As tech titans such as Google and Amazon attempt to conquer new markets and conglomerates continue to dominate in emerging economies, we look at the ingredients that determine whether diversification succeeds – or fails.
The appeal of diversification has waxed and waned across Western economies
Throughout history, companies seeking growth have been allured by new geographical territories and sometimes even different industries. The old adage of ’diversify or die‘ has gained fresh resonance in the current age of disruption, with the fear of being marginalised from their area of expertise encouraging company boards to explore solutions in a different market.
Whatever the motivation, history tells us that radical change comes with significant risk. Indeed, ’diversify and die‘ could be just as apt a phrase given the high failure rate of many businesses that expand into new areas.
So is it possible for investors to gauge whether a company’s venture into the unknown will meet with success or failure? Larry Shulman of the Boston Consulting Group has been studying business diversification for 20 years and believes it is.
“Enterprises that undertake a project in a different industrial space, perhaps a new end market or geography, but understand the underlying economics and the type of business model required to prosper, have every prospect of success,” he says.
“However, companies that venture into sectors where the competitive forces differ fundamentally from their area of expertise have every chance of failing.”
Shulman cites Danaher Corporation of the US as an example of a successful, highly-diversified business. The company sells centrifuges, dental implants, fuel dispensers and water fillers to a wide variety of buyers. At first glance, these product lines appear unconnected.
However, Shulman argues there are many common factors that explain the company’s prosperity. “Prior to an aggressive move into life sciences, Danaher focused on industrial areas that require no advertising, and enjoy low sales and general administrative costs, but require considerable engineering expertise. I would argue life sciences is very similar.”
In other words, Danaher understands the competitive characteristics of the markets in which it invests. So while Danaher is a highly-diversified company, which enjoys a myriad of revenue streams from a wide variety of products and geographic areas, it can apply the same strategies and principles of operation across its interests.
By contrast, Virgin’s attempt to break into the cola market in the 1990s is a prime example of a company failing to do its homework on the competitive forces driving a market. Sir Richard Branson’s analysis of Virgin’s failure also underscores how success in one industry can breed complacency that leads to failure in another.
“We felt confident that we could smash our way past Coca-Cola and Pepsi, our main competitors. It turned out, however, that we hadn’t thought things through. Declaring a soft drink war on Coke was madness,” recalled Branson in 2014. The key mistake, he acknowledged, was to ignore the reasons Virgin had succeeded elsewhere.
“Virgin only enters an industry when we think we can offer consumers something strikingly different that will disrupt the market, but there wasn’t really an opportunity to do that in the soft drinks sector,” said Branson. “People were already getting a product that they liked, at a price they were happy to pay – Virgin Cola just wasn’t different enough (even if we did create bottles shaped like Pamela Anderson that kept tipping over because they were top-heavy!).“1
Back in fashion
The appeal of diversification has waxed and waned across Western economies. It reached its apogee in the ’conglomerate boom‘ of the 1960s, but fell out of favour from the late 1980s onwards. Diversification often resulted in the creation of corporate empires that lacked synergies and sapped management energy. However, a trend back to conglomerates may now be underway.
Diversification is almost certainly getting harder
Even during its fallow years, Warren Buffett showed what can be achieved through diversification. Buffett’s Berkshire Hathaway directly owns dozens of businesses and holds large stakes in many more. Indeed, Buffett boasts that Berkshire “is now a sprawling conglomerate, constantly trying to sprawl further”. The ‘Sage of Omaha’ argues that the conglomerate structure, when used judiciously, is an ideal structure for maximizing long-term capital growth.
“At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by a lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.”2
Giles Parkinson, portfolio manager for global equities at Aviva Investors, believes a conglomerate can work well if the capital is allocated soundly within the business. He argues the ability to take money out of one industry and reinvest it in a completely different industry successfully is dependent on the quality of the people at the top.
“Conglomerates that have worked well in America and stood the test of time have been run by geniuses such as Warren Buffett. Henry Singleton, who built Teledyne into one of America’s most successful conglomerates in the 1960s, also had a brilliant mind; he could play chess blindfolded at just below the Grand Master level,” Parkinson says.
Advance of the tech giants
Technology companies such as Google, Tesla and Amazon are also driving the trend back to diversification. Shulman believes that, as with other companies, investors should focus on the basics of whether the technology titans understand the underlying economics of the businesses they are investing in.
Google, however, may be a unique case. “It has so much money and such a very long-term perspective on learning, information and data that it’s difficult to fathom whether it is brilliant or not,” Shulman explains.
The case is more clear-cut for the likes of Tesla, which is seeking to diversify away from its reliance on electric vehicles into areas such as mega batteries and solar power. “The Tesla car is basically a combination of moving batteries, and its new business lines are focused upon electric battery technology and the application of electrical systems,” says Shulman. “The economics of making batteries is something that Tesla should understand. If it doesn’t, its car business will fail!”
Elon Musk’s SpaceX project shares similarities with the car business – a factor that should theoretically enhance its chance of success. Shulman argues the design principles used in building Tesla cars have been applied to the economics of building rockets.
Meanwhile, Shulman believes investors should view Amazon as an infrastructure company, which owns warehouses and fulfillment systems, server farms and server platforms, rather than as a retailer.
“Amazon Web Services, which provides cloud facilities; Amazon, the fulfillment company; and Amazon Prime, the streaming service, are all massive infrastructure plays, where a competitive edge is gained through scale and the leverage of that scale,” says Shulman. “Jeff Bezos understood that making Amazon Prime a free delivery service would cause short-term pain, but consumers would become accustomed to ordering all their goods ranging from books to groceries to clothes through the same portal, and that would provide a huge competitive advantage in the long term.”
Preparing for the journey
“Stick to what you know” is the advice Lord Sugar gives to budding entrepreneurs. He learned this the hard way after buying Tottenham Hotspur Football Club in 1991, quickly realising he had made a mistake in entering a business he knew absolutely nothing about.3
Intuitively it makes sense to focus on expanding earnings from a familiar, existing business; whether via cross-selling or new platforms. It can, after all, take years to build up the knowledge and expertise required to succeed in any field of endeavour. Venturing into an unknown business area, where competitors are ready to pounce on any slip, is always risky. It is almost certainly getting harder too as regulations become more complex, technology more disruptive and skills more specialised.
Companies that do venture into new markets appear to do best when they enter areas where the competitive nature of the market is so similar to their existing field of endeavour that an already profitable business model is easily transferable. That is true across the world. Allowing managers with long experience in a particular industry the autonomy to make key business decisions appears another vital and universal ingredient.
Meanwhile, proper analysis of the financial returns expected can also help determine whether diversification is worth pursuing, argues Trevor Green, UK equities fund manager at Aviva Investors. For example, hurdle rates, the minimum rate that a company can expect to earn when investing in a project, should be set materially higher for moves into fresh fields given the inherent risks involved.
Management should be able to clearly justify that diversification makes more sense than investing further in an existing business or returning money to shareholders. “If a company’s leadership does give the green light to an acquisitive diversification, getting value for money is clearly the critical factor,” argues Green.
With legacies on the line, management need to be sure it is a price worth paying.
Asian Conglomerates: kepping up with the times
Asia’s corporate giants are adapting to external pressures to maintain their dominance.
The conglomerate has long been a popular business model in the emerging world, stretching back to the trading houses of the British Empire, some of which – like Jardines – have endured to the present day. Since its foundation in Canton in 1832, Jardines has grown to employ around 444,000 people with interests that include real estate, auto sales and engineering across a number of Asian countries.4
Professor Christian Stadler of Warwick Business School believes there are a number of reasons that explain the appeal of conglomerates in the developing world. “Access to finance can be a major hurdle facing a small start-up with a smart idea, whereas a large company can draw on its own resources or existing contacts with banks,” Stadler says.
The institutional environment is another factor. “In the West, problems between a company and its suppliers can be resolved via the legal process. That can prove very challenging in the emerging world, so a company might decide it is better to integrate backwards in order to avoid dealing with suppliers entirely,” adds Stadler.
Buying from a conglomerate also makes sense from the customer’s perspective. “Consumers in emerging markets do not enjoy the same protection as their western counterparts: if you trust a brand in one sector, you might be inclined to trust it in another,” Stadler adds.
Can the Asian model be copied?
While these factors may explain the origins of diverse business groups in emerging economies, K.S. Manikandan, associate professor at the Indian Institute of Management in Tiruchirappalli, Tamil Nadu, believes conglomerates have thrived due their organisational structure.
In India and other emerging economies, explains Manikandan, businesses are often diversified at the group level but individual units are separate, with their own board of directors who focus on their particular area of expertise.
Consequently, shareholders can pick and choose the parts of a conglomerate they want to invest in as individual units are listed separately. Manikandan uses the analogy of the tracking stocks that some US and UK firms offer when they operate multiple subsidiaries, whose value reflects the performance of a specific subsidiary rather than the group overall. This helps counter the main argument against diversification, namely that the lack of focus destroys shareholder value, asserts Manikandan.
In China, where conglomerates are less common, diversification also seems to work best when companies adopt a loose federated structure. Xiaoyu Liu, Asia equities portfolio manager at Aviva Investors, cites the example of Fosun International, which was founded in 1992 by five graduates and is managed like a private-equity firm.
“Fosun is run by Guo Guangchang, the chairman and one of the founders, and 30 global partners who tend to head individual assets such as the Club Med business,” says Liu. “Below them are 450 investors who pitch deals that are assessed by an investment committee. One partner from the target industry and another from an unrelated sector sit on the committee.”
Liu believes Fosun is successful because managers have autonomy to run individual units. “They invest in a relatively successful company and seek to improve it,” she explains. Club Med is a good example of this strategy. The company, founded in Europe in 1950, specialises in all-inclusive holidays. Club Med’s fortunes were in decline when Fosun acquired it in 2015, but profitability is now increasing as it focuses on China’ fast-growing middle class, who are increasingly keen to holiday abroad.
Corporate governance: not an optional extra
Historically, the fortunes of Asian conglomerates have been tied to a dominant individual or family, who may not always have the interests of minority shareholders at heart. This has frequently led to shareholder conflict in countries like India and South Korea, although Manikandan believes this is finally changing.
He cites the example of the Mahindra Group in India, whose interests range from autos to financial services, and which is now largely run by professional managers unconnected to the family that owns the business.
Recent events at Tata Group, which has over 100 operating companies and operations in a similar number of countries, further highlights this shift. The ousting of Cyrus Mistry as chairman in October 2016 eventually led to the appointment of a professional manager to head the business, with no family connections to the group.5
Corporate governance is also of increasing importance in South Korea, a country dominated by chaebols – industrial conglomerates that include world-famous names such as Samsung, Hyundai and LG.
Many South Koreans believe the immense wealth of the chaebols was accumulated at their expense and the authorities are coming under pressure to curb their power. Some are so large they are arguably too big to fail, while they may also smother competition. The affiliated companies that make up Samsung, for example, account for around 20 per cent of the entire market value of the Korean Stock Exchange, and around 15 per cent of South Korea's entire economy.6
“The government is trying to reform the chaebols and make the shareholding structure much more transparent,” says Ed Wiltshire, portfolio manager for emerging market and Asia Pacific equities at Aviva Investors.
Wiltshire believes the main problem with the chaebols is they are “organised to benefit the families that usually dominate them”. They are generally composed of affiliated companies and the links are labyrinthine, mainly to ensure that the family has as much control as possible.
“As a foreign investor, you're always at a slight disadvantage, because even though these are very good, strong companies, they're not run entirely for the benefit of the average individual investor,” Wiltshire argues. “However, the ownership structure is likely to be simplified and the owning family won't have as much control as in the past. This is encouraging for investors.”
1 ’What to do when things go wrong’, Virgin, December 2014
2 Berkshire Hathaway letter, February 2014
3 The Unauthorised Guide to Doing Business the Alan Sugar Way, 2010
4 ‘Jardines profile’, Jardines, May 2018
5 ‘Tata Mistry saga nearing its end’, Bloomberg, January 2018
6 How Samsung dominates South Korea's economy’, CNN, February 2017