Rethinking the “diversification discount”

Academics, managers, and investors agree with near unanimity that corporate diversification destroys value. In their best-seller, In Search of Excellence, Tom Peters and Robert Waterman argued managers should “stick to the knitting” by focusing on the business they know best. Their argument presaged a series of management articles and books using different terms–including “core competency,” “unbundling the corporation” and “profit from the core“–to make the same point: Firms should focus on activities and markets where they have a sustainable competitive advantage. Diversification, according to this line of thought, dissipates attention and resources and breeds complexity. Outsourcing, off-shoring, and alliances allow firms to offload peripheral activities and focus narrowly on discreet activities where they excel.

A series of studies by financial economists documents a correlation between diversification economic value destruction. Philip Berger and Eli Ofek find that diversified firms trade at a discount of approximately 15% compared to focused competitors in the same industry. Larry Lang and René Stulz show that a firm’s diversification is negatively correlated with its Tobin’s Q (a firm’s market value divided by the book value of its assets). Hemang Desai and Prem Jain find that increasing corporate focus by selling divisions outside a company’s core business creates approximately 50% higher returns to shareholders over a three-year time frame compared to spin-offs that do not refocus the firm. Angela Morgan and her co-authors found mergers and acquisitions that decreased corporate focus, on average, reduced a firm’s relative shareholder valuation by 25% over a three year period, and that every 10% increase in diversification through M&A activity was correlated with a 9% decrease in valuation.

Financial economists attribute the “diversification discount,” in large part, to poor resource allocation within conglomerates.  Senior executives in diversified firms use the cash generated by profitable divisions to subsidize under-performing units. I refer to this as peanut butter approach to resource allocation, when managers spread resources evenly like peanut butter on a slice of bread. Executives often misallocate resources in an attempt to preserve a sense of fairness within a firm and to avoid the unpleasant consequences of disinvestment.  David Scharfstein finds that diversified conglomerates tend to under-invest in their most promising businesses (measured by Tobin’s Q) and over-invest in their declining businesses compared to pure play rivals. In another study of capital budgeting within the firm, Owen Lamont found that diversified oil firms scaled back their investments in non-oil subsidiaries, not because these units were less attractive, but because of cash flow constraints in the core business.  Another study by my colleague Henri Servaes and co-authors finds that misallocation of resources grows more likely as the the level of diversification increases.

The arguments and evidence in favor of corporate focus seem so compelling, that they have hardened into a dogmatic prejudice against diversification. Like all dogmas, this bias toward focus can blind us to important arguments and evidence in favor of diversification.

1) The exception proves the rule. The long-term success of enterprises such as Johnson & Johnson, General Electric, and the Tata Group defy the generalization that diversification inevitably destroys economic value.  Top-performing leveraged buyout firms, moreover, such as Carlyle, TPG, and KKR, have provided rich returns to their limited partners over decades by assembling and managing diversified portfolios. In contrast to mutual funds, top-performing leveraged buyout firms sustain their performance over time, suggesting that they owe their success to skill rather than good luck. These counter-examples undermine the argument that diversification never works.

2) Diversification helps organizations to weather crises. Diversification of cash flows allows an organization to withstand hard times in one or more of its portfolio businesses. In a difficult time for the global steel industry, German group ThyssenKrupp benefited from the profits earned in its elevator and service divisions. A diversified portfolio can also serve as a store of wealth that companies can liquidate to invest in promising businesses when funding is not easily available. In the midst of the global recession in the early 1990s, Nokia sold off several business units and used the proceeds to fund expansion in mobile telephony.  In theory, firms could tap capital markets to underwrite good investments or weather economic crises, but in reality funding is often prohibitively expensive, or simply unavailable, in hard times.

3) Diversification provides platforms for growth. Diversification exposes a firm to more potential opportunities for future growth. In a recent study, McKinsey & Company analyzed the drivers of revenue growth of over 200 large corporations around the world. Their analysis revealed the most important determinant of growth–accounting for approximately two-thirds of revenue growth–was the mix of market segments a firm competed in, rather than share gains within segments, M&A activity, or aggregate market growth. By shifting resources from stagnant or declining segments into fast growing ones, firms can turbocharge growth, but some level of diversification is necessary to do so.

4) Under-performance causes diversification, not the other way around. A series of recent studies by financial economists suggests that diversification is often the symptom, rather than the cause, of poor performance. Campa and Kedia,, Lang and Stulz find that diversifying firms under-perform their peers before they make acquisitions to diversify.   Graham et al. find that the performance of acquired firms lags industry benchmarks by an average of 10% in their last year as stand-alone entities. Conglomerates often under-perform because the constituent units earn low returns, not because they are diversified. In a study that overcomes limitations in how public companies report their performance by segment, Belén Villalonga reconstructs firms’ business units in a consistent manner, and finds that diversified firms trade at a premium, not a discount to the market.

To exploit the benefits of a diversified portfolio, firms need what I call portfolio agility, or the capacity to shift resources from declining regions, units, products, and customers to more promising opportunities quickly and effectively.  My next post will discuss how managers can increase portfolio agility in their organization.

Leading in turbulent times

This blog is no longer active but it remains open as an archive.

Don Sull is professor of management practice in strategic and international management, and faculty director of executive education at London Business School. This blog is dedicated to helping entrepreneurs, managers, and outside directors to lead more effectively in a turbulent world.

Over the past decade, Prof Sull has studied volatile industries including telecommunications, airlines, fast fashion, and information technology, as well as turbulent countries including Brazil and China, and found specific behaviours that consistently differentiate more, and less, successful firms. His conclusion is that actions, not an individual’s traits, increase the odds of success in turbulent markets, and these actions can be learned.