NBER WORKING PAPER SERIES CONGLOMERATE INDUSTRY CHOICE AND PRODUCT DI ̇FFERENTIATION

We use text-based computational analysis of business descriptions from 10-Ks to examine in which industries conglomerates are most likely to operate and to understand conglomerate valuations. We find that conglomerates are more likely to operate in industry pairs that are closer together in the product space and in industry pairs that have profitable opportunities "between" them. Conglomerate firms have lower stock market valuations than matched single-segment firms when their products are easier to replicate with single-segment firms. Conglomerate firms have stock market premiums when they have higher product differentiation and produce in more profitable industries. These findings are consistent with successful conglomerate firms having higher product differentiation and lower cost entry into profitable markets when operating in strategically chosen industry pairs. Gerard Hoberg Robert H. Smith School of Business University of Maryland 4423 Van Munching Hall College Park, MD 20742 ghoberg@rhsmith.umd. edu Gordon M. Phillips Marshall School of Business University of Southern California Citigroup Center Los Angeles, CA 90089 and NBER Gordon.Phillips@marshall.usc. edu Why do firms operate in multiple industries? This question has been the focus of much research that takes the industries that firms operate in as given, and examines outcomes such as valuations and investment decisions. Existing explanations for multiple industry production based on investment decisions include advantages of internal capital markets (Stein (1997)), agency problems (Lang and Stulz (1994) Berger and Ofek (1995), Denis, Denis, and Sarin (1997), Scharfstein and Stein (2000)), conglomerate learning about ability (Matsusaka (2001)) and managerial talent that can be used in different industries (Maksimovic and Phillips (2002)). This literature does not examine why conglomerate firms span some industries and not others. We take a different approach in this study. We use fundamental product market characteristics to analyze in which industries conglomerate firms produce. We examine whether conglomerate firms may create value through operating in related industries that allow for synergies, new products to be created and potential entry into new markets. The idea we examine is simple and is related to that of RhodesKropf and Robinson (2008) who examine the importance of asset complementarities in mergers. While Robinson and Rhodes-Kropf examine firm complementarities, we examine potential industry complementarities. We ask whether certain industry characteristics distinct from vertical relatedness make operating in two different industries valuable? Are industries related in certain ways that make it likely that firms will find it optimal to produce in multiple industries? Apple Computer is an example of a firm that now produces in cell phones, computers, and digital music industries that are today very related to each other. It faces some firms that operate individually in each of these industries but more firms today are attempting to operate in these related industries. We use text-based analysis of conglomerate and pure play business descriptions from 10-Ks filed with the SEC to examine in which industries conglomerates are most likely to operate and to explore conglomerate valuations in cross-section. Following Hoberg and Phillips (2010a), we convert firm product text into a spatial representation of the product market. In this framework, each firm, and each industry, has a product location based on words that allow measurement of how close product markets are to each other. Our framework also allows an assessment of which in-