Introduction: Reason for diversification
Every company in its lifetime reaches a phase where the management is under dilemma as to whether they should go for diversification or launch new products in existing range in order to survive in the market. It’s almost inevitable: to boost growth when a company reaches a certain size and maturity, executives will be tempted to diversify. Companies implement diversification strategies to enhance or increase the strategic competitiveness of the overall organization. If they are successful, the value of the company increases. Value can be created through either related or unrelated diversification if the strategies enable the company’s mix of businesses to increase revenues and / or decrease costs when implementing their respective business-level strategies.
Companies may also implement a diversification strategy to gain market power relative to their competitors. Companies may implement diversification strategies that are either value neutral or result in devaluation of the company. They may attempt to diversify to neutralize a competitor’s market power or to reduce managers’ employment risk or to increase managerial compensation because of the positive relationships between diversification, company size, and compensation.
Although a few talented people over time have proved capable of managing diverse business portfolios, today most executives and boards realize how difficult it is to add value to businesses that aren’t connected to each other in some way. As a result, unlikely pairings have largely disappeared. In the United States, for example, by the end of 2010, there were only 22 true conglomerates. Since then, 3 have announced that they too would split up.
Achievements in past
The argument that diversification benefits shareholders by reducing volatility was never compelling. The rise of low-cost mutual funds underlined this point since that made it easy even for small investors to diversify on their own. At an aggregate level, conglomerates have underperformed more focused companies both in the real economy (growth and returns on capital) and in the stock market. From 2002 to 2010, for example, the revenues of conglomerates grew by 6.3 percent a year; those of focused companies grew by 9.2 percent. Even adjusted for size differences, focused companies grew faster. They also expanded their returns on capital by three percentage points, while the ROCs of conglomerates fell by one percentage point. Finally, median total returns to shareholders (TRS) were 7.5 percent for conglomerates and 11.8 percent for focused companies.*
What matters in a diversification strategy is whether managers have the skills to add value to businesses in unrelated industries—by allocating capital to competing investments, managing their portfolios, or cutting costs. Over the past 20 years, the TRS of the high and low performers among the 22 conglomerates remaining in 2010 clearly differed on exactly these points. While the number of companies is too small for statistical analysis, three characteristics for high performers generally seen are –
Disciplined (and sometimes contrarian) investors –
High-performing conglomerates continually rebalance their portfolios by purchasing companies they believe are undervalued by the market— and whose performance they can improve.
Aggressive capital managers –
Many large companies base a business’s capital allocation for a given year on its allocation the previous year or on the cash flow it generates. High-performing conglomerates, by contrast, aggressively manage capital allocation across units at the corporate level. All cash that exceeds what’s needed for operating requirements is transferred to the parent company, which decides how to allocate it across current and new business or investment opportunities, based on their potential for growth and returns on invested capital.
Rigorous ‘lean’ corporate centers –
High-performing conglomerates operate much as better private equity firms do: with a lean corporate center that restricts its involvement in the management of business units to selecting leaders, allocating capital, vetting strategy, setting performance targets, and monitoring performance. Just as important, these firms do not create extensive corporate-wide processes or large shared-service centers.
Future of Conglomerate: Growth vs. Risk Mitigation
The economic situation in emerging markets is sufficiently distinctive to make us cautious in applying insights gleaned from US companies. The conglomerate structure will face tests in near future, the level of which will vary from country to country and industry to industry.
In emerging markets, large conglomerates have economic benefits that don’t exist in the developed world. These countries still need to build up their infrastructure—such projects typically require large amounts of capital that smaller companies can’t raise. Companies also often need government approval to purchase land and build factories, as well as government assurances that there will be sufficient infrastructure to get products to and from factories and sufficient electricity to keep them operating. Large conglomerates typically have the resources and relationships needed to navigate the maze of government regulations and to ensure relatively smooth operations. Finally, in many emerging markets, large conglomerates are more attractive to potential managers because they offer greater career development opportunities.
Infrastructure and other capital-intensive businesses are likely to be parts of large conglomerates as long as access to capital and connections are important. In contrast, companies—including export-oriented ones such as those in IT services and pharmaceuticals—that rely less on access to capital and connections tend to be focused on, rather than part of, large conglomerates. The rise of IT services and pharmaceuticals in India and of Internet companies in China shows that the large conglomerates’ edge in access to managerial talent has already fallen. As emerging markets open to more foreign investors, these companies’ advantage in access to capital will also decline. That will leave access to government as their last remaining strength, further restricting their opportunities to industries where its influence remains important. Although the time could be decades away, conglomerates’ large size and diversification will eventually become impediments rather than advantages.
As the dynamics of doing business is becoming complicated the management of these conglomerates with the same efficiency is becoming an issue.
Taking an example of one of the big engineering and construction conglomerate, L&T. Looking at the performance of the company, the share price has fallen close to 25% in the past two years till date. If that was exception let’s look at another corporate powerhouse, Adani Enterprises. The company’s share has fallen close to 75% in the last two year.
ITC, in contrast, has shown a god performance in last two years i.e. its share price has grown close to 65%. This seems to contradict our discussion. But if we look closely the company has generated close to 65% from its Cigarettes business.
So what can be possible solutions for these can be –
Earlier during the license Raj, there were restrictions on the companies not to expand their capacities beyond a given point. Hence they were not able to scale up their business. And hence in some cases companies sat on the surplus cash were as in other cases went for diversifications looking for greater returns on the surplus cash from what they could have earned from the bank’s interest. In some cases, the results were as compared to the incomes that they would have earned from interests from banks whereas in many cases destroyed the values of their core business.
Now with the license raj dismantled so there is no need to have multiple businesses. In fact, consolidation happened in various industries like Cement where the major players like Ultratech, where the parent company increased its capacity by investing heavily, acquiring business etc.
Another type of structure that can work here is divestment i.e. sale of existing non-core business to raise funds to focus on their core business. This can be of great help especially in cases where the non-core businesses have underperformed and as a result, the whole company has suffered and their share prices were undervalued. It can also be of great help where the company had plans in place but didn’t have enough funds to expand. For e.g. IBM decided to sell its PC business to focus on IT solutions and services.
- Setting up Separate Companies –
Another way to deal with such situation is separating the businesses and running them as if they were different companies so that each company focuses on its business without getting influenced by other sister companies. By doing this the management and company as a whole can be made accountable for their doings. For e.g. TATA Group has been following this model for long. Each of their companies is running independently as a separate company.
Many companies in the past had a dream to become conglomerate in order to showcase their skills and talents to manage different businesses. But looking at the current scenario the concept “Conglomerate” is becoming a thing of the past i.e. corporate dinosaur on their way to extinction. This is mainly because of the changing dynamism of businesses world where competition has made companies think not much about profitability but towards sustainability. Further earlier general skills to manage the business and having a core competency in finance, HR, and other general functions were enough to give long term sustainability to many businesses. But present complexity in doing business superior skill sets in support functions will not allow any corporate to generate sustainable performance for a long term in multiple businesses. So focus infrastructure and team are the key to success for any business in today dynamic and a fast-changing business environment. Hence Corporates are forced to rethink their strategies set for growth from being diversified towards more focused businesses.