On Diversification by Firms
Every day, newspapers announce plans by firms to enter new areas. These projects are used as selling points when raising resources from the primary market. Diversification is becoming popular among firms. The question arises whether this diversification is indeed important from the viewpoint of the investor or not.
Ultimately, the responsibility of managers is to maximise the wealth of the owners or the shareholders. If diversification efforts are consistent with the objective of owners, then it is a good idea. My key contention is that diversification by firms in India often cater to the interests of managers running the companies rather than the interests of shareholders.
I will start by describing what diversification can surely accomplish, given reasonable management skills in implementation: it will reduce the volatility of sales and profits growth. This is particularly true for profits, where annual growth rates fluctuate between -75% and +100%. Diversification can be very effective for this purpose.
When the firm diversifies, the growth of sales becomes less vulnerable to industry-specific events which reduces the risk faced by managers whose performance is tracked by behaviour of firm profits. Therefore reducing volatility is attractive to the top management. This is most sharply observed when the CEO is given a bonus as percent of profits: with diversification, the volatility of profits diminishes and the year-to-year income of the manager becomes more stable.
Another effect of diversification is through the size of firms. Firms diversifying through acquiring other firms increase in size. Many of the hidden payoffs to top management (like perks and prestige) are a function of the sheer size of the company.
But is diversification by the company in the interests of its shareholders? Not necessarily as shown in the following two steps:
- For a shareholder's investment risk, there is no difference between diversification in a portfolio of shares and diversification by the firm. For every share of a steel company which is diversifying into telecommunications, there is an equivalent portfolio of shares in a purely-steel company and shares in a purely-telecommunications company.
Thus diversification through a portfolio is a perfectly feasible way to replicate the lower volatility in a diversified firm. This alternative is readily available to the owners directly -- hence managers do not add value by doing firm-diversification if the only gain is a reduction in the riskiness of profits and sales.
- While firm-diversification does not add value, it can easily subtract value. This is because the process of setting up a greenfield project, or putting together a merger, is more expensive than buying and selling a few shares -- it demands a great deal of management attention to execute the entire process of entering a new industry. Buying out an existing company in the target industry is easier than doing a greenfield project, but assimilating the taken-over company is still an onerous and time--consuming task where failures are not uncommon.
If the owners of a steel company want to reduce their exposure to steel-risk by going into telecom, financial markets are a cheaper alternative, where they can accomplish this at very low cost in terms of transitional difficulties -- around 3% for each trade after fully accounting for various execution costs.
If a portfolio of steel plus telecommunications has some particularly attractive risk/return properties, then mutual funds and professional money managers can exploit these properties on behalf of the lay investor. The services of top management of the steel company are not required in obtaining gains from such diversification.
The logical conclusion to this idea is the following: an index fund obtains extremely good diversification, and is very appealing to investors, but it does not mean that a merger of all the NSE-50 stocks to create one India Inc. is good.
In contrast, from the viewpoint of the manager of a firm, the volatility of profits which they control is their ``portfolio risk'', which they have strong incentives to reduce in ways that are inimical to the interests of the owners.
Thus I'm critical of diversification by firms as a way of reducing firm-risk. Every time I read of a successful television manufacturer diversifing into steel, I wonder how much the owners pay for the time and effort it is going to take the managers to learn to excel in the steel industry. In return they will get a reduction in risk which is a telephone call away through financial markets.
The firm must concentrate on creativity in the arena of the product market -- it should concentrate on core competences, to build outstanding human skills in chosen small areas, and to create value by becoming exceptionally good in one area.
This is not to suggest that all diversification by firms is futile. The question which the firm must ask itself when going into new areas is: as compared with distinct companies specialising in different lines of business, is the value of the whole much greater than the sum of the parts, even after the costs of entering a new industry are paid? If they can accomplish this, then the managers would have added value for the owners in a way which the owners could not have accomplished via financial markets by themselves.
Such a ``test'' is already routine when evaluating mergers: a merger is considered value-enhancing if it is felt that the market capitalisation of the merged firm would be larger than the sum of the parts. A variant of this test should be applied to every prospective diversification:
- Suppose East India Hotels contemplates diversifying into electricity distribution.
- We should first contemplate a merger between East India Hotels and a company like AEC or CESC or BSES. Would value be created in such a merger -- would the market capitalisation of the merged company exceed the individual market capitalisations?
- Only if this answer is Yes, then the proposed diversification is sound. Then we face an implementation question of whether such diversification is better implemented by a merger or by setting up a greenfield project, etc.
In the last few decades in India, two major motivations appear to have driven firms into sub-optimal diversification. One is the problem of conflict of interest between the management and the shareholders. The other was the regime of industrial licencing, where firms were often constrained to expand in areas where licences were available.
Many of these activities are currently being reversed in the new activities of mergers, acquisitions, takeovers, sale of divisions and sale of plants. One important thread that underlies these investment activities is to focus on improving productivity of companies. This viewpoint is consistent with the modern accent on ``core competence'' in management practice. Firms add value for their owners by constructing a coherent business plan, and then executing that plan by enhancing the required core competences.
In summary, diversification is intuitively most appealing -- you never put all your eggs in one basket -- but this intuition applies correctly to the thinking of investors forming portfolios, not for the management running companies.
Back up to Ajay Shah's media page (1997)