Diversification: When And How Far Should One Go

Introduction

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.

C. WHY DIVERSIFY WHEN OTHER TECHNIQUES ARE AVAILABLE:

Strategists argue that there are generally three strategies that a company can use for achieving success - category growth, market share gains (i.e. world class operators & Portfolio Shaper), or M&A.

1. New core may make sense for three reasons.-

I. The first has to do with profits. When the profitability of a business is in secular decline, a new core makes sense. 
ii. The second reason is inherently inferior economics. This becomes more apparent when a new competitor enters with a different cost structure. 
iii. The third reason for moving into a new core is an unsustainable growth formula. The market may be reaching saturation or competitors may have started to replicate a once unique source of differentiation.

2. Pros & Cons of Diversification:

Pros:- 
-Economies of scale and scope 
-Operational synergies can be realized. 
-Spreading the firm's unutilized organizational resources to other areas can create value. 
-Leveraging skills across businesses can create value.

Transaction costs 
-Coordination among independent firms may involve higher transaction costs. 
-Internal capital market 
-Cash from some businesses can be used to make profitable investments. 
-External finance may be more costly due to transaction costs, monitoring costs, etc. 
-Diversifying shareholders' portfolios 
-Individual shareholders may benefit from investing in a diversified portfolio. 
-Identifying undervalued firms 
-Shareholders may benefit from diversification if its managers are able to identify firms that are undervalued by the stock market.

Cons:- 
-Combining two businesses in a single firm is likely to result in substantial influence costs. 
-Resource allocation can be influenced by lobbying. 
-Costly control systems may be needed that reward manager based on division profits and discipline managers by tying their careers to business unit objectives.

Internal capital markets may not work well in practice. 
-Shareholders can diversify their own personal portfolios. Corporate managers are not really needed to do this. 
-Identifying undervalued firms may not be as easy as it sounds.

Two other themes became associated with diversification - synergy and core competencies. Synergy dealt with the fit between the existing and new businesses. By moving into a new business, could costs be cut or revenues increased? Core competence referred to the bundle of skills and expertise which an organization had developed over time. Diversification seemed to make a lot of sense when the core competencies could be leveraged and extended to manage the new business.

Benefits may come in various forms - better distribution, improved company image, defense against competitive threats and improved earnings stability. When entering a new business, the firm must be able to offer a distinct value proposition in the form of lower prices, better quality or more attractive features. Alternatively, it should have discovered a new niche or found a way to market the product in an innovative way. Jumping into a new business just because it is growing fast or current profitability is high, is a risk that is best avoided. Indeed, opportunistic diversification has been the main reason for the downfall of several Indian entrepreneurs in various businesses including financial services, granite, aquaculture, and floriculture.

Making Diversification Work:

When the core business is under severe threat, some companies go into denial and decide to defend the status quo. Others try to transform their companies all at once through a big merger or by leaping into a hot new market. Such strategies are inordinately risky. In contrast, the most successful companies proceed more systematically.

Strategists believe that making diversification work in well-managed conglomerates, the mediocre performance of unit managers is not tolerated. On the other hand, in focused firms, the CEO, who is effectively the business manager, is rarely sacked unless the performance is disastrous.

Moreover, well-managed conglomerates tend to have a corporate staff that goes through the annual budgets and long range plans of the operating units with a microscope. In contrast, directors of a focused company often do not spend enough time, going into details. In fact, one strategist puts it: "When conglomerates succeed, it is not because of their strengths. It is in spite of their weaknesses. The hidden reason why diversification can work and often does lie in the operation of the system of governance of independent corporations. Boards of directors are not prepared to improve performance standards in a manner comparable to that required by a corporate management." If a conglomerate selects able unit managers, energize them with a strong corporate purpose, monitors their progress and provides guidance and support when needed, it can outperform the boards of many independent companies.

In focused firms, the top management's role must be to understand the industry, make the key operating decisions and run the business. In a conglomerate, on the other hand, the top management must govern, not run operations. Its focus must be on selecting, motivating and mentoring the general managers of individual units.

In short, firms that diversify to exploit existing specialized core resources and focus on integrating old and new businesses, tend to outperform firms that make use of general resources and do not leverage interrelationships among their units. Successful diversification involves exploiting economies of scope that make it efficient to organize diverse businesses within a single firm, relative to joint ventures, contracts, alliances or other governance mechanisms.

Conclusion:

We are all aware of the famous saying: "Don't put all your eggs in one basket." The same applies to the fact that when the firm operates in one single business it exposes itself to various risks that come with it. When a firm operates in many businesses, the downs in one can be compensated by the ups in another.

On the flip side in the boom period the underperformance of one business unit tends to undermine the high growth of other units and in the aggregate, the whole company tends to underperform as compared to focused companies.

Diversification has its own advantages and disadvantages which are more in control of the management and type of diversification i.e. product diversification or business diversification than to external forces as the skill sets required in a diversified company is totally different than compared to the focused companies.