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Diversification: How Much Should You Do?

Diversification: How Much Should You Do?
"""Introduction

Today's executives and boards are generally aware of how challenging it is to bring value to organizations that are not interconnected in some way. Despite this, too many leaders continue to hold the mistaken belief that diversification into unrelated industries will lower investor risks or that diverse organizations can more efficiently deploy capital across enterprises than the market. Diversification frequently curbs the upward potential for shareholders but does not limit the downside risk because few people possess these skills. The best-performing conglomerates in the United States and other developed markets perform well not because they are diversified but rather because they are the best owners, even of businesses outside of their core industries. As managers consider moves to diversify, they would do well to keep this in mind.

Meaning

A corporation that uses diversification as a sort of corporate strategy aims to boost profitability by generating more revenue from new goods and/or markets. Either at the corporate level or the level of the business unit, diversification might take place. At the business unit level, it is most likely to diversify into a new area of an existing industry. At the corporate level, entering a lucrative business beyond the purview of the current business unit is typically extremely interesting.

Arguments

Similar to other structures, this one has a lot to offer that should be examined.

A. LIMITED BENEFIT, UNLIMITED DISADVANTAGE:

It has never been a convincing case that diversity benefits shareholders by lowering volatility. Conglomerates have generally lagged more specialized businesses in both the real economy (growth and capital returns) and the stock market. Focused businesses expanded more quickly even after adjusting for size disparities.

The graph above shows that, in comparison to targeted businesses, a bigger percentage of conglomerates tend to offer returns in the range of 8% to 18%. Contrarily, a significantly smaller percentage of conglomerate companies produce returns that are both negative and growing rapidly.

Conglomerates have both firms with high returns and those with lower returns, which is the explanation for these patterns. The returns are therefore averaged out. However, in the case of organizations with a narrow focus, those that are doing either tend to outperform or underperform as compared to their rivals. This is due to the concentrated nature of the money invested in these businesses, which leaves them with less room for maneuver than conglomerates, which frequently modify their capital in response to market conditions.

B. REQUIREMENTS TO CREATE VALUE:

Whether managers can provide value to companies in unrelated industries by allocating capital to competitive investments, managing their portfolios, or reducing costs is important in a diversification plan.

I. Conscious (and occasionally contrarian) investors: High-performing conglomerates constantly rebalance their portfolios by acquiring businesses they believe the market has undervalued and whose performance they can enhance.
ii. Aggressive capital managers: All excess cash is transferred to the parent company, which then decides how to distribute it among existing and potential new business or investment opportunities based on their potential for growth. Returns on invested capital are also rationalized from a capital standpoint, ensuring that excess capital is directed to where it will be most productive and that all investments pay for the capital they consume.
ii. Strict ""lean"" corporate centers: With a lean corporate center that limits its involvement in the management of business units to the selection of leaders, allocating capital, setting strategy, setting performance targets, and monitoring performance, high-performing conglomerates operate much like better private equity firms do.

When there are other techniques available, why diversify?

Category expansion, market share gains (i.e., world-class operators & Portfolio Shaper), or M&A are generally the three tactics that strategists claim a firm can utilize to succeed.

1. Three factors suggest that the new core is justified.

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I. The first relates to business success. A new core is justified when a company's profitability is experiencing a secular decrease.
ii. Inherently flawed economics is the second justification. When a new rival enters the market with a different cost structure, this becomes more obvious.
An unsustainable growth model is the third justification for relocating to a new core. It's possible that the market has reached saturation point or that rivals have begun to imitate a formerly distinct source of uniqueness.

2. Benefits & Drawbacks of Diversification

Advantages: -Scale and scope economies
-Synergies in operations may be attained.
-Value can be created by transferring unused organizational resources inside the company to other departments.
Utilizing abilities across industries can add value.

Transaction costs - There may be increased transaction costs when separate enterprises coordinate.
Cash from some businesses can be used to make profitable investments in the internal capital market.
-Due to processing fees, monitoring charges, etc., external financing may be more expensive.
-Diversifying the holdings of shareholders -Each shareholder may gain from having a diversified holdings.
-Selecting undervalued companies -Diversification may be advantageous to shareholders if its management are able to select companies that the stock market has undervalued.

Cons: -There could be significant influence expenses associated with combining two enterprises into one company.
-Lobbying has the potential to affect resource allocation.
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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 might not function effectively in reality.

Shareholders can diversify their own personal portfolios. Corporate managers are not really needed to do this.
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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."""
 

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"Diversification: How Much Should You Do?" was written by Mary under the Business category. It has been read 33 times and generated 0 comments. The article was created on and updated on 17 November 2022.
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