Corporate Strategy
Fall 2007
Session 3 - Lecture 2
Diversification and Performance
Dr. Olivier Furrer
Office: TvA 1-1-11, Phone: 361 30 79
e-mail: o.furrer@fm.ru.nl
Office Hours: only by appointment
Session 03 © Furrer 2002-2008
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Session 03 © Furrer 2002-2008
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Firms Vary by Degree of
Diversification
Low Levels of Diversification
> 95% of revenues from a single
Single-business
business unit
Dominant-business
Between 70% and 95% of revenues from
a single business unit
Moderate to High Levels of Diversification
<70% of revenues from a single
Related-Diversified
business unit
Businesses share product, techno-logical
or distribution linkages
High Levels of Diversification
Business units not closely related
Unrelated-Diversified
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Ref.: Rumelt, 1974
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Firms Vary by Degree of
Diversification
0.0
Related Ratio: Proportion of a firm’s revenues derived
from its largest single group of related businesses.
Unrelated
Business
0.7
DominantUnrelated
Single
Business
1.0
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Related Ratio
Specialization Ratio: Proportion of a firm’s revenues
derived from its largest single business.
Related
Business
Dominant
Business
0.95
1.0
0.0
0.7
Specialization Ratio
Ref.: Rumelt, 1974
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Types of Diversification Strategies
Low Levels of Diversification
Moderate to High Levels of
Diversification
A
A
Single Business
A
B
B
Dominant Business
A
C
Related
constrained
B
C
Related linked
Very High Levels of Diversification
A
B
C
Unrelated
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Ref.: adapted from Rumelt, 1974
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Reasons for Diversification
Motives to Enhance
Strategic Competitiveness
Resources
Economies of Scope
Market Power
Financial Economies
Incentives
Managerial Motives
Causing Value Reduction
Managerial
Motives
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Diversifying Managerial
Employment Risk
Increasing Managerial
Compensation
Incentives and Resources
with Neutral Effects of
Strategic Competitiveness
Anti-Trust Regulation
Tax Laws
Low Performance
Uncertain Future Cash Flows
Firm Risk Reduction
Tangible Resources
Intangible Resources
Ref.: Hoskisson and Hitt, 1990
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Summary Model of the Relationship between
Firm Performance and Diversification
Resources
Capital Market
Intervention and
Market for
Managerial Talent
Incentives
Diversification
Strategy
Ref.: Hoskisson and Hitt, 1990
Firm
Performance
Managerial
Motives
Internal
Governance
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Strategy
Implementation
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Adding Value by Diversification
Diversification most effectively adds value by either
of two mechanisms
By developing economies of scope between business
units in the firms which leads to synergistic benefits
By developing market power which lead to greater
returns
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Alternative Diversification Strategies
Related Diversification Strategies
1
Sharing Activities
2
Transferring Core Competencies
Unrelated Diversification Strategies
3
Efficient
Internal
Capital
Market
Allocation
Efficient
Internal
Capital
Market
Allocation
4
Restructuring
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Sharing Activities
Key Characteristics
Sharing Activities often lowers costs or raises differentiation
Example: Using a common physical distribution system and sales
force such as Procter & Gamble’s disposable diaper and paper
towel divisions
Sharing Activities can lower costs if it:
*
*
*
Achieves economies of scale
Boosts efficiency of utilization
Helps move more rapidly down Learning Curve
Example: General Electric’s costs to advertise, sell and service
major appliances are spread over many different products
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Sharing Activities
Key Characteristics
Sharing Activities can enhance potential for or reduce the cost of
differentiation
Example: Shared order processing system may allow new features
customers value or make more advance remote sensing technology
available
Must involve activities that are crucial to competitive advantage
Example: Procter & Gamble’s sharing of sales and physical distribution
for disposable diapers and paper towels is effective because these items
are so bulky and costly to ship
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Sharing Activities
Assumptions

Strong sense of corporate identity

Clear corporate mission that emphasizes the
importance of integrating business units

Incentive system that rewards more than just
business unit performance
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Transferring Core Competencies
Key Characteristics
 Exploits Interrelationships among divisions
 Start with Value Chain analysis
Identify ability to transfer skills or expertise
among similar value chains
Exploit ability to share activities
Two firms can share the same sales force,
logistics network or distribution channels
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Transferring Core Competencies
Assumptions
Transferring Core Competencies leads to competitive
advantage only if the similarities among business units
meet the following conditions:

Activities involved in the businesses are similar
enough that sharing expertise is meaningful

Transfer of skills involves activities which are
important to competitive advantage

The skills transferred represent significant sources
of cooperative advantage for the receiving unit
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Efficient Internal Capital Market
Allocation
Key Characteristics
Firms pursuing this strategy frequently diversify by acquisition:
• Acquire sound, attractive companies
• Acquired units are autonomous
• Acquiring corporation supplies needed capital
• Portfolio managers transfer resources from units that
generate cash to those with high growth potential and
substantial cash needs
• Add professional management & control to sub-units
• Sub-unit managers compensation based on unit results
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Efficient Internal Capital Market
Allocation
Assumptions

Managers have more detailed knowledge of
firm relative to outside investors

Firm need not risk competitive edge by disclosing
sensitive competitive information to investors

Firm can reduce risk by allocating resources among
diversified businesses, although shareholders can
generally diversify more economically on their own
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Portfolio Planning
• Portfolio Planning under the Boston Consulting
Group (BCG) matrix:
– Identifying the Strategic Business Units (SBUs) by
business area or product market
– Assessing each SBU’s prospects (using relative market
share and industry growth rate) relative to other SBUs in
the portfolio.
– Developing strategic objectives for each SBU.
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The BCG Matrix
Session 03 © Furrer 2002-2008
Ref: Adapted from The Boston Consulting Group, Inc.,
Perspectives, No. 66, “The Product Portfolio.” 1970.
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The Strategic Implications of the
BCG Matrix
• Stars
– Aggressive investments to support continued growth and
consolidate competitive position of firms.
• Question marks
– Selective investments; divestiture for weak firms or those
with uncertain prospects and lack of strategic fit.
• Cash cows
– Investments sufficient to maintain competitive position.
Cash surpluses used in developing and nurturing stars and
selected question mark firms.
• Dogs
– Divestiture, harvesting, or liquidation and industry exit.
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Limitations on Portfolio
Planning
• Flaws in portfolio planning:
– The BCG model is simplistic; considers only two
competitive environment factors– relative market share and
industry growth rate.
– High relative market share is no guarantee of a cost savings
or competitive advantage.
– Low relative market share is not always an indicator of
competitive failure or lack of profitability.
– Multifactor models (e.g., the McKinsey matrix) are better
though imperfect.
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The McKinsey Matrix
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Restructuring
Key Characteristics
Seek out undeveloped, sick or threatened organizations or
industries
Parent company (acquirer) intervenes and frequently:
- Changes sub-unit management team
- Shifts strategy
- Infuses firm with new technology
- Enhances discipline by changing control systems
- Divests part of firm
- Makes additional acquisitions to achieve critical mass
Frequently sell unit after making one-time changes since
parent no longer adds value to ongoing operations
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Restructuring
Assumptions

Requires keen management insight in selecting firms
with depressed values or unforeseen potential

Must do more than restructure companies

Need to initiate restructuring of industries to create
a more attractive environment
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Incentives to Diversify
External Incentives
Relaxation of Anti-Trust regulation allows more related
acquisitions than in the past
Before 1986, higher taxes on dividends favored spending
retained earnings on acquisitions
After 1986, firms made fewer acquisitions with retained
earnings, shifting to the use of debt to take advantage of
tax deductible interest payments
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Performance
Diversification and Firm Performance
Dominant
Business
Related
Constrained
Unrelated
Business
Level of Diversification
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Ref.: Palich, Cardinal and Miller, 2000
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Incentives to Diversify
Internal Incentives
Poor performance may lead some firms to diversify to
attempt to achieve better returns
Firms may diversify to balance uncertain future cash
flows
Firm may diversify into different businesses in order
to reduce risk
Managers often have incentives to diversify in order to
increase their compensation and reduce employment
risk, although effective governance mechanisms may
restrict such abuses
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Issues to Consider Prior to
Diversification
What Resources, Capabilities and Core Competencies do we
possess that would allow us to outperform competitors?
What Core Competencies must we possess to succeed in a new
product or geographic market?
Is it possible to leapfrog competitors?
Will diversification break up capabilities and competencies that
should be kept together?
Will we only be a player in the new product or geographic market or
will we emerge as a winner?
What can the firm learn through its diversification?
Is it organized properly to acquire such knowledge?
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Alternative Diversification Strategies
Related Diversification Strategies
1
Sharing Activities
2
Transferring Core Competencies
Unrelated Diversification Strategies
3
Efficient
Internal
Capital
Market
Allocation
Efficient
Internal
Capital
Market
Allocation
4
Restructuring
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Corporate Strategy and
Shareholder Value Creation
M&A Wave Era
Corporate Role
Portfolio
Management
(1960s, 1970s)
(1980s)
Transfer of Skills /
Sharing Activities
(1990s)
Active:
Surgeon; Asset
striping
Active:
Coach & Architect
Focus of Strategy Business Portfolio;
Conglomerates
Coordination of
businesses;
Divestitures
Sharing of
knowledge;
Relatedness
hypothesis
Operational
Approach
Higher operating cash Coordination of
flows
resources;
Economies of scale
and scope
Session 03 © Furrer 2002-2008
Passive:
Banker/Investor;
Antitrust law
Restructuring
Lowering costs of
capital, increasing
financial cash flows;
managerial synergies
Source: Business Horizons, January-February 1997, p. 34.
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Corporate Strategy and
Shareholder Value Creation
M&A Wave Era
Results
Portfolio
Management
(1960s, 1970s)
Restructuring
Efficient markets;
Conglomerate
discounts: the whole
less valuable than the
sum of its parts
Dept financed M&A
by raiders beneficial,
full-blown M&A less
beneficial
Many distressed
businesses result in
widespread divesture
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(1980s)
Partly beneficial, but
“deptism” occurs,
limiting ultimate
success
Transfer of Skills /
Sharing Activities
(1990s)
Potential for creation
of value high, postM&A management
crucial
(implementation
failures, excess
bidding)
The brave new world
of corporate synergy?
Source: Business Horizons, January-February 1997, p. 34.
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Level of Diversification
1980
1990
2000
Focused = 95% or more of sales within main industry.
Dominant Business = Between 80% and 95% of sales within main industry.
Diversified = Between 20% and 40% of sales outside main industry.
Highly Diversified = More than 40% of sales outside main industry.
Session 03 © Furrer 2002-2008
Reference: Franko, 2004
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How Parents Create Value
Stand-alone influence
Linkage influence
Central functions and services
Corporate development
Session 03 © Furrer 2002-2008
Source: Goold, Campbell and Alexander, 1994
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Summary Model of the Relationship between
Firm Performance and Diversification
Resources
Capital Market
Intervention and
Market for
Managerial Talent
Incentives
Diversification
Strategy
Ref.: Hoskisson and Hitt, 1990
Firm
Performance
Managerial
Motives
Internal
Governance
Session 03 © Furrer 2002-2008
Strategy
Implementation
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Summary
• Rumelt’s Strategy, Structure and Economic Performance
(1974) represents a landmark in the study of corporate
strategy.
• His key finding was the superiority of related over
unrelated diversification.
• Empirical studies of the relationship between
diversification strategy and performance initially
confirmed the superiority of related diversification over
unrelated diversification (Bettis, 1981; Christensen and
Montgomery, 1981; Rumelt, 1982: Lecraw, 1984).
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Summary
• However, as the volume of empirical work on the relationship
between diversification strategy and performance grew, the
findings became more inconsistent.
• Some studies found no significant relationship between
relatedness in diversification and profitability (Grant et al.,
1988)
• While other studies found unrelated diversification to be more
profitable than related diversification (Michel and Shaked,
1984; Luffman and Reed, 1984; Lubatkin, 1987).
• Some other studies observed a curvilinear relationship (Grant et
al, 1988; Lubatkin and Chatterjee, 1994; Palich et al. 2000).
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Summary
• Recent investigations of the relationship between corporate
strategy and performance have featured more refined
methodologies.
• These have deployed more sophisticated measures of
diversification (Hoskisson et al. 1993; Nayyar, 1992; Robins
and Wiersema, 1997) and the use of a wider range of control
variables.
• Particular attention has been devoted to the interactions
between corporate strategy and industry characteristics
(Montgomery and Wernerfelt, 1991; Stimpert and Duhaime,
1997) in addition to the links between resources and
diversification (Chatterjee and Wernerfelt, 1991).
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Summary
• In other areas of corporate strategy, the picture is less
confusing. Greater consistency found in relation to vertical
integration and international diversification.
• In relation to vertical integration, Rumelt’s (1974) fining hat
vertically integrated firms underperform both specialized and
diversified firms has been supported by subsequent evidence.
• In relation to international diversification, multinationals have
tended to outperform nationally focused firms (Grant, 1987;
Grant et al., 1988; Hitt et al., 1997)
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Summary
• Recent evidence concerning the relationship between
diversification and performance includes the consequences of
refocusing initiatives.
• The results of the divestments of diversified businesses by
conglomerates suggest that narrowing business scope leads to
increased profitability and increased stock market valuation.
• The stock market’s verdict on diversification is unambiguous.
The high price-earning ratios attached to conglomerates during
the 1960s have been replaced by a ‘conglomerate discount’.
• The result was that diversified companies came under attack
from leveraged-buyout specialists seeking to add value by
dismembering these companies.
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Conclusion
• The main conclusion that arises from the empirical
literature is that there is no simple and consistent
relationship between diversification and firm
performance.
• In answering the question: ‘Does diversification
enhance firm performance?’ the most we can say is:
‘It all depends’.
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Next Session: Case Study 1
Microsoft’s Diversification Strategy
1. What opportunities and challenges await Microsoft in markets
in which it did not have proprietary advantage?
2. What specific strategies did it have to adopt to capitalize on the
opportunities and counter the challenges?
3. How best could Microsoft execute its diversification strategy?
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