Managing Diversification

Introduction
Jindals, the Indian steel group have moved into various new businesses in recent years.
After having set up a captive power plant to support their Vijayanagar steel plant in the
mid-1990s, the group has been looking at electricity as a separate revenue stream and
started supplying power to the Karnataka Power Transmission Corporation through an
independent entity, JSW Energy. The Jindals are also expanding their power capacity
with the aim of selling surplus power especially when the spot rates are high. A senior
Jindal executive1 recently mentioned: “We want to enter all fields of energy including
wind and solar… our aim is to be in all segments such as transmission, generation and
trading in the next five years. “The other sectors Jindal is looking seriously at, are cement
and aluminium. Jindal is clearly betting on diversification to generate growth.

Should companies concentrate on one business or should they be holding a portfolio of

businesses? That is the topic which we will discuss in this article. Concentration enables
a company to focus on the business it knows best. Yet, concentration beyond a point is a
risky strategy. Indeed, most firms are diversified to some extent. Rare is the firm which is
focused only on one business.

Almost 40 years back, Peter Drucker mentioned,2 “Every business needs a core – an area
where it leads. Every business must therefore specialize. But every business must also try
to obtain the most from its specialization. It must diversify.” Drucker argued that while
the central core of a business should decide which businesses it enters, diversification
would be needed in an era of fast changing markets and technologies.

Today, the business environment has become much more volatile and dynamic. So, the
key issue, more often than not, is not whether to diversify, but when and how to diversify.
A related issue is for management to decide when the company is straying too far from
the core and get back the focus.

Understanding Diversification
Contrary to general perception, few businesses can be called completely focused. It is
useful to understand what is diversification and lay down a nomenclature before we
proceed further. How can we measure diversification? Rumelt has classified firms into
four business groups:
- Single business firm : Such a firm generates 95% or more of its revenues from one
business.
- Dominant business firm: Such a firm generates 70 – 95% of its revenues from its
principal activity.
- Related business firm: Such a firm generates less than 70% of revenues from its principal
activity but other lines of business are related.

1
Roy Pinto, “On the fast track,” Business India, March 9, 2008, pp. 49-54.
2
Managing for Results, pp. 208-209.
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- Conglomerate firm: Such a firm generates less than 70% of its revenues from the
principal activity and has other unrelated businesses.

Of course, the key to implementing Rumelt’s framework lies in appropriate definition of

terms like “business,” “principal activity,” and “related business.” Ratehr than embracing
rigid definitions or using arguments of convenience, managers must interpret these terms
in their business context with objectivity and clear logic.

The pros and cons of diversification

We are all aware of the famous saying: “Don’t put all your eggs in one basket.” When a
firm operates in many businesses, the downs in one can be compensated by the ups in
another. According to portfolio theory, unsystematic risk, the risk particular to a company
or an industry, can be eliminated by building a diversified basket of stocks. In fact, Harry
Markowitz, William Sharpe and Merton Miller won the Nobel prize in 1987 for their
theory of portfolio diversification. But the debate continues. Is it better for companies to
be in many businesses or for investors to maintain a diversified portfolio? For example,
as the sub prime crisis has grown in scale and scope, people are asking whether
Citigroup, the global financial conglomerate has become too unwieldy to manage. In the
case of another global bank, analysts are debating whether investment banking and
wealth management can be handled simultaneously by the same organization. Similar
questions have been raised about some of the other global financial services firms as
well.

A bit of history is in order here to understand how our thinking on diversification has
evolved in the past 50 years. In the 1950s, the development of management principles
and the professional education of managers led to the belief that general management
skills provided the justification for diversification. Diversified companies and
conglomerates were seen to add value through the skills of their professional top
managers, who applied modern management techniques and generalized approaches to a
wide variety of businesses across different industries.

During the late 1960s, however, the performance of many conglomerates weakened, and
a new approach to the corporate management of diversity was sought. Portfolio planning
techniques helped many companies improve capital allocation across businesses with
different strategic positions, and led to the idea of balanced portfolio management. But
managing businesses facing different strategic issues, this way, proved fairly complex
and challenging.

In the 1980s, many consultants and academicians argued that risk reduction could be
better achieved by individual investors. There was no need for companies to diversify as
they were not creating shareholder value. They were in favour of diversified businesses
being broken into smaller units, each of which could concentrate on the industry and
activities it knew best. Poor corporate performance became a critical issue. There was a
wave of takeovers, corporate break-ups, and restructuring back to core businesses driven
by a resolve to stick to the knitting.
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Two other themes became associated with diversification - synergy and core
competences. 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.

Management gurus also mooted the concept of the dominant strategic logic of a portfolio,
and its compatibility with the approaches of top management. The core of the argument
was that there should be a strategic logic tying all the businesses together.

The businesses in the portfolio had to be worth more under the management of the
company in question than they would be under any other ownership. Achieving this goal,
might involve restructuring of portfolios to allow more uniformity in dominant logic and
management style, more effective means of realizing synergies and more sharing of core
competences.

How do we sum up all these arguments? Clearly, even at the risk of sounding bookish, it
would be correct to say that diversification is advisable only if it is likely to have a
beneficial impact on the existing businesses. 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.

Related and unrelated diversification

Drucker once mentioned: “A company should either be diversified in products, markets
and end-uses and highly concentrated in its basic knowledge area; or it should be
diversified in its knowledge areas and highly concentrated in its products, markets and
end-uses. Anything in between is likely to be unsatisfactory 3.” This can be a useful
starting point in differentiating between related and unrelated diversification.

But before we pass judgment on what is related and what is unrelated diversification, it is
good to remember that the dividing line between core and non-core activities, related and
unrelated businesses is tenuous. Consider Microsoft. Starting with operating systems, it
diversified into applications software. In recent times, it has moved aggressively into
businesses such as enterprise software, web hosting and management services and video
games. Today, the Internet is becoming increasingly central to Microsoft’s business
model. In short, while software may be the common thread running through these
activities, the technical and management capabilities required to manage these different
business activities are obviously diverse and the markets are quite different. Yet,
3
Managing for Results, pp. 208-209.
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Microsoft sees entry into these new businesses as a means of maintaining growth and
profitability.

Similarly, the highly successful Silicon Valley company, Cisco has one of the broadest
portfolios in the data networking business. Cisco is far less dependent on the fortunes of
any single technology than its competitors. Google started off as an internet search
engine. But today it offers a wide range of services including email, desktop search, etc.

Take India’s own Network 18 promoted by Raghav Bahl, formerly an anchor with the
state controlled Doordarshan in the late 1980s. In three years, Bahl has taken his group
from a single channel operation, CNBC TV 18 with turnover of Rs. 15 crores to a Rs.
1000 crore media group that includes news, music entertainment channels, finance
websites, newswires, print publications, a tele shopping venture and a film company. As
Business World put it, “Networks 18 has become India’s most diversified and
“converged” media company. It is one of the few companies that has been successful in
monetizing its real time news content by making it available across television, the wire
and the Internet.” Responding to investor concerns about lack of focus, CEO Haresh
Chawla has mentioned” We are in the business of creating ecosystems through a network
of media properties. We will move in whatever direction that takes us.”

The risks associated with entering a new related business should be weighed against the
opportunities it provides. Indeed, some companies have missed great opportunities by not
embracing a new business. A good example is AT&T, which refused an offer from the
National Science Foundation (NSF) of the US to transfer its internet operations at no
cost. AT&T thought the Internet was an inferior technology with an insignificant role to
play in telephony. AT&T effectively gave up a golden opportunity to build a business
that could have operated across the value chain, combining the operations of a telecom
company, Internet service provider and switching equipment manufacturer.

Does unrelated diversification pay off?

There are some examples of successful unrelated diversification. Wipro is a good
example. When the young Azim Premji took charge of the group after the untimely
demise of his father, Wipro was essentially involved in the vegetable oils business.
Premji had the vision to take Wipro into new unrelated businesses including computer
hardware, lighting soaps, medical equipment and computer software.

Pros & cons of Diversification

Pros
Economies of scale and scope
- Operational synergies can be realized.
- Spreading the firm's unutilised 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

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- 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 managers 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.

GE is probably the best known example of a successful conglomerate diversification.

GE’s financial services business, is as different as one can imagine from its traditional
engineering businesses. GE’s businesses, range from medical devices to aircraft engines.
Its diversified portfolio has lent a degree of stability to earnings, which may not have
been possible had it focussed on one single industry. Few large companies have been able
to match GE’s ability to maximise value for shareholders.

While taking heart from the success of Wipro and GE, the dangers of unrelated
diversification should not be underestimated. A good example, though a little dated, is
Metal Box (India) Ltd, the metal packaging company which diversified into bearings.
This move destroyed the company. Similarly, Zapmail cost Federal Express $600 million
before the new fax service was withdrawn. Polaroid lost heavily (about $200 million)
when it diversified into instant movies. And we have seen earlier how opportunistic
diversification led to the downfall of many Indian entrepreneurs in the 1990s.

Identifying Adjacencies
Traditional management literature has divided diversification into two categories: Related
& Unrelated. But this kind of categorization is too broad and sweeping. Moreover, it
provides few clues for how to go about identifying and developing new businesses.
Management consultant and writer, Chris Zook4, argues that the most sustained,
profitable growth comes when a company pushes out the boundaries of its core business
into an adjacent space. Zook calls these new businesses, adjacencies.

Companies can move into adjacencies in various ways:

 Expand along the value chain. A company may move from manufacturing into
retailing. This is what many oil companies have been doing in recent years.
 Grow new products and services. IBM moved into global services, which now
constitutes 50% of the company's revenue and pretax profits. Indian IT services
4
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companies are trying to enter management consulting in a big way. Jain Irrigation
Systems5, the world’s second largest drip irrigation company has moved into piping
systems, plastic sheets and more recently food processing. The group is also planning
to supply clean drinking water to households. Alternative energy is another area the
group is looking at seriously.
 Use new distribution channels. Barnes & Noble, traditionally a brick-and-mortar store
has been attempting to increase its online retailing presence. Dell, too has leveraged
the Internet to strengthen its distributions capabilities.
 Enter new geographies. Vodafone expanded from the UK to Europe, the United
States, Germany, and Japan. Same is the case with many Indian IT services
companies. Tesco, the UK retailer is seriously looking at the US.
 Address new customer segments, often by modifying a proven product or technology.
Charles Schwab expanded its advisory services for discount brokerage customers to
target high-net worth individuals.
 Move into the "white space" with a new business built around a strong capability.
American Airlines created the Sabre reservation system, a spin-off now worth more
than the airline itself. Sabre, in turn, went on to create a new business adjacency of its
own in the online travel agent Travelocity. Harvard Business School has a strong
publishing division which generates a significant portion of the revenues of the
world’s most well known business school.
 Applying a superior business model to new segments. Dell has repeatedly adapted its
direct-to-customer model to new customer segments and new product categories.
 Developing hybrid approaches. Nike, has expanded into adjacent customer
segments, introduced new products, developed new distribution channels, and then
moved into adjacent geographic markets.

Many companies prematurely abandon their core and do not exploit it enough. They
chase some hot market or new idea, only to falter. But no core endures forever.
Companies tend to misjudge the point their core business has reached in its life cycle and
whether it is time to stay focused, expand, or move on.

How does a company know when the core needs to change in some fundamental way?
And how does the company determine what the new core should be? Zook mentions that
a new core may make sense for three reasons.

The first has to do with profits. When the profitability of a business is in secular decline,
a new core makes sense. Apple’s share of the market for personal computers plummeted
and profitability steadily declined. So Apple moved its business toward digital music.
General Dynamics was in a similar situation in the 1990s, when defense spending
declined sharply. The company sold off many of its units and redefined itself around just
three core businesses where it held a competitive advantage: submarines, electronics, and
information systems.

The second reason is inherently inferior economics. This becomes more apparent when a
new competitor enters with a different cost structure. General Motors saw this in
5
Krishna Gopalan, “The winner that came in from the cold,” Business Today, April 6, 2008, pp. 60-64.
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competition with Toyota, just as Compaq (now a part of Hewlett Packard) did with Dell.
Other well-known examples include Kmart (vis-à-vis Wal-Mart) and Xerox (vis-à-vis
Canon).

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. A company that has prospered by simply reproducing its
business model may have limited scope for further geographic expansion. In all such
circumstances, a new formula for growth depends on finding a new core.

The companies which successfully pursue adjacencies seem to apply rigorous screens
before they make an adjacency move. This discipline pays off in the form of learning-
curve benefits, increased speed, and lower complexity. Such companies also develop
their repeatable formulas by studying the needs and economics of their customers
carefully.

Developing a new core

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. A few examples
will illustrate the point.

Consider the Swedish company Dometic6, which in the 1920s, applied absorption
technology to refrigeration. Whereas most household refrigerators used compressors
driven by electric motors, Dometic used the absorption technology with no moving parts
and no need for electricity. Only a source of heat, was required. The new technology was
particularly useful in places like boats and recreational vehicles (RV), where electric
current was hard to come by.

In 1925, AB Electrolux acquired the patent rights. The division responsible for absorption
refrigerators later became the independent Dometic Group. By 1973, Dometic was still a
small company and losing money. Then the company moved aggressively into the hotel
minibar market, where the absorption refrigerator's silent operation had a real advantage
over conventional technology. Instead of merely selling more refrigerators to the RV
segment, (The company's market share within that segment was already nearly 100%).
Dometic started to offer other products, such as air-conditioning, generators, and systems
for cooking, lighting, sanitation, and water purification. As a result, the company's core
shifted far beyond absorption refrigeration.

By selling all its products through the same dealers and installers, Dometic also gained
formidable channel power and improved its cost structure dramatically. By 2005,
Dometic’s sales had grown to roughly $1.2 billion. No longer part of Electrolux (the
private equity firm EQT bought it in 2001 and sold it to the investment firm BC Partners

6
Based on the article by Chris Zook
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a few years later), the company was highly profitable and commanded 75% of the world
market share for RV interior systems.

American Can is an example of a business which completely reinvented itself to cope

with threats in the environment and limited growth opportunities in existing businesses.
The company moved away from can manufacturing into financial services. American
Can initially manufactured cans/containers for the beverage industry. In an industry
which used a simple technology, commoditization and intensifying competition were
inevitable. Forward integration by aluminum producers and backward integration by food
companies eroded the company’s ability to raise prices. Plastics emerged as an important
substitute. American Can diversified into paper, musical records retailing and direct mail
marketing. In 1980, it started to refocus and entered the financial services business in a
big way through acquisitions. The can business was sold off. In 1987, the company
changed its name to Primerica. In 1997, it acquired Salomon for $9.2 billion. About a
year later, it merged with Citicorp.

Barrick7, the world’s biggest gold mining firm today was originally not involved in the
gold business. Barrick’s founder, Peter Munk ran a television manufacturing business,
then a hotel business and later on a property business. Subsequently he moved into oil
and gas and finally gold mining. But Munk’s moves into gold were calculated and well
thought out. Based in Canada, he saw that the country had a pool of mineral deposits,
readily available capital and talented engineers. Munk was also determined to modernize
mines and improve productivity. Munk decided to grow by acquisitions. The purchase of
Canada’s PlacerDome for $10 billion in 2006 made Barrick the world’s biggest gold
miner.

A good example of an Indian company attempting to diversify and develop a new core is
ITC. Though it is a subsidiary of the UK based BAT, ITC has operated with considerable
autonomy. Among the businesses which ITC has entered in recent years are apparel
retailing and branding, ready-to-eat packaged foods, confectionery items, infotech, paper
and boards. Earlier ITC had set up the Welcome Group hotel chain.

Over the years, the cigarette business has been quite profitable for ITC. ITC has retired
much of its debt taking full advantage of its healthy cash flows. But it still has a lot of
cash that can be invested to generate faster growth. Moreover, there are major question
marks about the cigarette business, as public opinion continues to swell against smoking.
In late 2001, the Indian Supreme court banned smoking in public places and public
transport. The ITC share fell by 10% on the NSE as soon as the judgement was made. All
these reasons prompted the company to take a serious look at new businesses.

Can ITC successfully manage this wide portfolio of businesses? Top management
sources explain that there should not be a problem as ITC is rapidly becoming a holding
company with a venture capital mindset. The company is confident that it can use its
existing skills and competencies to manage new businesses. In the lifestyle retailing
business, ITC feels its strong branding capabilities backed by good quality will help it to

7
“Jolly gold giant,” The Economist, April 19, 2008, p. 76.
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stay ahead of competition. On the other hand, in the foods business, ITC’s strong
distribution capabilities may be a useful asset. ITC hopes to take full advantage of its
formidable expertise in distribution and the Wills brand name. Similarly, the company
hopes to leverage the paper division’s capabilities in manufacturing high quality paper for
the greeting cards business. ITC is also counting on its brand management expertise as it
moves into businesses like confectionery.

ITC has been using its agri sourcing network to source raw materials for its biscuits and
atta businesses. It has used the e choupal network to distribute products in areas where
channels do not exist. ITC Hotels has tapped the expertise of its master chefs to help the
foods division create 16 distinct taste platforms for Bingo and a number of other branded
packaged foods.

Making diversification work

How does a company effectively manage a portfolio of businesses? Under what
circumstances does diversification work? Milton Lauenstein8 has an
interesting explanation for the success of some diversified companies. He
argues that 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 who go 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. As he
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, lies 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,
energises 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.

But the dividing line between governance and bureaucratic interference from the top can
be very thin. As Lauenstein puts it: “If it begins trying to coordinate the activities of
various units, it will be drawn into operating management functions. The corporate office
will expand and begin making decisions which would be better made by executives in
operating units.” Lauenstein also points out that 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.

8
Sloan Management Review, Fall 1985.
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This is exactly what GE, the most successful large diversified company in corporate
history, did under the leadership of Jack Welch and now seems to be doing
under his successor Jeffrey Immelt. Welch killed bureaucracy, encouraged
innovation and selected extraordinarily talented managers to manage each of
the diverse businesses. Welch was also ruthless with non-performers. Immelt
has also been quite successful in holding GE’s disparate business units
together. Like Welch, Immelt too has divested some unpromising businesses.

In India, the mild mannered and impeccably behaved legendary businessman, JRD Tata
successfully built a portfolio of diverse businesses, even though his management style
was quite different from that of Welch. But Tata had the extraordinary knack of selecting
some truly outstanding managers to run the different companies. He kept Russi Mody at
Tata Steel, Sumant Mulgaonkar at Telco, Darbari Seth at Tata Chemicals and Ajit Kerkar
at India Hotels. Some of these managers like Russi Modi had a higher profile than JRD
himself. But the visionary Tata did not have any problems in providing space to these
gifted managers. Azim Premji, the widely admired Chairman of Wipro has attempted to
do this on a smaller scale in his business group.

Conclusion
Several research studies have been done on the impact of diversification on financial
performance. The relationship between performance and diversification is still not clear.
Firms with highly specialised resources to diversify seem to achieve superior results
compared to firms that use unspecialised resources, such as cash or general management
capabilities. But what is related and what is not, what is a specialized resource and what
is not, is always a matter of debate and often better understood in hindsight. One problem
affecting research studies is the assumption that different types of relatedness have an
equal impact on firm performance. Valuation studies show that shares of diversified firms
trade at a discount relative to those of their undiversified counterparts. But part of the
diversification discount can be explained by the fact that firms that elect to combine
appear to be those whose shares traded at discounts even before the combination.
Diversified firms with shares trading at large discounts are also more likely to be taken
over.

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.
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References:

 Peter Drucker, in his book, “Managing for Results,” pp. 208-209.

 Milton Lauenstein, Sloan Management Review, Fall 1985.
 Roy Pinto, “On the fast track,” Business India, March 9, 2008, pp. 49-54.
 Krishna Gopalan, “The winner that came in from the cold,” Business Today, April 6, 2008,
pp. 60-64.
 “Jolly gold giant,” The Economist, April 19, 2008, p. 76.