1. DEVELOPING STRATEGIES FOR COMPETITIVE ADVANTAGE Session 8 Diversification Strategy Session 8 Diversification Strategy 1

2. 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 Diversification Strategy 2 OUTLINE

3. RETURN ON CAPITAL > COST OF CAPITAL INDUSTRY ATTRACTIVENESS COMPETITIVE ADVANTAGE Superior profit derives from two sources: Diversification decisions involve these same two issues: How attractive is the sector to be entered? Can the firm achieve a competitive advantage? The Basic Issues in Diversification Decisions 3

4. Business Strategy is concerned with how a firm computes within a particular market Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities The dimensions of scope are: –vertical scope –geographical scope –product scope From Business Strategy to Corporate Strategy: the Scope of the Firm 3

5. P1P1 P2P2 P3P3 C1C1 C2C2 C3C3 Vertical Scope V1V2V3V1V2V3 P3P3 P2P2 P1P1 C3C3 C2C2 C1C1 V1V1 V2V2 V3V3 [A] Single Integrated Firm [B] Several Specialized Firms Linked by Markets In situation [A] businesses 1, 2 & 3 are integrated within a single firm. In situation [B] businesses 1, 2 & 3 are independent firms linked by markets. Which situation is more efficient? Depends upon whether the administrative costs of the integrated firm are less than the transaction costs of markets? Product Scope Geographical Scope Transactions Costs and the Scope of the Firm 4

6. United StatesUnited Kingdom % Diversification Strategies of Large US and UK Companies During Late 20th Century 4

7. DEVELOPMENTS IN CORPORATE STRATEGY MANAGEMENT PRIORITIES STRATEGY TOOLS & CONCEPTS Quest for Growth Improving perfo- rmance of widely diversified firms Creating shareholder value 1960197019801990 2000 2009 Emergence of conglomerates Established firms diversify into related sectors Emphasis on “related’ & “concentric” diversification Refocusing on core businesses Divesting diversified businesses Financial analysis Diffusion of M form structures Creation of corporate planning depts. Economies of scope Portfolio planning models Capital asset pricing model Max. share-holder value Transaction cost analysis Core competence Dominant logic Competitive advantage through speed & flexibility Growth Joint ventures and alliances Focused Diversification to create growth options Dynamic capabilities Parenting advantage Real options Diversification: The Evolution of Strategic Thinking 5

8. 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. --Diversification in that seeks growth (esp. by acquisition) tends 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]. VALUE --For diversification to create shareholder value, then CREATION bringing putting different businesses under common ownership must somehow increase their profitability. Motives for Diversification 6

9. 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) Diversification and Shareholder Value: Porter’s Three Essential Tests 7

10. Competitive Advantage from Diversification (The “Better-Off” Test) ECONOMIES OF SCOPE 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 common general management capabilities to different businesses ECONOMIES FROM INTERNALIZING TRANSACTIONS Economies of scope not a sufficient basis for diversification ----must be supported by transaction costs Diversified firm can avoid external transactions by operating internal capital and labor markets Diversified firm has better information on resource characteristics than external markets Diversification: The Evolution of Strategic Thinking 8

11. 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. Relatedness in Diversification 9

12. Corporate Management TasksDeterminants of Strategic Similarity Resource allocation Similar sizes of capital investment projects Similar time spans of investment projects Similar sources of risk Similar general management skills required fo business unit managers Strategy formulation Similar key success factors Similar stages of the industry life cycle Similar competitive positions occupied by each business within its industry Performance management and control Targets defined in terms of similar performance variables The Determinants of Strategic Relatedness Between Businesses 10