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During the past 25 years an increasing proportion of U.S. companies have seen wisdom in pursuing a strategy of diversification. Between 1950 and 1970, for example, single-business companies comprising the Fortune “500” declined from 30% to 8% of the total. Acquisition has become a standard approach to diversification.
In recent years the productivity of capital of many multibusiness companies has lagged behind the economy. Nevertheless, diversification through acquisition remains popular; between 1970 and 1975, acquired assets of large manufacturing and mining companies averaged slightly more than 11 % of total new investment in those companies, and most of that activity was diversifying acquisition.1 In the past few years the pace of activity has been slower than in the hectic 1967–1969 period, but the combination of high corporate liquidity, depressed stock prices, and slow economic growth has meant that for many companies acquisitions are among the most attractive investment alternatives. Since mid-1977, hardly a week has gone by without at least one major acquisition being announced by a diversifying corporation.
In light of this continuing interest and the apparent economic risks in following such a strategy, we present a review of the theory of corporate diversification. We begin by discussing seven common misconceptions about diversification through acquisition. We then turn to the basic question facing companies wanting to adopt the strategy: How can a company create value for its shareholders through diversification?
Our consideration of value creation leads to an examination of the potential benefits of the alternatives available—related-business diversification and unrelated-business diversification. Businesses are related if they (a) serve similar markets and use similar distribution systems, (b) employ similar production technologies, or (c) exploit similar science-based research.2
There are seven common misconceptions about diversification through acquisition that we can usefully highlight in the context of recent history. They relate to the economic rationale of this strategy and to the management of a successful diversification program.
1. Acquisitive diversifiers generate larger returns (through increased earnings and capital appreciation) for their shareholders than nondiversifiers do. This notion gained a certain currency during the 1960s, in part because of the enormous emphasis that securities analysts and corporate executives placed on growth in earnings per share (EPS). Acquisitive diversifiers that did not collapse at once from ingesting too many businesses often sustained high levels of EPS growth.
However, once it became apparent that a large proportion of this growth was an accounting mirage and that capital productivity was a better indicator of management’s performance and a business’s economic strength, the market value of many acquisitive companies plunged.
Many widely diversified companies have had low capital productivity in recent years. Exhibit I shows the performance of a sample originally selected by the Federal Trade Commission in 1969 as representative of companies pursuing strategies of diversification and not classifiable in standard industrial categories. While the average return on equity of the sample was 20% higher than the average of the Fortune “500” in 1967, it was 18% below the Fortune average in 1975. Even the surge in profits in 1976 and 1977 and the impact of nonoperating, accounting profits in several corporations failed to bring the sample average up to the Fortune average. What is even more telling than the return on equity figures is that the sample’s return on assets was 20% or more below the Fortune “500” average throughout the ten-year period.
Exhibit I Performance Data of 36 Diversified Manufacturers (1967, 1973, 1975, 1977)
So it is not surprising that acquisitive diversifiers have had low price-earnings ratios. On December 31, 1977, the average P/E of the sample, which includes many busy diversifiers, was 30% below that of the New York Stock Exchange stocks as a whole. This discount has changed little over several years. Even high return-on-equity performers like Northwest Industries, Teledyne, and Textron have P/Es well below the market’s average.
Such low market values imply great uncertainty about the size and variability of future cash flows. And when they are uncertain about a company’s cash flow, investors and stock analysts view them as less valuable than reliable and predictable earnings streams, so they are inclined to discount the company’s future earnings heavily. The high discount rates of acquisitive diversifiers produce growth with less capital appreciation than that of nondiversifiers, whose earnings streams appear to be more predictable. What will create value is growing cash flows with little uncertainty about their size or variability.
2. Unrelated diversification offers shareholders a superior means of reducing their investment risk. Unrelated diversification may be attractive from an investor’s point of view—its use is frequently offered to justify or defend conglomerate mergers—but it is not a superior means of reducing investment risk. (By investment risk we mean the variability of returns over time, returns being defined as capital appreciation plus dividends paid to investors.)
According to contemporary financial theory, a security’s risk and return can be decomposed into two elements: (1) what is specific to each company and called “unsystematic” because it can be diversified away and (2) what is “systematic” because it is common to all securities (the securities market) and hence nondiversifiable.3 Since the unsystematic risk of any security can be eliminated through simple portfolio diversification, the investor does not need widely diversified companies like Litton Industries and Gulf & Western Industries to eliminate the risk for him.
Contemporary financial economists believe that prices of securities reflect the consensus of many knowledgeable buyers and sellers concerning a company’s prospects. This consensus leads to an efficient capital market, where the investor finds it extremely difficult to consistently make risk-adjusted profits in excess of those the market realizes as a whole. While it does not claim that the price of every security always accurately reflects its underlying (systematic) risk, the theory does suggest that when one views all securities over time, the “overvaluations” and “undervaluations” by the market balance out.4
Several researchers have extended this efficient capital market concept to the analysis of conglomerate mergers. Their studies suggest that unrelated corporate diversification has little to offer investors with respect to risk reduction over a diversified portfolio of comparable securities.
They also suggest that if diversified companies cannot increase returns or reduce risks more than comparable portfolios do, these companies can at best offer the investor only value comparable to that of a mutual fund. Indeed, widely diversified companies with systematic risks and returns equivalent to those of a mutual fund may actually be less attractive investment vehicles because of their higher management costs and their inability to move into or out of assets as quickly and as cheaply as mutual funds do.5 For a specific case involving systematic risk, see the ruled insert above comparing Gulf & Western Industries with a portfolio having like assets.
Analysis of Systematic Risk
Since portfolio theory tells us that reducing systematic risk is impossible through portfolio diversification, let us analyze a portfolio of assets against a diversified company’s assets similar in size and allocation. This risk analysis requires three kinds of information: (1) the investment composition, by industry, of the diversified company; (2) the size of the investment the company has made in each industry; and (3) the systematic risk of each of those industries.
Summing the industries’ systematic risks, weighted by their relative size in the portfolio, results in a measure of the portfolio’s systematic risk. The last step before comparing the portfolio’s systematic risk with the diversified company’s systematic risk is to adjust for differences in financial risk. Once he has done this, the analyst can determine, within statistical limits, whether the diversifying corporation has reduced its systematic risk.
The results of a risk analysis of Gulf & Western Industries, a high return-on-equity performer for over a decade, are presented in Table A. An analysis of a comparable portfolio for G&W is given in Table B. Both tables reflect a five-year period ending in July 1975. The businesses of G&W’s eight divisions overlap very little. Grouping these divisions with Gulf & Western’s investment portfolio produces a well-diversified comparable portfolio.
Table A Portfolio Comparison
Table B Systematic Risk Analysis of a Portfolio Similar to That of Gulf & Western Industries (Dollars in Millions)
As Table A indicates, Gulf & Western’s systematic risk, adjusted for financial leverage, differs insignificantly from that of a comparable portfolio. All three systematic risk measurements are within one standard deviation of each other. Whatever benefits Gulf & Western provides its shareholders, reduction of investment risk apparently is not one of them.*
*A more thorough presentation of this method of making a comparative risk analysis is available from the authors at Harvard Business School, Soldiers Field, Boston, Massachusetts 02163.
3. Adding countercyclical businesses to a company’s portfolio leads to a stabilized earnings stream and a heightened valuation by the marketplace. This misconception is an extension of the previous one. For decades, proponents of unrelated or conglomerate diversification have argued that when a company diversifies into an industry with a business cycle or a set of economic risks different from its own, it enhances the “safety” of its income stream. In essence, this sense of safety is a very simple form of the “risk pooling” concept underlying insurance.
In light of the poor performance of many diversified companies, it should be obvious that safety is difficult to attain. Because of the complex interactions of the U.S. and other nations’ economies, finding genuinely countercyclical businesses is very hard. At the most, there are industry cycles that either lead or lag behind the general economy (e.g., housing and capital goods, respectively) or that are less cyclical than the general economy (e.g., consumer goods and tobacco products).
Even if diversifying companies can identify the countercyclical businesses, diversifiers find it difficult to construct balanced portfolios of businesses whose variable returns balance one another. Moreover, inasmuch as businesses grow at various rates, widely diversified companies face the continual challenge of rebalancing their business portfolios through very selective acquisitions.
Quite apart from this argument, the low stock market values of widely diversified companies during the past eight years indicate that the market-place has heavily discounted the future cash returns to investors in companies consisting of purportedly countercyclical businesses. While there are undoubtedly many reasons for this situation, it suggests that the market may be more interested in growth and the productivity of invested capital than in earnings stability per se. In addition, investors have little incentive to bid up the prices of diversified companies since an investor can obtain the benefits of stabilizing an income stream through simple portfolio diversification.
4. Related diversification is always safer than unrelated diversification. This misconception rests on the notion of corporate executives that they reduce their operating risks when they stick to buying businesses they think they understand. They want to limit their diversification to businesses with similar marketing and distribution characteristics, similar production technologies, or similar science-based R&D efforts.
While this presumption often has merit, making related acquisitions does not guarantee results superior to those stemming from unrelated diversification. For example, Xerox’s entry into data processing via its acquisition of Scientific Data Systems, which Xerox justified on the ground of technological, marketing, and manufacturing compatibility, led to a great drain on earnings for years. The management of Singer decided to take advantage of the company’s competence in electromechanical manufacturing as the basis for its diversification program. The result was dramatic failure, leading to a $500 million write-off of assets.
A close reading of the Xerox and Singer cases suggests that successful related diversification depends on both the quality of the acquired business and the organizational integration required to achieve the possible benefits of companies exchanging their skills and resources. Such exchange has been called synergy.
Even more important, the perceived relatedness must be real, and the merger must give the partners a competitive advantage. Unless these conditions are met, related diversification cannot be justified as superior or even comparable to unrelated diversification as a means of reducing operating risks or increasing earnings.
5. A strong management team at the acquired company ensures realization of the potential benefits of diversification. Many companies try to limit their pool of acquisition candidates to well-managed companies. This policy is rarely the necessary condition for gaining the potential benefits of diversification.
As we shall stress later in this article, the potential benefits of related diversification stem from augmenting the effective use of the surviving company’s core skills and resources. Usually such improvement requires an exchange of core skills and resources among the partners. The benefits of unrelated diversification are rooted in two conditions: (1) increased efficiency in cash management and in allocation of investment capital and (2) the capability to call on profitable, low-growth businesses to provide the cash flow for high-growth businesses that require significant infusions of cash.
Whether pursuing related or unrelated diversification, it is often the acquiring company’s management skills and resources—not those of the acquired company—that are critical to achieving the potential benefits of diversification. Indeed, if the acquired company is well managed and priced accordingly by the capital market, the acquirer must exploit the potential synergies with the acquiree to make the transaction economically justifiable.
6. The diversified company is uniquely qualified to improve the performance of acquired businesses. During the height of the merger and acquisition activity of the 1960s, executives of conglomerates often argued that they could improve the profitability of acquired companies by “modernizing” administrative practices and exerting more operating discipline than that demanded by the marketplace.
Consider the testimony of Harold S. Geneen, then chairman and president of International Telephone & Telegraph Corporation, at a government hearing concerning how ITT provided “constructive bases for merger.”
“We can afford to price fairly,” Geneen said, “and to exchange our own equity stocks with the shareholders of an incoming company. We can improve operating efficiencies and profits sufficiently to make this valuation worthwhile to both sets of shareholders.” In a document outlining ITT’s acquisition philosophy and submitted to the hearing, Geneen wrote that from 1960 to 1965 the company had “developed the ability through management skills, routines, and techniques to set and progressively meet higher competitive standards and achieve them in practically every line and product that we have undertaken.”6
The claims that Geneen and many other successful diversifiers have invoked are not benefits of diversification per se but simply the benefits of that nebulous factor, “good management.” Single-business companies pursuing vertical integration or horizontal expansion through acquisition can achieve identical results. To gain the benefits Geneen claimed, a company needs only to allow managers with the requisite skills to implement their desired improvements in the organization.
Rarely, it may be argued, does an organization willingly take steps that could alter its traditional administrative and managerial practices. Under these circumstances, change will occur only when forced from the outside, and diversifying companies often represent such a force. Nevertheless, the benefits achieved are not, strictly speaking, benefits of diversification.
7. Great deals are made by professional “deal makers.” The most potentially dangerous misconception on our list is the one that credits the imaginative work of investment bankers and other brokers with the success of a diversifying acquisition. The investment banker’s role is to provide attractive ideas, but it is the company’s role to select the ideas that have the greatest strategic and economic value.
This role involves developing diversification objectives and acquisition guidelines that fit a carefully prepared concept of the corporation. It also involves the company’s ability to recognize and exploit the potential for creating value through diversifying acquisitions. Every experienced corporate diversifier has learned, often painfully, that he must live with an acquisition long after it has ceased being a “great deal.”
Ways to Create Value
A company following a diversification strategy can create value for its shareholders only when the combination of the skills and resources of the two businesses satisfies at least one of the following conditions:
- An income stream greater than what could be realized from a portfolio investment in the two companies.
- A reduction in the variability of the income stream greater than what could be realized from a portfolio investment in the two businesses—that is, reduced systematic risk.
Included in both conditions is explicit comparison of corporate diversification on the shareholder’s behalf with independent portfolio diversification on the investor’s part. This comparison deserves comment.
Most benefits derived from reducing unsystematic corporate risk through diversification are, of course, equally available to the individual investor. Diversified companies can achieve trade-offs between total risk and return that are superior to the trade-offs available to single-business companies. Diversified companies cannot create value for their stockholders merely by diversifying away unsystematic risk.
Inasmuch as investors can diversify away unsystematic risk themselves, in efficient capital markets unsystematic risk is irrelevant in the equity valuation process. A diversifying company can create value for its shareholders only when its risk-return trade-offs include benefits unavailable through simple portfolio diversification.
There are seven principal ways in which acquisition-minded companies can obtain returns greater than those obtainable from simple portfolio diversification. The first four are particularly relevant to related diversification, while the last three are more relevant to unrelated diversification.
1. A diversifying acquisition can raise the productivity of capital when the particular skills and one merger partner’s knowledge of the industry are applied to the competitive problems and opportunities facing the other partner. When the reinforcement of skills and resources critical to the success of a business within the combined company leads to higher profitability, value is created for its shareholders. This reinforcement is the realization of synergy.
The acquisition by Heublein, Inc. of United Vintners in 1968 is a good case in point. Heublein’s strategy during the 1960s was to obtain high margins in marketing liquor and specialty food products through intensive, innovative advertising. At the time, Heublein stood out in this respect because the industry was production-and distribution-oriented. The company’s liquor products division accounted for more than 80% of 1965 sales. Its principal product was the premium-priced Smirnoff vodka, the fourth largest and fastest growing liquor brand in the United States.
The 1968 acquisition of United Vintners, the marketing arm of a large grape growers’ cooperative that owned two of California’s best-known wine brands, gave Heublein the opportunity to raise its investment in an industry where it had some experience (it was the U.S. distributor for Lancers wine) and to extend the application of its proven skills in promoting specialty products. By identifying and then exploiting an emerging consumer preference for lighter-bodied, often slightly flavored products, Heublein helped United Vintners launch two new products—Cold Duck (a champagne-sparkling burgundy combination) and Bali Hai (a fruit-flavored wine).
By the end of 1969, one year after its acquisition of United Vintners, Heublein had increased sales by over 2.5 million cases and augmented the subsidiary’s profitability. Heublein’s marketing strategy was so successful that during the 1960s and early 1970s its return on equity averaged over 30% and the marketplace valued Heublein at over 35 times its earnings. Heublein discovered in its diversification efforts, however, that its strategy of aggressive advertising was not the key success factor in either brewing (Hamm’s beer) or fast foods (Kentucky Fried Chicken), and its market valuation suffered accordingly. By 1977, Heublein had seen its P/E fall to 10 and its stock price to one-third of its previous high.
2. Investments in markets closely related to current fields of operation can reduce long-run average costs. A reduction in average costs can accrue from scale effects, rationalization of production and other managerial efforts, and technological innovation. For example, a marketing department’s budget as a percent of sales will decline if existing resources can be used to market new or related products.
Similarly, a large company like Procter & Gamble can expect its per-unit distribution costs to decline when it augments the use of its existing distribution system to move products to the marketplace. This notion has been the basis of many acquisitions made by consumer products companies.
3. Business expansion in an area of competence can lead to the generation of a “critical mass” of resources necessary to outperform the competition. In many industries, companies have to achieve a certain size, or critical mass, before they can compete effectively with their competitors.
For example, the principal way many small laboratory instrumentation companies hope to offer sustained competition against such entrenched companies as Hewlett-Packard, Tektronix, Beckman Instruments, and Technicon is to attain a size giving them sufficient cash flow to underwrite competitive research and development programs. One way to reach this size is to make closely related diversifying acquisitions.
4. Diversification into related product markets can enable a company to reduce systematic risks. Many of the possibilities for reducing risk through diversification are implicit in the previous three ways to increase returns because risk and return are closely related measurements. However, diversifying by acquiring a company in a related product market can enable a company to reduce its technological, production, or marketing risks. If these reduced business risks can be translated into a less variable income stream for the company, value is created.
Although there is no evidence that General Motors’ strategy was developed with this notion in mind, an important result of GM’s diversification within the motor vehicle industry has been its ability to easily absorb changes in demand for any one automotive product. GM’s extensive related-product line reduces the company’s marketing risk and enables GM’s managers to concentrate on production efficiencies. As a result, GM’s income stream tends to be less volatile than those of its competitors and of portfolios of discrete investments in unassociated, though automotive-related, companies.
5. The diversified company can route cash from units operating with a surplus to units operating with a deficit and can thereby reduce the need of individual businesses to purchase working capital funds from outside sources. Through centralizing cash balances, corporate headquarters can act as the banker for its operating subsidiaries and can thus balance the cyclical working capital requirements of its divisions as the economy progresses through a business cycle or as its divisions experience seasonal fluctuations. This type of working capital management is, of course, an operating benefit completely separate from the recycling of cash on an investment basis.
6. Managers of a diversified company can direct its currently high net cash flow businesses to transfer investment funds to the businesses in which net cash flow is zero or negative but in which management expects positive cash flow to develop. The aim is to improve the long-run profitability of the corporation. This potential benefit is a by-product of the U.S. tax code, which imposes double taxation of dividends—once via corporate profits taxes and once via personal income taxes. By reinvesting its surplus cash flow, the company defers taxes that stockholders otherwise would have to pay on the company’s dividends.
In November 1975, Genstar, Ltd. of Canada justified this way of creating value in a submission to the Royal Commission on Corporate Concentration. There Genstar argued that the well-managed, widely diversified company can call on its low-growth businesses to maximize net cash flow and profits in order to enable it to reallocate funds to the high-growth businesses needing investment. By so doing, the company will eventually reap benefits via a higher ROI and the public will benefit via lower costs and, presumably, via lower prices.
As Exhibit II shows, two of Genstar’s major business areas—cement as well as chemicals and fertilizers—used far less cash (for working capital and reinvestment) in 1971–1974 than they generated (cash generated being defined as net income after taxes plus depreciation and deferred taxes). Genstar recycled the excess cash flow into its housing and land development, construction, and marine activities. So Genstar was able not only to employ its assets more productively than before but also to reap economic benefits beyond those possible from a comparable securities portfolio.
Exhibit II Relationship Between Cash Generated by Business Areas of Genstar, 1971–1974
Genstar’s argument for cross-subsidization has an important extension. Diversified companies have access to information that is often unavailable to the investment community. This information is the internally generated market data about each industry in which it operates, data that include information about the competitive position and potential of each company in the industry.
With this inside information, diversified enterprises can enjoy a significantly better position in assessing the investment merits of particular projects and entire industries than individual investors can. Such access enables the companies to choose the most attractive projects and thereby to allocate capital among “their” industries more efficiently than the capital markets can.
7. Through risk pooling, the diversified company can lower its cost of debt and leverage itself more than its nondiversified equivalent. The company’s total cost of capital thereby goes down and provides stockholders with returns in excess of those available from a comparable portfolio of securities. As the number of businesses in the portfolio of an unrelated diversifier grows and the overall variability of its operating income or cash flow declines, its standing as a credit risk should rise. Because the company pools its own divisions’ risks and supports any component threatened with bankruptcy, theoretically (at least) the company should have a somewhat lower cost of debt than that of companies unable to pool their risks. More important, the reduced variability of the diversified company’s cash flow improves its ability to borrow.
This superior financial leverage enables the corporation’s shareholders to shift some risk to government and thereby reduce the company’s total cost of capital. (Since interest, in contrast to dividends, is tax deductible, the government shoulders part of the cost of debt capitalization in a business venture.) These benefits become significant, however, only when the enterprise aggressively manages its financial risks by employing a high debt-equity ratio or by operating several very risky, unrelated projects in its portfolio of businesses.
While this type of company can enjoy a lower cost of capital than a less diversified company of comparable size, it can also have a higher cost of equity capital than the other type. This possibility stems from the fact that part of the financial risk of debt capitalization is borne by the equity owners. In addition, investors’ perceptions of risk are not solely conditioned by the degree of diversification in corporate assets. Indeed, the professional investor may be unwilling to lower the rate of return on equity capital just because a company has acquired a well-balanced or purportedly countercyclical collection of businesses.
The risks and opportunities the investor perceives for a company greatly depend on the amount and clarity of information that he or she can effectively process. As a company becomes more diversified, its business can become less clearly defined and its investors’ uncertainty about its risks and opportunities can rise. The greater this uncertainty, of course, the higher the risk premium the equity investor demands and the higher the company’s cost of equity capital becomes.
An unrelated-business diversifier is a company pursuing growth in product markets where the main success factors are unrelated to each other. Such a company, whether a conglomerate or simply a holding company, expects little or no transfer of functional skills among its various businesses. In contrast, a related-business diversifier uses its skills in a specific functional activity or product market as a basis for branching out.
The most significant benefits to the stockholder occur in related diversification when the special skills and industry knowledge of one merger partner apply to the competitive problems and opportunities facing the other. Shareholders’ benefits from unrelated or conglomerate diversification can occur where more efficient capital and asset management leads to a better return for investors than that available from a diversified portfolio of securities of comparable systematic risk. Exhibit III summarizes the benefits that are attainable from the two types of diversification.
Exhibit III Potential Benefits of Diversification
Unfortunately, the benefits that offer the greatest potential are usually the ones least likely to be implemented. Of the synergies usually identified to justify an acquisition, financial synergies are often unnoted while operating synergies are widely trumpeted. Yet our experience has been that the benefits most commonly achieved are those in the financial area.
It is not hard to understand why. Most managers would agree that the greatest impediment to change is the inflexibility of the organization. The realization of operating benefits accompanying diversification usually requires significant changes in the company’s format and administrative behavior. These changes are usually slow to come; and so are the accompanying benefits.
Nevertheless, diversification does offer potentially significant benefits to the corporation and its shareholders. When a company has the ability to export or import surplus skills or resources useful in its competitive environment, related diversification is an attractive strategic option. When a company possesses the skills and resources to analyze and manage the strategies of widely different businesses, unrelated diversification can be the best strategic option. Finally, when a diversifying company has both of these abilities, choosing a workable strategy will depend on the personal skills and inclinations of its top managers.
1. Bureau of Economics, Federal Trade Commission. Statistical Report on Mergers and Acquisitions (Washington, D.C., November 1976), p. 93.
2. Richard P. Rumelt first articulated this useful definition in his Strategy, Structure, and Economic Performance (Boston: Division of Research, Harvard Business School, 1974).
3. William F. Sharpe, Portfolio Theory and Capital Markets (New York: McGraw-Hill, 1970), p. 96.