Diversification today most executives and boards realize how
difficult it is to add value to businesses that aren't connected to each
other in some way. Yet too many executives still believe that
diversifying into unrelated industries reduces risks for investors or
that diversified businesses can better allocate capital across
businesses than the market does-without regard to the skills needed to
achieve these goals. Because few have such skills, diversification
instead often caps the upside potential for shareholders but doesn't
limit the downside risk. As managers contemplate moves to diversify,
they would do well to remember that in practice, the best-performing
conglomerates in the United States and in other developed markets do
well not because they're diversified but because they're the best
owners, even of businesses outside their core industries.
Meaning
Diversification
is a form of corporate strategy whereby a company seeks to increase
profitability through greater sales volume obtained from new products
and/ or new markets. Diversification can occur either at the business
unit level or at the corporate level. At the business unit level, it is
most likely to expand into a new segment of an industry that the
business is already in. At the corporate level, it is generally very
interesting entering a promising business outside of the scope of the
existing business unit.
Arguments
Like any other structure, this structure has also lot to offer which needs to be analyzed-
A. LIMITED UPSIDE, UNLIMITED DOWNSIDE:
The
argument that diversification benefits the shareholders by reducing
volatility was never compelling. At an aggregate level, conglomerates
have underperformed more focused companies both in the real economy
(growth and returns on capital) and in the stock market. Even adjusted
for size differences, focused companies grew faster.
From the
above graph, it can be viewed that a higher % of conglomerates tend to
provide returns in the range of 8% to 18% as compared to focused
companies. On the contrary, there are much lesser % of conglomerate
companies that offer negative returns and also high growth rate returns.
The
answer to these patterns is that in conglomerates there are businesses
that offer high returns and others which offer lower returns. Thus the
returns are averaged out. But in the case of focused companies, those
which are performing companies perform either tend to outperform or
underperform as compared to its peers. This is because of the fact that
the capital that is invested in these companies is focused and thus
there is little leeway available for them to maneuver as compared to the
conglomerates which tend to readjust their capital as per the
situation.
B. PREREQUISITES FOR CREATING VALUE:
What matters
in a diversification strategy is whether managers have the skills to
add value to businesses in unrelated industries-by allocating capital to
competing investments, managing their portfolios, or cutting costs.
I.
Disciplined (and sometimes contrarian) investors: High-performing
conglomerates continually rebalance their portfolios by purchasing
companies they believe are undervalued by the market-and whose
performance they can improve.
ii. Aggressive capital managers: All cash that exceeds what's needed
for operating requirements is transferred to the parent company, which
decides how to allocate it across current and new business or investment
opportunities, based on their potential for growth and returns on
invested capital are rationalized from a capital standpoint: excess
capital is sent where it is most productive, and all investments pay for
the capital they use.
ii. Rigorous 'lean' corporate centers: High-performing conglomerates
operate much as better private equity firms do with a lean corporate
center that restricts its involvement in the management of business
units to selecting leaders, allocating capital, setting strategy,
setting performance targets, and monitoring performance.