Testing the limits of diversification

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Testing the limits of diversification
This strategy can create value, but only if a company is the best possible owner of businesses outside its core industry.

Joseph Cyriac, Tim Koller, and Jannick Thomsen

It’s almost inevitable: to boost growth when a company reaches a certain size and maturity, executiveswill be tempted to diversify. In extreme cases—the United States during the 1960s and 1970s, for example—a corporation with a sharp focus on its core business can end up as a mix of strange bedfellows. One global oil enterprise famously acquired a computer business, another a retailer. And a major US utility once owned an insurance company. Although a few talented people over time have provedcapable 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.1 Since then, 3 have announced that they too would split up. Yettoo many executives still believe that diversifying into unrelated industries reduces risks for investors or that diversified businesses can better allocate capital across businesses than the market does—without regard to the skills needed to achieve these goals. Because few have such skills, diversification instead often caps the upside potential for shareholders but doesn’t limit the downsiderisk. As managers contemplate moves to diversify, they would do well to remember that

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in practice, the best-performing conglomerates in the United States and in other developed markets do well not because they’re diversified but because they’re the best owners, even of businesses outside their core industries (see sidebar, “Conglomerates in emerging markets”). Limited upside, unlimiteddownside 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 7.5percent for conglomerates and 11.8 percent for focused companies. As usual, the median doesn’t tell the entire story: some conglomerates did outperform many focused companies. And while the median return from conglomerates is lower, the distribution’s shape tells an instructive story: the upside is chopped off, but not the downside (exhibit). Upside gains are limited because it’s unlikely that allof a diverse conglomerate’s businesses will outperform at the same time. The returns of units that do are dwarfed by underperformers and therefore probably won’t affect the entire conglomerate’s returns in a meaningful way. Moreover, conglomerates are usually made up of relatively mature businesses, well beyond the point where they would be likely to

generate unexpected returns. But thedownside isn’t limited, because the performance of the more mature businesses found in most conglomerates can fall a lot further than it can rise. Consider a simple mathematical example: if a business unit accounting for a third of a conglomerate’s value earns a 20 percent TRS while other units earn 10 percent, the weighted average will be about 14 percent. But if that unit’s TRS is negative 50...