To Diversify or Not to Diversify?

To diversify or not to diversify? That is a critical strategic decision all firms, large and small, face at some point. Indeed, managing a portfolio of businesses is the most important responsibility taken on by corporate headquarters. Unfortunately, the track record of diversifiers is notoriously negative.

For several decades conglomerates in developed economies have obtained much lower performance than less diversified firms or than those specialized in only one sector. Finance and strategy experts coined the term “conglomerate discount” to refer to the lower market value of heavily diversified corporations, which is usually analyzed in detail in strategic management courses like the one I teach at IE Business School (formerly Instituto de Empresa at Madrid). Though there are some exceptions, there is overwhelming evidence that firm performance and diversification is negatively correlated, particularly for unrelated diversifiers. Based on this evidence, and a little of common sense, many strategy experts would recommend that a company “stick to its knitting.”

The reasons behind diversification failure are well known. Synergies, the key motivation behind many decisions to diversify into new businesses, are often overestimated. On paper, substantial savings look possible (and sometimes even increased sales) by merging two or more businesses together, but when push comes to shove, the gains are not realized because there are often unexpected challenges in restructuring overlapping activities. The expected savings never materialize.

Furthermore, there are alternatives to the integration of two businesses as a means to exploit synergies between them. Often, alliances are enough and do not have to suffer negative aspects that characterize larger corporations, such as the increase in bureaucracy. It can be the personal interests of its managers rather than a solid economic rationale what motivates the decision to diversify in some large corporations.

Despite these arguments against diversification, researchers have questioned in the last decade whether diversification is as bad as the record shows. My IE colleague Juan Santalo and I conducted a study of the market value of a large number of diversified and specialized U.S. public firms . Our results confirmed the expected negative relationship between firm value and diversification. In line with earlier studies, diversifiers suffer a penalty around 15% of their market value versus specialized competitors. This is the value that on average would be created if conglomerates were broken into single-business firms and set free into the market. However, we also showed that this relationship changes and becomes positive once differences across industries are taken into consideration. In other words, there are systematic differences across industries such that diversifiers typically perform worse than specialized firms in some contexts, but there are other sectors in which diversifiers usually have greater market value. Sometimes it is beneficial to be a specialist, in the software industry for example, and sometimes it is preferable to be part of a diversified conglomerate, such as Procter and Gamble. Diversification may not be so bad after all.

Strategy and finance scholars are slowly starting to change their negative views about diversification. Certainly, firms often make expensive mistakes when they move into new markets, but the conclusion that diversification reduces performance on average and, thus, it is inherently negative may have been taken too far. To begin with, the causality direction in the argument may actually be reversed. Recent research suggests that large diversifiers generally have lower performance not necessarily because diversification reduces financial performance, but because firms with limited growth potential are the ones that have greater motivation to diversify and actually do so. If those firms had not diversified, they would still suffer low performance. That is, poor performance induces firms to diversify, but this does not mean that diversification caused lower performance. The question underperforming firms should ask is not “Should we diversify?” but rather, “What is the right industry to diversify into?”

In addition, the evidence regarding the conglomerate discount comes primarily from developed economies with well-developed capital markets, but their experience may not be exportable to other contexts in developing and emerging economies. There are very strong conglomerates in countries like South Korea, India, and Mexico, and being part of these business groups may provide substantial advantages to their different business units, such as cheaper and easier access to capital, even if there are no apparent synergies among them. This was also the case in the 1950s and 60s in the U.S. when there was actually a conglomerate premium. Thus, “stick to your knitting” may not be the best recommendation for firms in high-growth markets or regions that have strong corporate advantages, especially when they can be transferred to a broad variety of industries.

In summary, diversification is neither bad nor good on its own. Context is important as well as the motivation behind the decision to diversify and the direction it will take the firm. It is a complex decision of critical importance to managers that has been studied for several decades by management scholars. In my recent book Theory of the Firm for Strategic Management (2009), I review the academic research regarding the appropriate boundaries of firm including the contributions of the most recent Nobel Prize winner in economics, Oliver Williamson, and many other ideas about strategies for creating value. Though we have learned many things about diversification, no general prescription can be provided in the end. Diversification should not be treated as a cursed strategy or a dirty word, even though it has often been associated with lower performance of conglomerates in some countries. As always, only adequate strategic analysis can help managers decide whether value can be created through diversification.

Manuel Becerra is Professor of Strategy at IE Business School

[This research paper has been reproduced with permission of the authors, professors of IE Business School, Spain http://www.ie.edu/]