Maximizing Value Through Diversification

Corporate diversification is a prime example of a once-popular management idea that has fallen from grace. In the 1960s, the “conglomerate kings” — giants such as Gulf & Western and ITT — snapped up dozens of businesses to general acclaim. More recent studies, however, have found that diversified companies trade at a 5% to 12% discount relative to focused companies.

Most economists interpret this evidence to mean that diversification causes poor performance. According to the standard agency account, managers pursue diversification for selfish reasons, such as the desire to build an empire or reduce their personal risk. The resulting conglomerates often operate inefficiently —strong divisions, for example, may subsidize the weak — leading investors to punish diversified companies.

But what if the causal arrow points the other way? Could diversification be not the cause of poor performance, but its result? That's the argument put forward by John Matsusaka, professor of finance and business economics at the University of Southern California, in an article titled “Corporate Diversification, Value Maximization and Organizational Capabilities,” which appeared in the July 2001 issue of the Journal of Business.

Matsusaka presents a mathematical model that shows how diversification can be a value-maximizing strategy — even if specialization remains the ultimate goal. He begins by observing that companies can be seen as collections of organizational capabilities, such as expertise in marketing or new-product development, that are transferable across products and industries to a certain degree. Because such capabilities have value, companies facing a decline in their core business should not simply shut down. Instead, they can maximize shareholder value by trying to find a new industry that offers a good match for their skills.

Although careful analysis can improve the search process, some uncertainty about the quality of a match will almost invariably remain. Consequently, experimentation — “entering an industry and observing the outcome” — is often the only way to determine whether a sector offers a good fit. Very rarely, managers choose to liquidate their existing operations before embarking on experimentation. More often, diversification —combining old and new activities — is the result.

Viewed from that perspective, diversification typically marks a period of transition. Companies will try to reject a number of possible businesses before refocusing in the industry that offers the closest fit. However, under certain conditions, diversification can become a long-term strategy.