Diversification Strategy

OUTLINE

• Introduction: The Basic Issues

• The Trend over Time
• Motives for Diversification
- Growth and Risk Reduction
- Shareholder Value: Porter’s Essential Tests.
• Competitive Advantage from Diversification
• Diversification and Performance: Empirical Evidence
• Relatedness in Diversification
The Basic Issues in Diversification Decisions

Superior profit derives from two sources:

INDUSTRY
ATTRACTIVENESS
RATE OF PROFIT
> COST OF CAPITAL
COMPETITIVE
ADVANTAGE

Diversification decisions involve these same two issues:

• How attractive is the sector to be entered?
•Can the firm achieve a competitive advantage?
Diversification among the US Fortune 500, 1949-74

70.2 63.5 53.7 53.9 39.9 37.0

29.8 36.5 46.3 46.1 60.1 63.0

1949 1954 1959 1964 1969 1974

Percentage of Specialized Companies (single-business,
vertically-integrated and dominant-business)
Percentage of Diversified Companies (related-business
and unrelated business)

Note: During the 1980s and 1990s the trend reversed as large
companies refocused upon their core businesses
 Diversification among Large UK
Corporations, 1950-93

70
60
Single business
50
40 Dominant
business
30 Related business
20
Unrelated
10 business
0
1950 1960 1970 1983 1993
 Diversification: The Evolution of Management
Thinking and Management Practice

MANAGEMENT Quest for Growth Financial Refocusing on Competitive

GOALS problems of shareholder advantage through
conglomerates value Speed, flexibility,
and capability

Rise of conglomerates Emphasis on“related’ Refocusing on Joint ventures,

COMPANY Related diversification & “concentric” core businesses Alliance, corporate
DEVELOPMENTS by industrial firms diversification Divestment venturing

Portfolio Value based Transaction

Analysis of management cost analysis
Financial Analysis planning
economies of
scope & models
Diffusion of “synergy” Core Dynamic
STRATEGY TOOLS M form structures competences capability
Capital asset
& CONCEPTS
Development of corporate planning systems pricing model Dominant logic

1950 1960 1970 1980

1990
 Motives for Diversification

GROWTH --The desire to escape stagnant or declining industries

a powerful motives for diversification (e.g. tobacco,
oil, newspapers).
--But, growth satisfies managers not shareholders.
--Growth strategies (esp. by acquisition), tend to
destroy shareholder value

RISK --Diversification reduces variance of profit flows

SPREADING --But, doesn’t create value for shareholders—they can
hold diversified portfolios of securities.
--Capital Asset Pricing Model shows that diversification
lowers unsystematic risk not systematic risk.

PROFIT --For diversification to create shareholder value, then

bringing together of different businesses under
common ownership & must somehow increase
their profitability.
 Diversification and Shareholder Value:
Porter’s Three Essential Tests
If diversification is to create shareholder value, it must meet
three tests:

1. The Attractiveness Test: diversification must be directed

towards attractive industries (or have the potential to
become attractive).

2. The Cost of Entry Test : the cost of entry must not capitalize
all future profits.

3. The Better-Off Test: either the new unit must gain

competitive advantage from its link with the company, or
vice-versa. (i.e. some form of “synergy” must be present)

Additional source of value from diversification: Option value

 Competitive Advantage from Diversification
• Predatory pricing/tie-in sales Evidence
MARKET • Reciprocal buying of these
POWER • Mutual forbearance is sparse

• Sharing tangible resources (research labs, distribution

systems) across multiple businesses
ECONOMIES • Sharing intangible resources (brands, technology) across
OF multiple businesses
SCOPE • Transferring functional capabilities (marketing, product
development) across businesses
• Applying general management capabilities to multiple
businesses

• Economies of scope not a sufficient basis for

ECONOMIES diversification ----must be supported by transaction costs
FROM • Diversification firm can avoid transaction costs by
INTERNALIZING operating internal capital and labor markets
TRANSACTION • Key advantage of diversified firm over external markets---
S superior access to information
 Competitive Advantage from Diversification

• Predatory pricing Evidence

MARKET • Reciprocal buying of these
POWER • Mutual forbearance is sparse

• Sharing tangible resources (research labs, distribution

systems) across multiple businesses
ECONOMIES • Sharing intangible resources (brands, technology) across
OF multiple businesses
SCOPE • Transferring functional capabilities (marketing, product
development) across businesses
• Applying general management capabilities to multiple
businesses

• Economies of scope not a sufficient basis for

ECONOMIES diversification—must be supported by transaction costs
FROM • Diversification firm can avoid transaction costs by
INTERNALIZING operating internal capital and labor markets
TRANSACTION • Key advantage of diversified firm over external markets---
S superior access to information
 Relatedness in Diversification

Economies of scope in diversification derive from two

types of relatedness:
• Operational Relatedness-- synergies from sharing
resources across businesses (common distribution
facilities, brands, joint R&D)
• Strategic Relatedness-- synergies at the corporate level
deriving from the ability to apply common management
capabilities to different businesses.

Problem of operational relatedness:- the benefits in terms

of economies of scope may be dwarfed by the
administrative costs involved in their exploitation.
 Branson & the Virgin Companies: Making strategic
sense of apparent entrepreneurial chaos
KEY RESOURCES
•Virgin brand
•Branson DOMINANT LOGIC
-charisma/image •Seek competitive advantage by start-up cos.
--PR skills pursuing innovative differentiation in
-networking skills underserved market with sleepy incumbents
-entrepreneurial flair
CHARACTERISTICS OF
DESIGNING A CORPORATE STRATEGY MARKETSTHAT CONFORM
& STRUCTURE TO THIS LOGIC
• What’s the business model? •consumer
(Does Virgin create value by •dominant incumbent
being an entrepreneurial incubator, •scope for new approaches
a venture capital fund, a to customer service
diversified corporation, or what?) •high entry barriers to other
• Which businesses to divest? start-ups
• Criteria for future diversification •Branson/Virgin image
• What type of structure?—Is there appeals to customers
a need for greater formalization?