Diversification StrategyDiversification Strategy

• 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

OUTLINE

RATE OF PROFIT

> COST OF CAPITAL

INDUSTRY

ATTRACTIVENESS

COMPETITIVE

ADVANTAGE

The Basic Issues in Diversification DecisionsThe Basic Issues in Diversification Decisions

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?

Diversification among the US Fortune 500, 1949-74Diversification 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

1949 1954 1959 1964 1969 1974

70.2 63.5 53.7 53.9 39.9 37.029.8 36.5 46.3 46.1 60.1 63.0

0

10

20

30

40

50

60

70

1950 1960 1970 1983 1993

Single business

DominantbusinessRelated business

Unrelatedbusiness

Diversification among Large UK Corporations, 1950-93

Diversification among Large UK Corporations, 1950-93

COMPANY DEVELOPMENTS

MANAGEMENT

GOALS

STRATEGY TOOLS & CONCEPTS

1950 1960 1970 1980 1990

Financial problems of

conglomerates

Refocusing on shareholder

value

Rise of conglomeratesRelated diversification

by industrial firms

Emphasis on“related’ & “concentric” diversification

Refocusing on core businesses

Divestment

Diffusion of M form structures

Analysis of economies of

scope & “synergy”

Value based management

Capital asset pricing model

Portfolio planning models

Core competences

Transaction cost analysis

Development of corporate planning systems

Diversification: The Evolution of Management Thinking and Management Practice

Diversification: The Evolution of Management Thinking and Management Practice

Joint ventures, Alliance, corporate

venturing

Competitive advantage throughSpeed, flexibility,

and capability

Dynamiccapability

Quest for Growth

Financial Analysis

Dominant logic

Motives for DiversificationMotives 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 flowsSPREADING --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

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 DiversificationCompetitive Advantage from Diversification

• Predatory pricing/tie-in sales Evidence• Reciprocal buying of these• Mutual forbearance is sparse

MARKETPOWER

• 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 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 OF

SCOPE

ECONOMIESFROM

INTERNALIZINGTRANSACTIONS

Competitive Advantage from DiversificationCompetitive Advantage from Diversification

• Predatory pricing Evidence• Reciprocal buying of these• Mutual forbearance is sparse

MARKETPOWER

• 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 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 OF

SCOPE

ECONOMIESFROM

INTERNALIZINGTRANSACTIONS

Relatedness in DiversificationRelatedness 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

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 OFMARKETSTHAT 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?