1. Diversification Strategy
OUTLINE
Introduction: The Basic Issues
The Trend over Time
Motives for Diversification
- Growth and risk spreading
- Diversification and Shareholder Value: Porter’s Three Essential Tests.
Competitive Advantage from Diversification
Diversification and Performance: Empirical Evidence
Relatedness in Diversification 27

2. Introduction: The Basic Issues
Diversification decisions involve two basic issues:
Is the industry to be entered more attractive than the firm’s existing business?
Can the firm establish a competitive advantage within the industry to be entered? (i.e. what synergy's exist between the core business and the new business?) 28

3. The Trend Over Time: Diversified Companies among the Fortune 500
Percentage of Specialized Companies (single-business, vertically-integrated and dominant-business)
Percentage of Diversified Companies (related-business and unrelated business)
BUT Since late 1970’s, diversification has declined. 29

4. Corporate Strategy & Diversification: A Time-Line of Management Thought & Practice
ISSUES
Quest for Growth
Financial problems of conglomerates
Shareholder activism Leveraged Buyouts
Rise of conglomerates Related diversification by industrial firms
Emphasis on
“related’ & “concen-tric” diversification
Refocusing on core businesses Divestment
Licensing, JVs, & strategic alliances
COMPANY DEVELOPMENTS
Development of corporate planning systems
Transaction cost analysis
Value based management
Financial Analysis
Portfolio planning
STRATEGIC MANAGEMENT ANALYSIS
Analysis of economies of scope & “synergy”
Diffusion of M form structures
Core competences
Capital asset pricing model
Planning concepts
Dominant logic 1

5. Why diversify?

6. Motives for Diversification
GROWTH --The desire to escape stagnant or declining industries has been one of the most powerful motives for diversification (tobacco, oil, defense).
--But, growth satisfies management not shareholder goals.
--Growth strategies (esp. by acquisition), tend to
destroy shareholder value
RISK Diversification reduces variance of profit flows
SPREADING --But, does not normally create value for shareholders, since shareholders can hold diversified portfolios.
--Capital Asset Pricing Model shows that diversification lowers unsystematic risk not systematic risk.
PROFIT For diversification to create shareholder value, the act
of bringing different businesses under common owner-
ship & must somehow increase their profitability. 31

7. How should we evaluate proposed diversification moves?

8. 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 actual or potentially-attractive industries.
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 corporation, or vice-versa. (i.e. synergy must be present) 32

9. More on the better off test - 1
What can our company do better than any of its competitors I its current market?
What are our company’s strategic assets and how can we make the best use of them?
What strategic assets do we need to succeed in the new market?
Some vs. all (e.g. Coke in wine)

10. More on the better off test - 2
Can we catch up to or leapfrog competitors at their own game?
Will diversification break up strategic assets that need to be kept together? (McDonald’s example)

11. More on the better off test - 3
Will we be simply a player in the new market or will we emerge a winner? (VRIO)
What can our company learn by diversifying and are we sufficiently organized to learn it?
Absorptive capacity GM

12. Potential access to a wide variety of markets
Core Competence Tests
Potential access to a wide variety of markets
Makes a significant contribution to the perceived customer benefits
Difficult to imitate 35

13. But, what is a core competence
But, what is a core competence? For example, what is your firm’s core competence?

14. Core Competences are. . .
Usually defined by describing successes and failures
Often confused with non-core competences
Broad generalities (e.g. marketing excellence)
Often not clear about limits
“some companies think everything they do is a core competency”

15. McKinsey Approach to Core Competence
Definition
“a combination of complementary skills and knowledge bases embedded in a group or team that results in the ability to execute one or more critical processes to a world-class standard.”

16. Core competence: two categories
Insight/Foresight
Technical/Scientific knowledge (Canon optics)
Proprietary data
Creative flair (e.g. Disney
Superior analysis (e.g. Berkshire-Hathaway)
Frontline Execution
e.g. Southwest, Nordstrom, McDonalds

17. Evaluating Core Competences
Are our skills truly superior?
(What independent tests show that we are better at this skill than leading competitors in technical terms or customer opinion [or both]).
How sustainable is the superiority? (R-I)
How much value can the competence generate?

18. How does a company develop a core competence?

19. Creating Core Competences
Evolution
Incubation
Acquisition

20. What does the evidence on diversification show?

21. Diversification and Performance: Empirical Evidence
Diversification trends have been driven by beliefs rather than evidence:- 1960s and 70s diversification believed to be profitable; 1980s and 90s diversification seen as value destroying.
Empirical evidence inconclusive-- no consistent findings on impact of diversification on profitability, or on related vs. unrelated diversification.
Some evidence that high levels of diversification detrimental to profitability
Diversifying acquisitions,
on average, destroy share-
holder value for acquirers
Refocusing generates
positive shareholder returns 3
return on net assets (%) 2 1
index of product diversity 33

22. Type of Diversification May Matter
Conglomerate
Concentric-related
Related-linked

23. Summary