Diversification: A Broader Perspective

John Byrd, Kent Hickman, and Hugh Hunter

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D iversification plays an impor- tant role not

only in the personal in- vestment field but also in corporate strategy. One of the pillars of financial economics and invest- ment theory is that port- folio diversification re- duces risk without affect- ing returns. When a vari- ety of securities are com- bined into a single invest- ment portfolio, the poor returns to some are offset by superior returns to

others, dampening the overall variability of the portfolio’s returns.

The strong preference investors show toward mutual funds (well-diversified investments) dem- onstrates the power of diversification. Articulating and modeling portfolio diversification was one of the insights for which Harry Markowitz and Will- iam Sharpe (along with Merton Miller) shared the Nobel Prize in Economics in 1987.

In the corporate arena, diversification usually refers to companies pursuing several unrelated lines of business. The ultimate diversified firms have subsidiaries in dozens of completely unre- lated areas. Examples of such companies include Textron, ITT, and GE-companies for which many people could not name the primary line of business. Unlike the diversification of investment portfolios, with its well-documented benefits, the benefits of corporate diversification are not as obvious. In the 1960s and '7Os, many companies pursued diversification strategies. Earnings smoothing, increased debt capacity, risk reduc- tion! tax offsets, and administrative economies of scale were most often cited as sources of eco- nomic gains from diversification.

In the 198Os, both financial economists and corporate managers began to question the value of the corporate diversification strategy. Because shareholders can easily and cheaply diversify their own portfolios, economists doubted that corporate diversification helped them much. Moreover, corporate diversification forced share- holders to accept a fixed combination of industry exposure that might not suit every investor’s risk and return profile.

Academics also examined the incentives di- versification might create within the corporation. Are poor performing units of diversified compa- nies subsidized by the profitable divisions? That is, are unprofitable divisions of diversified com- panies kept alive longer than those of an other- wise identical stand-alone company? And do poor performing divisions receive an unwar- ranted amount of investment? A growing body of academic research finds that diversification typi- cally harms shareholders. There is also some evidence of over-investment and cross-subsidiza- tion of unprofitable divisions.

As the 1980s progressed, companies began shedding divisions, or had divisions shed for them through takeovers and buy-outs. With in- creased competition, companies responded by focusing on fewer business activities. For ex- ample, Sears returned to merchandising by spin- ning off Dean Witter, Discover, and Allstate Insur- ance and selling Coldwell Banker. (It is now try- ing to sell its Homart division). In just two years, Sears was transformed from a highly diversified retail/financial services/insurance company to a streamlined merchandiser.

Limiting discussion of diversification to the polar cases of personal investment portfolios and the entire corporation ignores a range of ways that the concept is applied in business today. In this vein, we discuss a number of examples of diversification and develop a better understand- ing of when it is likely to be beneficial.

Business Horizons / March-April 1997

Investing: When Diversification Is Commonplace

Investment Managers. Investors intuitively un- derstand the lessons of diversification when they invest in several mutual funds across several mu- tual fund families. By doing this, they rid their portfolios of adverse effects from the idiosyn- cratic behavior or bad luck of a single fund man- ager. Similarly, diversifying by investing in mutual funds with different objectives can provide some protection against drops in particular segments of the stock market.

International. Investing in several national or regional markets reduces market specific ef- fects. The growing importance of international stocks or mutual funds in personal investment portfolios demonstrates this type of diversifica- tion. The benefits from such strategies accrue from risk reduction due to differential systematic effects across markets. Certain costs are associ- ated with international diversification, however. Particularly in emerging markets, portfolio risk may be increased because of less well-established institutional arrangements, such as audited disclo- sure of financial results, as well as greater politi- cal risk exposure and exchange rate or inflation- ary exposures.

More Examples Of Corporate Diversification

Shareholders. Corporations increasingly try to diversify their shareholder mix across investors, particularly institutional investors, who have a variety of financial objectives. Managers recog- nize that having a large percentage of stock in portfolios with similar objectives makes their firm’s share price vulnerable to particular types of news. For example, if a company has been the darling of earnings momentum investors, a slow- ing of earnings growth will generate a great deal of selling, with its associated downward price pressure. Investor relations professionals invest in shareholder targeting efforts to identify and nur- ture shareholders who will diversify their owner- ship base.

Plant Equipment. In 1992, Toyota built a new plant in which the entire assembly process could be shifted to a different model of car in just a few hours. This option to assemble several lines of cars from a single plant cost an estimated $3 million over a traditional assembly line that would take days or weeks to change to another model. Designing equipment that allows for di- versifying across product lines reduces the risk of changes in demand or consumer tastes. In a time of accelerating technological change and the opening of international markets, diversification like Toyota’s that creates options or choices can be especially valuable.

International Sales. Just as investors look to international securities for diversification, manu- facturers are looking to international markets. By selling in a wider range of markets, research and development costs are spread over more con- sumers. A product that might be outmoded in one market may continue to be marketable in another, thereby extending its life cycle. More- over, because some macroeconomic effects are localized to markets-that is, disposable income doesn’t necessarily go down in all economies at the same time-selling across borders reduces sensitivity to some systemic forces.

Geopolitical. A seldom recognized form of diversification occurs across political boundaries. Why would a company locate facilities in differ- ent locales when it could design a single com- plex for all its activities? One reason for dispers- ing facilities is to broaden the company’s political representation. Having plants in several congres- sional or senatorial districts gives the company more voices in Washington. This type of diversifi- cation can be particularly important for compa- nies in politically sensitive industries, such as defense or aerospace.

Government agencies follow a similar strat- egy. By dispersing offices or bases across many political districts, the agencies increase their abil- ity to protect or increase funding. Threatening to close offices threatens the economies of many communities, so the broader support that emerges from political diversification helps pro- tect the agency. An individual community will- ingly supports helping other communities protect bases or offices, if in turn its base is also pro- tected. In a similar view, many firms and indus- tries find the means to contribute to the cam- paigns of candidates from both political parties, assuring themselves that someone is beholden to them regardless of who is elected.

Suppliers. Having a single supplier increases a company’s vulnerability to expropriation. Com- pared to competitive markets, monopolists pro- duce a smaller supply and charge higher prices. The possible expropriation by a monopolist sup- plier is clear, but new importance has been added to supplier diversification with the advent of Just-In-Time manufacturing processes.

JIT minimizes inventory both before and after the manufacturing process. By ordering materials as needed and producing on demand, working capital investments are minimized, freeing valu- able capital for other uses. However, this Japa- nese manufacturing technique is not without risk, as demonstrated by the 1995 earthquake in Kobe, Japan. When transportation and distribution lines were disrupted in Kobe, many plants following the JIT model were without key materials or products. The resulting stock-outs dominoed from supplier to producer to customer.

Diversification: A Broader Perspective

Ford Canada’s assembly plants use JIT deliv- ery of parts from suppliers via truck and rail. But the Canadian railroad strike in early 1995 forced Ford to run its three plants at half capacity be- cause of insufficient parts. A Canadian labor leader estimated that Ford lost about $90 million in sales because of the railroad strike.

Customers. Economic theory suggests that monopsony relationships create the same threats to sellers as a monopoly does to buyers. When one customer purchases a significant portion of a company’s product, the producer is vulnerable in several ways. The company suffers if the customer changes suppliers or shifts to different types of products. A major customer can demand-and get-price concessions, delivery concessions, product modifications, and so on. The company can ill afford to say no because the threat of the buyer finding another supplier always exists. The idiosyncratic risk of the major customer is trans- ferred, in part, to the supplier.

A number of examples can be cited. When the Campeau retailing chain experienced cash flow problems in autumn 1989, they were unable to pay their suppliers. Because these suppliers were often small garment manufacturers selling primarily to Campeau and a few other large chains, and because the goods were dated in terms of style, they had little recourse. Many of these companies suffered, and some even went bankrupt.

When American Express dropped Union Corporation as one of its debt collection agen- cies, Union’s stock lost 21 percent in one day. American Express had represented about 25 per- cent of Union’s annual $80 million revenue. In addition, Union said it would cost about $9 mil- lion to restructure its operations to the smaller activity levels anticipated as a result of the lost business.

Strategic Decision Making. In a recent Fortune article by Kenneth Labich (19941, one of the six items the author linked to failure was the inability of companies to )ok at themselves, their

markets, and their industries from dif- ferent perspectives. Diversifying how a business is defined can offer new solu- tions to problems and opportunities for growth. Broad- ranged or wildest- case scenario think- ing can help firms avert disaster. Such

thinking might have helped tobacco companies foresee the anti-smoking trends of the 1980s and 1990s. Mainframe computer manufacturers might

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have seen the rise of PCs. Many companies might have realized that their tried-and-true technology was obsolete and impeding profits.

Relying on traditional approaches to decision making, surrounding oneself with people who agree or share a vision, or choosing not to imag- ine what markets will look like in 10 to 20 years can prevent companies from being able to re- spond to shifts in customer tastes, technological advances, or competitors’ actions. In his book Y%e Art of the Long View, Peter Schwartz attributes Shell Oil Company’s ability to prepare for the oil shocks of the 1970s to listening to a diverse set of strategists, some of whom were able to think the unthinkable: an oil supply boycott.

Diversification Of People. The value of diversity in human resources should not be over- looked. A culturally diverse marketing depart- ment may have helped General Motors avoid its famous Chevy Nova mistake when it marketed the vehicle in Mexico without considering that “no va” means “no go” in Spanish. As customers and employees become more diverse, effective communication can be enhanced by having a diversity of individuals available as resources. To avoid “rubber stamping” and single-track think- ing, organizations may diversify recruitment across universities and adopt affirmative action plans to ensure a variety of backgrounds among employees. Universities themselves often have policies against hiring their own Ph.D.s as faculty in an effort to curb intellectual “inbreeding.”

Diversification Across Firms. Surprisingly, specialization can lead to valuable forms of diver- sity. Tailoring special products to particular mar- ket segments, for example, leads to greater prod- uct variety and more choices for consumers. To ensure the availability of a variety of skills and outlooks, it may be important for society to main- tain and foster “specialized” educational organiza- tions such as trade schools, technical universities, ag schools, liberal arts colleges, public and pri- vate schools, military academies, and research universities. In this case, society benefits from having a diversity of institutions, some of which are near “monolithic” in character, rather than having all organizations “equally diverse.”

To Diversity Or Not To Diversify?

There are many ways in which companies and investors can diversify, but when does it make sense? Here we consider the case of the corpora- tion. As in all corporate investments, diversifica- tion should be pursued if its benefits (in a present value sense) exceed its costs, and if the company can capture these benefits more cheaply than shareholders can do so individually. A hard look needs to be taken at the following questions before pursuing a diversification strategy.

Business Horizons / March-April 1997

goes diversification generate valuable benefits? As an example, diversification of prod- ucts using the same raw materials can enhance revenue via economies of scope. Consider the farmer who leases his land to bird hunters in the autumn and to cross-country skiers in the winter. Greater income is produced as he broadens the scope of his business from simply farming to “land management.”

Could shareholders diversify themselves? And if so, can they do it more cheaply than the corporation? Most individuals cannot pursue a strategy of political diversification (one-person, one-vote). So it may be very valuable for a com- pany to carry out this geopolitical diversification on behalf of individual shareholders. Contrast this with individuals’ portfolio diversification. Inves- tors can easily and inexpensively diversify their portfolios across borders by investing in interna- tional mutual funds. Therefore, it is unnecessary for all mutual funds to diversify internationally on behalf of their investors. It is better for investors to have a range of more narrowly defined funds from which to choose; then they may create the mix of funds from that universe that best fits their needs.

Does the extended span of control create costs that offset potential benefits? In the corporate world, with its increased competition, success requires increasingly skilled managers. Hence, corporate diversification, which was often predicated on uniformly applying general man- agement skills to all business lines, sometimes stretches the ability of managers to oversee a wide range of business lines successfully. More- over, the lack of constant monitoring could allow some segments to lag competitors or pursue un- profitable activities.

Does the situation require self-reliance? One way to think about diversification is in terms of self-reliance or self-sufficiency in interactions. If a situation requires self-sufficiency, then diver- sification is in order. For example, if the input purchase decisions of a project would reveal its essence, then vertical integration to produce in- puts is required.

Despite social security and other safety nets, individuals must be relatively self-sufficient. Indi- viduals diversify their portfolios because they need to generate and maintain their own finan- cial security. Failure to make good investment decisions-in other words, plunging into a single bad investment-harms an individual’s financial security and threatens his well-being. Therefore, individuals need to diversify.

To compete, most corporations must special- ize. Companies specialize when dependable sources of inputs exist, so they do not have to be self-reliant. It is unnecessary, say, for a bakery to own a farm on which to grow wheat. However,

McDonald’s opened its first restaurant in Russia only after several years of developing its own farms for beef and bakeries for bread. Without an assured source of inputs, McDonald’s had to diversify vertically to ensure an adequate supply of raw materials that could meet its quality speci- fications.

If the availability of inputs is uncertain, then it makes sense to diversify vertically. Few of us in the United States need to worry about the avail- ability of food; it is as near as the supermarket. What we must worry about, however, is having the money to buy that food. Because employment is uncertain, it makes sense to diversify our human capital, perhaps by acquiring many skills or general skills that are easily adaptable to a variety of jobs. Individuals often opt for a liberal arts degree rather than a profes- sional degree with the idea that learning how to learn and having a broad range of I

learning skills and knowledge are more valuable than acquiring one particular skill. With the rapid development of technology and the advent of freer trade, job displacement is becoming more commonplace, putting a premium on diversified human capital.

T he 1990s have been a period of great efficiency gains, thanks to IS0 9000, total quality management, and corporate re-

engineering and restructuring. However, focusing solely on efficiency gains based on current prod- ucts, current markets, and the current political environment may make a company profitable in the short term without preparing it for the inevi- table change global competition generates. The challenge for managers now is not just to pro- duce more efficiently, but to combine efficiency with adaptability

Increasing competition speeds change. Prod- uct life cycles have shrunk, customers switch brands more quickly, and new markets emerge, grow, and contract faster than ever before. In the face of this new competitive environment, com- panies must design and implement strategies that allow them to withstand change and quickly take advantage of opportunities. Without such skills, they will be left in the dust of more adaptable and responsive firms.

Applying the concept of diversification, in any of its many forms, can help companies pre- pare for this competition-bred uncertainty. And it can increase the acceptance of their products, securities, or political preferences as the world changes. 0

Diversification: A Broader Perspective 43

References

Phillip Berger and Eli Ofek, “Diversification’s Effect On Firm Value,” Journal Of Financial Economics, January 1995, pp. 39-65.

John Byrd, Waldennan Goulet, Marilyn Johnson, and Mark Johnson, “Finance Theory And The New Investor Relations,” Journal Clf Applied Corporate Finance,

Summer 1993. pp. 78-82.

John Byrd and Pamela Jameson, “In Practice: Targeting Tools,” Investor Relations, January-February 1994, pp. 59-63.

Robert Comment and Greg Jxrell, “Corporate Focus And Stock Returns,” Journal Of Financial Economics,

January 1995, pp. 67-87.

Kenneth Labich and Patty de Llasa, “‘Why Businesses Fail,” Fortune, November 14, 1994, pp. 52-58.

Larry Lang and Rene Stulz, “Tobin’s Q, Corporate Di- versification And Firm Performance.“Journal Of Politi-

cal Economy, December 1994, pp. 1248-1280.

Margaret Meyers, Paul Milgrom, and John Roberts, “Organizational Prospects, Influence Costs, And Own- ership Changes,“Journal Of Economics Aizd Manage-

ment Strategy, 1, 1 (1992): 9-23.

Peter Schwartz, me Art Of 7be Long Vieuj (New York: Doubleday. 1991).

John Byrd is an assistant professor of finance at the University of Colorado at Denver. Kent Hickman is an associate professor of finance at Gonzaga Univer- sity, Spokane, Washington. Hugh Hunter is a professor of finance at Eastern Wash- ington University, also in Spokane. The authors would like to thank John Beck, Paul Buller, and Dennis Organ for their helpful suggestions.

44 Business Horizons / March-April 1997