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
29.8
1949
63.5
53.7
36.5
1954
53.9
46.3
1959
39.9
46.1
1964
37.0
60.1
1969
63.0
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
Dominant
business
Related business
40
30
20
Unrelated
business
10
0
1950 1960 1970 1983 1993
Diversification: The Evolution of Strategy and
Management Thinking
MANAGEMENT
PRIORITIES
DEVELOPMENTS
IN CORPORATE
STRATEGY
STRATEGY TOOLS
& CONCEPTS
Quest for Growth
•Emergence of
conglomerates
•Diversification by
established companies
into related sectors
•Financial analysis
•Diffusion of M form
structures
•Creation of
corporate planning
depts.
1960
1970
Addressing underperformance of
widely-diversified
firms
Emphasis on
“related’ &
“concentric”
diversification
•Economies of
scope & synergy”
• Portfolio planning
models
• Capital asset
pricing model
1980
Creating
shareholder
value
•Competitive
advantage through
speed & flexibility
•Creating
opportunities for
future growth
•Refocusing on
core
businesses
•Divesting
diversified
businesses
•Joint ventures and
alliances
•Creating growth
options
through focused
diversification
•Maximization
of shareholder
wealth
•Core
competences
•Dominant logic
•Dynamic
capabilities
•Transaction cost
analysis
•Real options
1990
2000
2006
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
SPREADING
--Diversification reduces variance of profit flows
--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
MARKET
POWER
ECONOMIES
OF
SCOPE
• Predatory pricing/tie-in sales
• Reciprocal buying
• Mutual forbearance
Evidence
of these
is sparse
• Sharing tangible resources (research labs, distribution
systems) across multiple businesses
• Sharing intangible resources (brands, technology) across
multiple businesses
• 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
-charisma/image
--PR skills
-networking skills
-entrepreneurial flair
DOMINANT LOGIC
•Seek competitive advantage by start-up cos.
pursuing innovative differentiation in
underserved market with sleepy incumbents
DESIGNING A CORPORATE STRATEGY
& STRUCTURE
• What’s the business model?
(Does Virgin create value by
being an entrepreneurial incubator,
a venture capital fund, a
diversified corporation, or what?)
• Which businesses to divest?
• Criteria for future diversification
• What type of structure?—Is there
a need for greater formalization?
CHARACTERISTICS OF
MARKETSTHAT CONFORM
TO THIS LOGIC
•Consumer businesses
•dominant incumbent
•scope for new approaches
to customer service
•high entry barriers to other
start-ups
•Branson/Virgin image
appeals to customers