Monday 13 March 2023

Corporate diversification

Corporate diversification refers to the process of a company expanding its business activities into new product lines, markets, or industries. This strategy offers various benefits to firms, including financial, operational, and strategic advantages. 

  • Financial diversification helps a company to reduce its overall risk by spreading its investments across various assets, minimizing its exposure to any single investment. 

    Argument Critique
    Conglomerates can reinvest retained earnings to capitalise in new/unrelated markets. The role of the organisation is not to reinvest but to provide value to Shareholders, and it's the shareholders who should choose where to invest for themselves.
    Conglomerates have privileged information as well as domain expertise regarding profitable investment opportunities within related markets.  Little empirical evidence suggests that internal capital markets are more efficient.
    Conglomerates can reduce the volatility of earnings, by spreading their investments across multiple lines of business, if one doesn't do well it's impact is tampered by the others. Again this is a decision that should be left to the shareholders, how they wish to diversify their own portfolios and how much risk they are comfortable with.
    By diversifying their portfolio of businesses a conglomerate may be able to reduce the risk of bankruptcy and thus lowering theirs costs of financing as well as employment. If there is less likelihood of bankruptcy then loans should be granted on more favourable terms.  Little empirical evidence suggests that this is true, and some evidence suggests that this diversification increases risks, that the problems of one business can bleed into another, for example in the case of a boycott.

  • Operational diversification allows firms to leverage existing resources, technology, and expertise across different business lines, enabling them to achieve economies of scale and scope. A common nomenclature for this in business is 'synergy', the term  basically means "the interaction or cooperation of two or more organizations, substances, or other agents to produce a combined effect greater than the sum of their separate effects:" 

    Argument Critique
    exploit economies of scale and scope, meaning that conglomerate can lower costs by reducing or eliminating duplicate effort, for example creating shared services such as HR or IT between lines of business. Synergies are often hard to realise in practice and often better achieved through strategic partnerships or simple outsourcing rather than acquisitions. 
    Share technology, know-how, reputation, maximise underutilised resources across lines of business. Synergies are often hard to realise in practice and often better achieved through strategic partnerships or simple outsourcing rather than acquisitions. 
    Conglomerates can improve coordination among their held businesses, incentivise cooperation and information exchange between business units. Synergies are often hard to realise in practice and often better achieved through strategic partnerships or simple outsourcing rather than acquisitions. 

  • Strategic diversification enables companies to explore new markets and capitalize on emerging opportunities, helping them to stay ahead of the competition and maintain long-term growth. 

    Argument Caution
    if a Conglomerate acquires a business they can subsidise a price war with the competition, allowing their acquisition to operate at a loss to drive out competition.  This may actually be illegal and a violation of anti-trust laws.
    Aquire organisations upstream or downstream to one of your existing businesses, and use it to starve out your competition, by restricting their access to a key resource this can only be achieved by holding a monopolistic position in the up/down stream activity. Again their are legal considerations to take into account.
    Reduce rivalry through mutual forbearance, in other words, through mutually assured destruction; Conglomerates who overlap in businesses and markets can price each other out of business in an all out war. By holding similar positions to competitors this can reduce the risk of anyone throwing the first stone.  If a price war does break out it could mean the end of one or both conglomerates, it's generally a gentleman's agreement at best and a fragile peace treaty at worst.
    minimise transaction costs of using preferred partners, geographically located facilities near upstream suppliers to minimise transport fees   This requires either vertical integration or extreme trust between partners.

Overall, corporate diversification is a valuable strategy for firms looking to increase their competitiveness, minimize risk, and maximize their potential for success, however it is extremely difficult and complicated to accomplish successfully. 

Diversification matrix

The strategist can leverage the diversification matrix to help analyse the multiple business that on organisation operates in.

On the y-axis we measure how attractive an industry, this refers to how much potential and how profitable the industry is, the more opportunity to generate revenue the more attractive a business is.

On the x-axis we measure what the competitive advantage the business unit has, do they have a patent or are their other barriers to entry that allow them to have a competitive advantage.

based on where a business unit falls on the diversification matrix we can decide whether it's worth holding onto it, building it up more or harvesting it, that is selling it off, for more capital to invest in one of the other quadrants. Keep in mind that you have take into account the impact on other business units, a conglomerate may very well have a shipping company that is low on both scores, but provides a competitive advantage for a different business unit.