Diversification Dilemma

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Diversification has given way to focus in developed countries like the United States and the United Kingdom,  and has often been correlated with lower performance. In contrast, diversified business groups have been hugely successful in most emerging markets, particularly in Asia.

Since the mid 1980s, strategists in countries like the United States and the United Kingdom have mostly advocated the use of focused strategies for businesses and have advised companies to ‘stick to their knitting’. Many diversified conglomerates in these advanced economies have been dismantled since 1980s to focus on one or a few core businesses.

A look at the motives with which companies diversify reveals some of the reasons why diversification by conglomerates yields benefits in the developing markets as against the discount associated with diversified conglomerates in the developed economies.

Growth is a primary motive for diversification

However growth does not always translate into higher profitability. Since management status and power is correlated more closely with the size of assets under management, management (the ‘agent’) may have the incentive to diversify for pursuing growth in preference to profitability, which is not in the best interest of shareholders.

Reducing risk

Having different businesses in their portfolio can potentially balance differences in the industry cycles and thus it increases the stability of a company. But the value of diversification advantage to the company may be offset by the high transaction cost associated with acquisition. Moreover shareholders can themselves reduce the risk of their portfolio by holding diversified portfolios. This is another argument against diversification in the developed economies.

Diversify or not

Corporate parenting advantage

Effective corporate management is given as the reason for existence and success of diversified conglomerates in the developing markets. The differences in the institutional context—i.e. a country’s capital markets, labour markets, consumer awareness, regulatory and legal system  that influences business practices and ethics,  infrastructure etc favours the presence of diversified conglomerates in developing countries.

Profitability

Corporate advantage due to diversification exists if the portfolio performance is greater than sum of performances of individual businesses. In the developing economies, diversified conglomerates wield considerable economic and political clout. Being a part of a diversified group increases the overall stability of the company’s cash flow.

Thus, diversification is context specific. “Stick to your knitting” may not be the best recommendation for firms in high-growth markets or regions that have strong corporate advantages.

Core of a Business

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We know that firms need to adapt their strategies as per the changes in the business environment.

Strategies are highly context specific.

What was good five years back will not hold good now. The business model that works for a particular firm may not work in a similar manner for another firm. The strategy that pays off in one country may not produce similar results in another country. While responding to the changes in the environment, sometimes companies have even moved away from their core business.

  • Today, Nokia is a world leader in digital technologies, including mobile phones, telecommunications networks, wireless data solutions and multimedia terminals. You would be surprised to know that Nokia started with a wood pulp mill in Finland as a manufacturer of paper. The company later went on to manufacture rubber bands, industrial parts and raincoats. After World War II they expanded into Electronics and then into telecommunications.
  • HP’s first product was an audio oscillator – an electronic test instrument used by sound engineers. They shifted to computers, printers, servers & imaging products.
  • Reliance Industries Limited (RIL) started as a textile manufacturing business in 1966, and is one of the world’s most vertically integrated and horizontally diversified group with a wide range of businesses such as retail, telecom, textiles, petrochemicals, infrastructure development, etc. RIL sold off its textiles business and its ‘Only Vimal’ brand in 2012.

core

Alternately there are businesses that diversify into other areas while retaining their core business.

  • Indian Tobacco Company ITC has diversified from its main business of cigarette into various other businesses like FMCG, lifestyle retailing,  stationeries, hotels, paper businesses, and agriculture products.
  • IBM started as a computing, tabulating & recording company in 1880s, moved to PCs in 1980s , to integrated solutions and consulting servicers.
  • Pepsico has broken out of confines of cola drinks to become one of world’s most successful suppliers of drinks, snacks and breakfast cereals. Pepsico had diversified into restaurant business after acquiring Pizza Hut in 1977, Taco Bell a year later, and Kentucky Fried Chicken in 1986. But these acquisitions failed to live up to expectations of the shareholders, as Pepsi began losing ground to Coca Cola in the soft drinks. In 1997 PepsiCo decided to spin off its under-performing restaurants and Yum brands was created.  PepsiCo has since expanded to a broader range of food and beverage brands, the largest of which include an acquisition of Tropicana in 1998 and a merger with Quaker Oats in 2001, adding with it the Gatorade sports drink to its portfolio.

So we see that the core of a business need not necessarily be static. It can very well be a moving target. 

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Shareholder Engagement or Activism ?

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Continuing from my last post ‘ Is shareholder engagement good for companies? ’,  here we look at the scope of shareholders engagement and different approaches to shareholder engagement.

What is the scope of shareholder engagement?

Shareholders have a legitimate role in areas pertaining to:

  • Corporate Strategy – such as mergers, diversification, restructuring, non core asset sale.
  • Capital Structure – such as capital allocation discipline, use of cash on balance sheet.
  • Governance – such as audit-related issues, board structure, managerial remuneration.

However shareholders are not expected to micromanage companies. Nor is it desirable that shareholders push for short term profitability over sustainability and long term value creation. It is important that shareholders and board members engage effectively in the shared pursuit of high quality governance.

What are the different ways in which shareholders engage with companies?

Shareholders can either have a proactive approach for engagement with a company or may adopt a passive approach towards a company.

passive

Passive investors sell off their shares if they are dissatisfied with the corporate decisions.

active

On the other hand, active investors engage proactively with the management, prior to a corporate decision being affected, in order to change the outcome of the decision. While the term ‘shareholder engagement’ is used to describe a collaborative approach, ‘shareholder activism’ refers to the use of a more assertive approach by the minority shareholders to affect changes in management and strategy of a firm. Read more

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