1. 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 27

2. 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?

3. Diversification among the US Fortune 500, 1949-74
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 29

4. Diversification among Large UK Corporations, 1950-93

5. Related diversification Development of corporate planning systems
Diversification: The Evolution of Management Thinking and Management Practice
MANAGEMENT
GOALS
Quest for Growth
Financial
problems of
conglomerates
Refocusing on
shareholder
value
Competitive
advantage through
Speed, flexibility,
and capability
Rise of conglomerates
Related diversification
by industrial firms
Emphasis on“related’
& “concentric”
diversification
Refocusing on
core businesses
Divestment
Joint ventures,
Alliance, corporate
venturing
COMPANY
DEVELOPMENTS
Value based
management
Transaction
cost analysis
Portfolio
planning
models
Analysis of
economies of
scope &
“synergy”
Financial Analysis
STRATEGY TOOLS
& CONCEPTS
Diffusion of
M form structures
Core
competences
Dynamic
capability
Capital asset
pricing model
Development of corporate planning systems
Dominant logic

6. 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. 31

7. 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 32

8. Competitive Advantage from Diversification
Predatory pricing/tie-in sales Evidence
Reciprocal buying of these
Mutual forbearance is sparse
MARKET
POWER
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
Economies of scope not a sufficient basis for diversification ----must be supported by transaction costs
Diversification firm can avoid transaction costs by operating internal capital and labor markets
Key advantage of diversified firm over external markets--- superior access to information
ECONOMIES
FROM
INTERNALIZING
TRANSACTIONS

9. Competitive Advantage from Diversification
Predatory pricing Evidence
Reciprocal buying of these
Mutual forbearance is sparse
MARKET
POWER
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
Economies of scope not a sufficient basis for diversification—must be supported by transaction costs
Diversification firm can avoid transaction costs by operating internal capital and labor markets
Key advantage of diversified firm over external markets--- superior access to information
ECONOMIES
FROM
INTERNALIZING
TRANSACTIONS 34

10. 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. 35

11. 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
CHARACTERISTICS OF
MARKETSTHAT CONFORM
TO THIS LOGIC
consumer
dominant incumbent
scope for new approaches
to customer service
high entry barriers to other
start-ups
Branson/Virgin image
appeals to customers
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?