6 minute read
Diversification has fallen out of favour in UK boardrooms over recent decades. The recent trend towards making existing assets work even harder could be a better approach, says Trevor Green.
As the old adage goes, fortune favours the brave. But does it in reality? Throughout history, companies seeking growth have been allured by new geographical territories and sometimes even new industries. In the current age of disruption, it is also easy to see why the fear of being marginalised from their area of expertise could lead company boards to explore solutions in a different market. Whatever the motivation, history also tells us that radical change comes with significant risk. A great track record in one area is no guarantee of success in another: sometimes, there is more to be gained by sticking to what you know but doing it better.
UK billionaire Sir James Dyson’s plan to produce a cutting-edge electric vehicle, announced in September 2017, is a good example of a successful business leader looking at a radical way to grow. But vacuum cleaners, where Dyson made his fortune, and electric vehicles are worlds apart: while time will tell whether Dyson has been able to bridge both worlds, there is scepticism about his chances.
The move has sparked comparisons with a disastrous move into transport by a British businessman of a slightly earlier vintage, Sir Clive Sinclair. Sinclair, who pioneered personal computers in the UK, promised his electric tricycle, the Sinclair C51, would revolutionise transport.
Sadly, when unveiled in 1985, the vehicle was greeted with derision, being described on ITN’s 'News at Ten' as a “plastic hip-bath on wheels” and a “menace to all road users”2. Only 5,0003 were sold against projected sales of 200,0004, and Sinclair Vehicles soon went into receivership.
You don’t have to look far for similar cases of diversification gone wrong. Sir Richard Branson’s analysis of Virgin’s failure to break into the cola market in the 1990s 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!)5."
Success can prove elusive even when companies do thorough research on new markets, as Tesco discovered when it attempted to conquer the US. The UK supermarket giant has an excellent record of expanding into new markets in Eastern Europe and Asia, yet was forced to admit defeat on the other side of the Atlantic when it sold its 150-store Fresh & Easy chain in 2013.
Tesco spent nearly £1 billion on its loss-making US venture and “lavished time and resources understanding how Americans live, shop and eat”, according to a CBS analysis of the company’s American experiment. Tesco may just have been unlucky. Fresh & Easy’s focus on ready meals proved unfortunate given the 2007 launch coincided with the start of the sub-prime mortgage crisis and the 'Great Recession'. Many Americans had time to prepare food but little money to spend on relatively-pricey ready meals6&7.
To boldly go…
While many UK companies continue to try and replicate their domestic success in overseas markets, the appetite for diversifying into completely new industries has waned over the past few decades. Enthusiasm for conglomerates raged across industry in the 1960s and 1970s. Hanson Trust was the leading example in the UK. A small family haulage business at the beginning of the 1960s, it grew to become the UK's fourth largest manufacturer by the early 1990s; “making batteries, typewriters, bricks, HP sauce and Jacuzzi whirlpool baths after a riot of acquisitions in both the UK and the United States”8.
However, diversification often resulted in the creation of corporate empires that lacked synergies and were a stretch on management’s time and energy. Unsurprisingly, the strategy fell out of favour in the 1980s. The legendary investor Peter Lynch, for example, coined the term “diworsification” to describe the practice of managers who spend their leftover cash on an acquisition and end up paying too much or simply make a bad deal9.
The fate of GEC, once one of Britain’s most successful industrial companies, exemplifies Lynch’s argument. From the 1960s onwards, Sir Arnold Weinstock built GEC into a diversified, cash-rich empire and leader in defence electronics and power generation. Weinstock retired in 1996 and within a decade GEC had vanished. His successors embarked on a series of disastrous acquisitions, many made at the height of the dotcom bubble and ironically designed to turn GEC into "a hi-tech company focused on new sectors with high growth prospects and high value"10.
Yet venturing into uncharted territory is not always a disaster. London Stock Exchange is arguably the poster child for diversification. Under the leadership of its former chief executive, Xavier Rolet, the business moved away from UK equities into clearing and indices, partly through some astute acquisitions11. Under Rolet’s nine-year tenure that ended in late 2017, the share price rose from £5 to £38.7012.
John Menzies, which has displayed a chameleon-like ability to adapt to changing conditions over many years, is another success story. The company sold its eponymous high street newsagent chain in the late 1990s to focus on distribution. When this sector began to decline, reflecting falling demand for print media, it successfully diversified into aviation services13. Between 20 March 2009 and 20 February 2018, Menzies share price rose from 27 pence to £6.5414.
Menzies’ management had the vision to recognize the business would struggle and even fail if it didn’t explore other sectors. Could it be that management facing terminal decline is more focused when exploring fresh opportunities than the leaders of successful companies?
Companies generally now concentrate on their core businesses. However, a new management theory has encouraged them to widen their ambitions while eschewing all-out diversification. 'The Edge Strategy', advocated by management consultants L.E.K Consulting, calls on businesses to exploit the “opportunities that lie at the edge of your current market offering, opportunities to capture incremental profits with the customers you have already won and assets you have already developed”15.
ZPG, formerly Zoopla Property Group, encapsulates the successful implementation of 'The Edge Strategy'. Alex Chesterman, founder and chairman of ZPG, has monetized the huge numbers of people visiting its websites (68 million visits in January 2018 alone16) through its 2015 acquisition of uSwitch, a leading comparison website and lead generation engine for energy and communications17.
When people move house, they often decide to switch mortgage and take a fresh look at their utility bills. They can find their new home on the Zoopla property search portal and use uSwitch to identify the best mortgage and utility deals. ZPG benefits from both the growth in online switching activity and its property listing and price comparison businesses to cross-sell products.
ITV is another company seeking to exploit its existing assets, although the jury remains out on whether its strategy will be successful. In the face of increasing competition from digital streaming businesses such as Netflix and Amazon, ITV’s management is building its online content via the ITV Hub, an online service that can be accessed on mobile phones, PC and connected TVs. The Hub is available on over 27 platforms including ITV’s website (itv.com) and pay providers such as Virgin and Sky, or through direct content deals with services such as Amazon, Apple iTunes and Netflix18.
ITV is also investing heavily in new content via its Studios division with the aim of reducing its dependency on income from advertising. This approach appears to be paying off with revenue at ITV Studios rising by seven per cent to £697 million in the six months to 30 June 2017, helping offset an eight per cent fall in advertising revenue to £769 million19.
Hero to hubris?
“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 about20.
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 so 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.
Nevertheless, there are examples of companies that have successfully diversified. Judgement, teamwork, focus, research, timing and luck are among the many factors that play a role in dividing fortune from failure. The problem lies in predicting when those variables will meld together and form a golden elixir.
Proper analysis of the financial returns expected from any diversification can help determine whether such a move is worth pursuing. 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 also ask whether 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. With legacies on the line, management need to be sure it is a price worth paying.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 21 February 2018. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.