The concept of the diversification discount
In the previous post, we talked about Disney and their related diversification strategy. That is, moving into markets that have some relevance to your core business, enabling you to build synergy and economies of scope between your business units.
So, we know how related diversification works and how it can prove successful for the companies that adopt the strategy. However, it’s not very clear how unrelated diversification can benefit an organisation. After all, operating in very different markets leads to no apparent economies of scope or synergies.
Well, in fact, there isn’t a whole lot of sense to unrelated diversification in 2016. In the past, companies like HP and Ebay adopted an unrelated diversification strategy and were very successful. However, the economic landscape has changed significantly since then and both of those companies have been through corporate breakup. Ebay split from PayPal and HP split their consumer and commercial business units.
Why did they split? Because analysts determined that the whole was worth less than the sum of the parts (the breakup value). That is to say, if each business unit were independent from one another, the companies would be more valuable than the current market value of the corporate owner.
When this happens & the business units would be more valuable independently, we refer to it as the ‘diversification discount’. That is, by diversifying, the companies have discounted the value of the overarching brand.
Of the 33% of diversified companies that do NOT trade at a discount, most have adopted the related diversification strategy. Almost all unrelated diversification strategies lead to a discounted market value.
In fact, recent history shows that an increase in focus (i.e. related diversification) often leads to a stock price increase. While a decrease in focus (i.e. unrelated diversification), often leads to stock price decreases.
What are invalid reasons for unrelated diversification?
Many companies will conclude that unrelated diversification is a good thing because it will enable them to diversify risk across different industries. So, if one industry falters, the other business units can support it. However, this assumes that management understand when, where and how growth will happen and often times, the company acquires struggling organisations in other industries. With no synergies between the two companies, it leaves little room for growth of the acquired company.
Another reason some companies adopt this strategy is termed ‘cross subsidisation’. That is where a company takes funds from their mature, profitable business to fund start-ups. Again, this assumes that management understand when, where and how growth will happen. Generally, risk averse, bureaucratic corporations struggle with the ‘start up mentality’. Severing the link between cash cows and promising market opportunities often leads to improved growth, making this an invalid reason for unrelated diversification.
Next, we have those companies that have ‘stalled’ in their core market. Fosters is a good example of this. They were market leaders in the beer market and sought to move into the wine market. This seems like a related product, because they’re both alcoholic beverages. However, after further analysis, you’ll find that there are very few synergies between the two business units & that very few economies of scope can be realised.
Finally, we have companies that wish to manipulate the stock markets. They seek to enhance the value of their stocks by acquiring a higher growth business.
All of the above have historically been proven to be invalid reasons for unrelated diversification.
What is a reason for unrelated diversification?
One potential reason for unrelated diversification is termed ‘governance economies’. This is where the various business units are operated by the same corporate management with the acceptance that there will be few synergies between the business units.
In this case, the organisation seeks to add value by using a common management team across all business units. This way, they can transfer knowledge and best practices between the business units for optimal performance.
An example of this happening is General Electric (GE). You’ll note that GE operate in multiple industries: aviation, healthcare and white goods to name a few. You’ll also note that there are very few synergies between those business units.
GE intended (and still intends) to leverage management skill across business units. They have developed ‘the GE way’ and have adopted Six Sigma heavily. Once it’s been adopted by the corporate management, it can be filtered through the businesses, delivering a highly efficient, common way of working.
For around 100 years, this worked very well for them and they outperformed the stock market.
However, there are now calls for GE to break up – to spin-off each of their business units to operate as independent companies. Why? Because governance economies are not as powerful now as they once were. The GE talent development machine is not as powerful now that there are books that detail the way they work and wide-spread availability of Six Sigma learning material. In other words, spreading knowledge is now cost-less, making the strategy far less effective.
Moreover, spreading the knowledge across business units becomes far harder if each business unit has a different strategy. A low-cost business model cannot be controlled by a differentiated corporate office – it simply won’t fit. To consider governance economies as a reason for unrelated diversification, you’d have to ensure that all business units were aligned on their overarching strategy.
So, in recent years, the question has been raised by a number of analysts, ‘is the whole of GE worth more than the parts?’ They can calculate this in a number of ways, including analysing the return on assets for each of the business units & comparing those returns against a comparable, focused player in the market.
They could also evaluate the business worth by calculating sum of the parts (i.e. how much each business unit would be worth in isolation) and then compare that to the market value of the company as a whole.
The outcome of their analysis is that, yes, GE is trading at a diversification discount and that a breakup makes most sense.
So when does unrelated diversification make sense?
Unrelated Diversification doesn’t make sense in developed economies. In developing economies though, it does. For example, in India, unrelated diversification can do quite well. Let’s look at an example.
Tata has many unrelated business units. This model works because in that market, they don’t have so many intermediaries. What does that mean?
Well, in the UK we can identify the best staff (by using a recruitment agent), we can attain investment from an angel investor or venture capitalist, we can follow strictly managed processes to obtain permits and licenses to do what we want to do. It’s a structured economy, with many intermediary companies and laws to support our activities.
In India, it’s not quite the same. There are less intermediaries and a fair bit of corruption. So, when someone wants to launch a new business, what do they do? They go to the head of Tata & make arrangements for them to support the business. By doing this, Tata has filled the gap of many intermediaries, leading to extreme unrelated diversification.
Tata have the political connections and influence to make things happen and the brand clout to give consumers confidence that the product they’re buying is quality, making the unrelated diversification strategy extremely successful.
We can see that in developed countries, unrelated diversification just doesn’t work. We see a number of major, global players breaking up their companies into smaller parts as they come to the realisation that the whole is worth less than the sum of the parts. This is called diversification discount.
Ultimately, focus wins over unrelated diversification.