study the profitability development. I further conduct panel regression analysis to control for other relevant factors. To examine the underlying driver of the profitability difference, I utilize bivariate analysis, matching analysis, as well as conduct addi- tional tests on the relation between allocation activeness and efficiency.

I show that active firms experience lower future profitability than conglomerates following a more passive capital allocation strategy. The result is robust for other firm characteristics, for a longer time period in measuring activeness, and for applying another measure of profitability. The most interesting finding of my paper relates to the underlying driver of active firms' lower future profita- bility. While the prior literature points at allocation efficiency as the underlying cause, my results reveal that past performance seems to be the most likely explanation of the phenomenon. Moreover, active firms seem to catch up with their passive peers in terms of profitability over time. Thus, the lower future profitability of active firms is not likely to be a sign of inefficient allocations per se, but rather a continuation of poor performance and a failed attempt to fully close the profitability gap. Active firms tend to choose active allocation strategy because of their poor past performance. In fact, as active firms appear to catch up with the passive firms profitability-wise over time, activeness can be argued to be even beneficial for them.
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