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Diversification: How Far Should One Go?

Diversification: How Far Should One Go?
"""Introduction

Today, most executives and boards recognize how difficult it is to add value to businesses that aren't connected in some way. Nonetheless, too many executives continue to believe that diversifying into unrelated industries reduces risks for investors or that diversified businesses can better allocate capital across businesses than the market—regardless of the skills required to achieve these goals. Because few people have such skills, diversification frequently limits the upside potential for shareholders while not limiting the downside risk. Managers considering diversification should keep in mind that the best-performing conglomerates in the United States and other developed markets do so not because they are diverse, but because they are the best owners, even of businesses outside their core industries.

Meaning

Diversification is a type of corporate strategy in which a company seeks to increase profitability by increasing sales volume from new products and/or new markets. Diversification can take place at the business unit or corporate level. At the business unit level, it is most likely to expand into a new segment of an existing industry. At the corporate level, it is usually very appealing to enter a promising business that is outside the scope of the existing business unit.

Arguments

This structure, like any other, has a lot to offer that must be evaluated-

A. LIMITED UPSIDE, ENDLESS DOWNSIDE:

The claim that diversification benefits shareholders by lowering volatility was never convincing. Conglomerates have outperformed more focused companies in both the real economy (growth and returns on capital) and the stock market. Focused businesses grew faster even when size differences were taken into account.

According to the graph above, a higher percentage of conglomerates provide returns in the range of 8% to 18% when compared to focused companies. On the contrary, a much smaller percentage of conglomerate companies offer negative returns as well as high growth rate returns.

The answer to these patterns is that there are businesses in conglomerates that offer high returns and others that offer low returns. As a result, the returns are averaged. However, in the case of focused companies, those that perform either outperform or underperform in comparison to their peers. This is due to the fact that the capital invested in these companies is focused, leaving little room for maneuvering in comparison to conglomerates, which tend to readjust their capital based on the situation.

B. REQUIREMENTS FOR CREATING VALUE:

What matters in a diversification strategy is whether managers can add value to businesses in unrelated industries by allocating capital to competing investments, managing portfolios, or cutting costs.

I. Disciplined (and sometimes contrarian) investors: High-performing conglomerates rebalance their portfolios on a regular basis by purchasing companies that they believe are undervalued by the market and whose performance they can improve.
ii. Aggressive capital managers: All excess cash 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. Returns on invested capital are rationalized from a capital standpoint: excess capital is directed where it is most productive, and all investments pay for the capital they use.
ii. Strict 'lean' corporate centers: High-performing conglomerates operate similarly to better private equity firms, with a lean corporate center that limits its involvement in business unit management to selecting leaders, allocating capital, setting strategy, setting performance targets, and monitoring performance.

C. WHY DIFFERENTIATE WHEN OTHER TECHNIQUES ARE AVAILABLE:

According to strategists, there are three general strategies that a company can use to achieve success: category growth, market share gains (i.e. world class operators & Portfolio Shaper), or M&A.

1. A new core may be appropriate for three reasons.

-

I. The first is concerned with profits. When a company's profitability is declining over time, a new core makes sense.
The second reason is that economics is inherently inferior. This becomes more apparent when a new competitor with a different cost structure enters the market.
The third reason for changing core is an unsustainable growth formula. The market may be saturated, or competitors may have begun to replicate a previously unique source of differentiation.

2. The Benefits and Drawbacks of Diversification:

Advantages: -Economies of scale and scope
-Operational synergies are possible.
-Value can be created by redistributing the firm's underutilized organizational resources to other areas.
-Value can be created by leveraging skills across businesses.

Coordination among independent firms may result in higher transaction costs.
Cash from some businesses can be used to make profitable investments in the internal capital market.
-External financing may be more expensive due to transaction costs, monitoring costs, and so on.
-Diversifying shareholder portfolios -Investing in a diversified portfolio may benefit individual shareholders.
-Identifying undervalued firms -Diversification may benefit shareholders if its managers can identify firms that are undervalued by the stock market.

Cons: -Combining two businesses into a single firm will almost certainly result in significant influence costs.
Lobbying has the potential to influence resource allocation.
-
Costly control systems that reward managers based on division profits and discipline managers by linking their careers to business unit objectives may be required.

Internal capital markets may not function properly in practice.

Individual shareholders can diversify their personal portfolios. Corporate executives are not required to do this.
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Identifying undervalued companies may not be as simple as it sounds.

Synergy and core competencies were two other themes associated with diversification. Synergy addressed the fit between existing and new businesses. Could costs be reduced or revenues increased by starting a new business? The term ""core competence"" referred to a set of skills and expertise that an organization had developed over time. When the core competencies could be leveraged and extended to manage the new business, diversification seemed to make a lot of sense.

Benefits can take many forms, including improved distribution, improved company image, defense against competitive threats, and increased earnings stability. When entering a new market, a company must be able to provide a distinct value proposition in the form of lower prices, higher quality, or more appealing features. Alternatively, it should have discovered a new niche or found a novel way to market the product. Jumping into a new business simply because it is growing quickly or has high current profitability is a risk that should be avoided. Indeed, opportunistic diversification has been the primary cause of the failure of several Indian entrepreneurs in industries such as financial services, granite, aquaculture, and floriculture.

How to Make Diversification Work:

When a company's core business is threatened, some go into denial and decide to defend the status quo. Others attempt to transform their businesses all at once, either through a large merger or by entering a hot new market. Such strategies are extremely dangerous. In contrast, the most successful businesses take a more systematic approach.

Strategists believe that in well-managed conglomerates, mediocre performance of unit managers is not tolerated in order to make diversification work. In contrast, unless the performance is disastrous, the CEO, who is effectively the business manager, is rarely fired in focused firms.

Furthermore, well-managed conglomerates typically have a corporate staff that scrutinizes the annual budgets and long-term plans of the operating units. In contrast, directors of a focused company often do not spend enough time, going into details. Indeed, one strategist puts it this way: """"When conglomerates succeed, it is not because of their strengths. It is in spite of their flaws. 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 Far Should One Go?" was written by Mark under the Finance category. It has been read 85 times and generated 0 comments. The article was created on and updated on 13 January 2023.
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