Throughout the previous 25 years a raising propercent of UNITED STATE companies have checked out wisdom in pursuing a strategy of diversification. Between 1950 and also 1970, for example, single-organization carriers consisting of the Fortune “500” declined from 30% to 8% of the complete. Acquisition has become a standard strategy to diversification. In recent years the productivity of capital <…>

Throughout the previous 25 years a boosting propercent of U.S. providers have actually checked out wisdom in pursuing a strategy of diversification. Between 1950 and also 1970, for instance, single-company suppliers consisting of the Fortune “500” declined from 30% to 8% of the total. Acquisition has become a traditional method to diversification. In recent years the productivity of funding <…>

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During the past 25 years a raising proportion of U.S. providers have actually viewed wisdom in pursuing a strategy of diversification. Between 1950 and also 1970, for instance, single-service service providers consisting of the Fortune “500” declined from 30% to 8% of the full. Acquisition has come to be a typical technique to diversification. In current years the productivity of funding <…>

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During the previous 25 years an enhancing propercent of U.S. companies have viewed wisdom in pursuing a strategy of diversification. Between 1950 and 1970, for instance, single-service companies consisting of the Fortune “500” declined from 30% to 8% of the full. Acquisition has become a traditional method to diversification.

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In recent years the performance of funding of many type of multiservice service providers has actually lagged behind the economy. Nevertheless, diversification through acquisition stays popular; in between 1970 and 1975, got assets of large production and mining carriers averaged slightly even more than 11 % of total brand-new investment in those service providers, and also the majority of of that task was diversifying acquisition.1 In the previous few years the pace of activity has actually been sreduced than in the hectic 1967–1969 duration, yet the combicountry of high corporate liquidity, depressed stock prices, and sluggish economic expansion has actually supposed that for many kind of suppliers acquisitions are among the many attractive investment choices. Since mid-1977, hardly a week has actually gone by without at least one significant acquisition being announced by a diversifying corporation.

In light of this proceeding interest and also the apparent financial risks in following such a strategy, we present a review of the theory of corpoprice diversification. We begin by pointing out salso widespread misconceptions about diversification via acquisition. We then turn to the standard question facing service providers wanting to take on the strategy: How have the right to a firm develop worth for its shareholders via diversification?

Our consideration of value development leads to an examicountry of the potential benefits of the choices available—related-service diversification and unrelated-service diversification. Businesses are connected if they (a) serve comparable markets and use similar distribution systems, (b) employ equivalent manufacturing modern technologies, or (c) make use of similar science-based research.2

Typical Misconceptions

Tright here are salso common misconceptions around diversification via acquisition that we deserve to usetotally highlight in the conmessage of recent background. They relate to the financial rationale of this strategy and also to the monitoring of a effective diversification program.

1. Acquisitive diversifiers generate bigger returns (with raised earnings and capital appreciation) for their shareholders than nondiversifiers execute. This concept acquired a particular currency during the 1960s, in component because of the huge focus that securities experts and corporate executives put on growth in income per share (EPS). Acquisitive diversifiers that did not collapse at as soon as from ingesting as well many businesses often continual high levels of EPS growth.

However, as soon as it became apparent that a huge propercent of this expansion was an bookkeeping mirage and also that resources efficiency was a much better indicator of management’s performance and also a business’s economic strength, the market worth of many acquisitive carriers plunged.

Many type of extensively diversified service providers have actually had low funding performance in current years. Exhilittle bit I reflects the performance of a sample initially selected by the Federal Trade Commission in 1969 as representative of providers pursuing tactics of diversification and also not classifiable in traditional commercial categories. While the average rerevolve on equity of the sample was 20% higher than the average of the Fortune “500” in 1967, it was 18% listed below the Fortune average in 1975. Even the surge in earnings in 1976 and also 1977 and also the influence of nonoperating, audit earnings in several corporations faicaused bring the sample average approximately the Fortune average. What is also even more telling than the return on equity figures is that the sample’s rerevolve on assets was 20% or more listed below the Fortune “500” average throughout the ten-year period.


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Exhilittle I Performance File of 36 Diversified Manufacturers (1967, 1973, 1975, 1977)


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So it is not surpclimbing that acquisitive diversifiers have had actually low price-revenue ratios. On December 31, 1977, the average P/E of the sample, which has many busy diversifiers, was 30% listed below that of the New York Stock Exadjust stocks in its entirety. This discount has readjusted bit over numerous years. Even high return-on-equity performers like Northwest Industries, Teledyne, and Textron have actually P/Es well listed below the market’s average.

Such low sector worths suggest excellent uncertainty around the dimension and also varicapacity of future cash flows. And once they are uncertain about a company’s cash circulation, investors and also stock experts check out them as less handy than trustworthy and predictable income streams, so they are inclined to discount the company’s future earnings heavily. The high discount rates of acquisitive diversifiers create growth via much less capital appreciation than that of nondiversifiers, whose revenue streams appear to be even more predictable. What will certainly create value is prospering cash flows through bit uncertainty about their size or variability.

2. Unconnected diversification provides shareholders a exceptional indicates of reducing their investment danger. Unassociated diversification might be attractive from an investor’s allude of view—its use is typically offered to justify or protect conglomeprice mergers—yet it is not a superior indicates of reducing investment risk. (By investment risk we intend the varicapacity of returns over time, returns being identified as funding appreciation plus dividends paid to investors.)

According to modern financial concept, a security’s risk and also return can be dewritten into two elements: (1) what is certain to each company and also referred to as “unsystematic” because it have the right to be diversified ameans and also (2) what is “systematic” because it is prevalent to all securities (the securities market) and also therefore nondiversifiable.3 Because the unorganized risk of any security have the right to be removed through easy portfolio diversification, the investor does not require widely diversified companies choose Litton Industries and Gulf & Western Industries to remove the danger for him.

Conshort-term financial financial experts think that prices of securities reflect the agreement of many knowledgeable buyers and sellers concerning a company’s prospects. This consensus leads to an reliable resources market, wright here the investor finds it extremely difficult to continuously make risk-adjusted profits in excess of those the market realizes in its entirety. While it does not insurance claim that the price of eincredibly protection always accurately reflects its underlying (systematic) danger, the theory does suggest that as soon as one views all securities over time, the “overvaluations” and “undervaluations” by the sector counter.4

Several researchers have actually extended this effective resources sector concept to the analysis of conglomeprice mergers. Their researches suggest that unconnected corporate diversification has actually little bit to offer investors with respect to hazard reduction over a diversified portfolio of comparable securities.

They additionally imply that if diversified service providers cannot increase returns or reduce risks more than equivalent portfolios do, these service providers deserve to at ideal offer the investor only value comparable to that of a common money. Without a doubt, widely diversified providers through organized dangers and retransforms identical to those of a common fund might actually be less attrenergetic investment vehicles because of their better management costs and also their incapacity to relocate right into or out of assets as conveniently and also as cheaply as shared funds carry out.5 For a certain case entailing systematic hazard, view the ruled insert over comparing Gulf & Western Industries with a portfolio having choose assets.

Analysis of Systematic Risk

Due to the fact that portfolio theory tells us that reducing methodical danger is difficult with portfolio diversification, let us analyze a portfolio of assets versus a diversified company’s assets comparable in dimension and also alarea. This hazard evaluation needs three kinds of information: (1) the investment complace, by industry, of the diversified company; (2) the size of the investment the firm has actually made in each industry; and (3) the systematic danger of each of those markets.

Summing the industries’ methodical dangers, weighted by their family member size in the portfolio, outcomes in a measure of the portfolio’s methodical danger. The last action before comparing the portfolio’s methodical hazard through the diversified company’s methodical danger is to readjust for differences in financial danger. Once he has done this, the analyst deserve to identify, within statistical boundaries, whether the diversifying corporation has actually diminished its methodical danger.

The outcomes of a danger 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 provided in Table B. Both tables reflect a five-year period ending in July 1975. The businesses of G&W’s eight departments overlap incredibly little. Grouping these departments via Gulf & Western’s investment portfolio produces a well-diversified similar portfolio.


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Table A Portfolio Comparison


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Table B Systematic Risk Analysis of a Portfolio Comparable to That of Gulf & Western Industries (Dollars in Millions)


As Table A indicates, Gulf & Western’s organized threat, readjusted for financial leverage, differs insubstantially from that of a comparable portfolio. All 3 systematic risk measurements are within one standard deviation of each various other. Whatever before benefits Gulf & Western offers its shareholders, reduction of investment danger apparently is not among them.*

*A more thounstable presentation of this strategy of making a comparative danger analysis is obtainable from the authors at Harvard Company 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 expansion of the previous one. For years, advocates of unassociated or conglomeprice diversification have actually said that once a company diversifies into an industry with a company cycle or a collection of financial risks various from its very own, it boosts the “safety” of its income stream. In essence, this sense of safety is a really easy create of the “hazard pooling” principle underlying insurance.

In light of the negative performance of many diversified suppliers, it need to be apparent that security is tough to obtain. Because of the complicated interactions of the UNITED STATE and also various other nations’ economic situations, finding genuinely countercyclical businesses is incredibly difficult. At the the majority of, tbelow are market cycles that either lead or lag behind the general economic climate (e.g., real estate and also resources products, respectively) or that are less cyclical than the basic economy (e.g., customer goods and tobacco products).

Even if diversifying suppliers can determine the countercyclical businesses, diversifiers find it difficult to construct well balanced portfolios of businesses whose variable returns balance one one more. Additionally, inasmuch as businesses thrive at various prices, commonly diversified carriers face the constant difficulty of rebalancing their business portfolios through extremely selective acquisitions.

Quite apart from this discussion, the low stock industry values of extensively diversified service providers in the time of the previous eight years show that the market-place has actually greatly discounted the future cash retransforms to investors in suppliers consisting of purportedly countercyclical businesses. While there are undoubtedly many type of reasons for this instance, it says that the industry may be even more interested in expansion and the efficiency of invested capital than in earnings stability per se. In addition, investors have bit motivation to bid up the prices of diversified providers because an investor have the right to achieve the benefits of stabilizing an earnings stream via simple portfolio diversification.

4. Related diversification is always safer than unassociated diversification. This misconception rests on the idea of corporate executives that they minimize their operating dangers once they stick to buying businesses they think they understand. They desire to limit their diversification to businesses via comparable marketing and circulation features, equivalent production modern technologies, or equivalent science-based R&D initiatives.

While this presumption regularly has actually merit, making related acquisitions does not guarantee outcomes remarkable to those stemming from unrelated diversification. For instance, Xerox’s enattempt into information handling through its acquisition of Scientific Documents Solution, which Xerox justified on the ground of technical, marketing, and also manufacturing compatibility, led to an excellent drain on earnings for years. The monitoring of Singer chose to take advantage of the company’s competence in electromechanical manufacturing as the basis for its diversification program. The outcome was dramatic failure, causing a $500 million write-off of assets.

A close reading of the Xerox and also Singer cases suggests that successful associated diversification relies on both the quality of the obtained service and the organizational integration required to accomplish the possible benefits of companies exchanging their abilities and also sources. Such exreadjust has actually been dubbed synergy.

Even even more necessary, the regarded relatedness must be genuine, and also the merger must provide the partners a competitive advantage. Unmuch less these problems are met, associated diversification cannot be justified as premium or also similar to unconnected diversification as a means of reducing operating dangers or enhancing income.

5. A solid administration team at the obtained company ensures realization of the potential benefits of diversification. Many companies attempt to limit their pool of acquisition candidates to well-regulated suppliers. This policy is seldom the necessary problem for gaining the potential benefits of diversification.

As we shall tension later in this post, the potential benefits of associated diversification stem from augmenting the efficient use of the enduring company’s core skills and also resources. Usually such development needs an exreadjust of core abilities and also resources among the partners. The benefits of unassociated diversification are rooted in 2 conditions: (1) enhanced efficiency in cash monitoring and also in alplace of investment funding and also (2) the capcapability to contact on profitable, low-development businesses to administer the cash circulation for high-expansion businesses that need considerable infusions of cash.

Whether pursuing associated or unrelated diversification, it is regularly the gaining company’s monitoring skills and also resources—not those of the got company—that are instrumental to achieving the potential benefits of diversification. Without a doubt, if the obtained firm is well controlled and priced accordingly by the funding sector, the acquirer must manipulate the potential synergies through the acquiree to make the transaction economically justifiable.

6. The diversified firm is uniquely qualified to enhance the performance of acquired businesses. Throughout the height of the merger and also acquisition task of the 1960s, executives of conglomeprices frequently suggested that they could improve the profitcapability of acquired providers by “modernizing” bureaucratic methods and also exerting even more operating discipline than that demanded by the marketplace.

Consider the testimony of Harold S. Geneen, then chairman and also president of International Telephone & Telegraph Corporation, at a government hearing concerning just how ITT offered “constructive bases for merger.”

“We can afford to price reasonably,” Geneen said, “and also to exadjust our very own equity stocks via the shareholders of an incoming company. We deserve to boost operating efficiencies and revenues sufficiently to make this valuation worthwhile to both sets of shareholders.” In a record outlining ITT’s acquisition approach and submitted to the hearing, Geneen created that from 1960 to 1965 the company had “arisen the ability through management abilities, routines, and also approaches to set and progressively fulfill higher competitive criteria and also attain them in almost every line and also product that we have actually undertaken.”6

The clintends that Geneen and many other effective diversifiers have actually invoked are not benefits of diversification per se however simply the benefits of that nebulous factor, “good administration.” Single-service providers pursuing vertical integration or horizontal growth via acquisition have the right to accomplish the same outcomes. To get the benefits Geneen claimed, a agency needs only to enable supervisors with the requisite skills to implement their wanted renovations in the company.

Racount, it might be suggested, does an organization willingly take actions that can alter its standard administrative and also managerial techniques. Under these situations, adjust will certainly happen only as soon as required from the exterior, and diversifying service providers often reexisting such a force. Nonetheless, the benefits accomplished are not, strictly speaking, benefits of diversification.

7. Great deals are made by expert “deal devices.” The a lot of potentially dangerous misconception on our list is the one that credits the imagiindigenous work of investment bankers and various other brokers with the success of a diversifying acquisition. The investment banker’s role is to carry out attrenergetic ideas, however it is the company’s duty to pick the ideas that have the biggest strategic and economic worth.

This function involves developing diversification missions and also acquisition guidelines that fit a very closely ready concept of the corporation. It additionally involves the company’s ability to recognize and exploit the potential for developing worth through diversifying acquisitions. Eexceptionally knowledgeable corporate diversifier has actually learned, regularly paincompletely, that he have to live with an acquisition long after it has ceased being a “great deal.”

Ways to Create Value

A firm complying with a diversification strategy have the right to produce value for its shareholders only as soon as the combination of the abilities and also sources of the two businesses satisfies at least one of the complying with conditions:

An income stream higher than what might be realized from a portfolio investment in the 2 providers. A reduction in the varicapability of the earnings stream greater than what could be realized from a portfolio investment in the two businesses—that is, decreased methodical danger.

Included in both conditions is explicit comparison of corporate diversification on the shareholder’s befifty percent with independent portfolio diversification on the investor’s component. This compariboy deserves comment.

Many benefits obtained from reducing unsystematic corpoprice risk with diversification are, of course, equally accessible to the individual investor. Diversified companies have the right to accomplish trade-offs in between full risk and rerotate that are remarkable to the trade-offs easily accessible to single-business providers. Diversified providers cannot create worth for their stockholders simply by diversifying ameans unorganized hazard.

Inasmuch as investors deserve to diversify amethod unorganized threat themselves, in reliable capital sectors unsystematic risk is irpertinent in the equity valuation procedure. A diversifying agency deserve to produce worth for its shareholders just as soon as its risk-rerotate trade-offs incorporate benefits unaccessible via straightforward portfolio diversification.

Tbelow are seven primary means in which acquisition-minded service providers deserve to obtain returns better than those obtainable from straightforward portfolio diversification. The initially 4 are especially pertinent to associated diversification, while the last three are more appropriate to unrelated diversification.

1. A diversifying acquisition deserve to raise the performance of capital once the particular skills and one merger partner’s expertise of the sector are applied to the competitive difficulties and opportunities facing the various other partner. When the reinforcement of skills and also resources critical to the success of a service within the merged company leads to better profitcapability, worth is produced for its shareholders. This reinforcement is the realization of synergy.

The acquisition by Heublein, Inc. of United Vintners in 1968 is a great instance in allude. Heublein’s strategy throughout the 1960s was to obtain high margins in marketing liquor and also specialty food commodities via intensive, innovative advertising. At the moment, Heublein stood out in this respect bereason the market was production-and also distribution-oriented. The company’s liquor assets department accounted for even more than 80% of 1965 sales. Its principal product was the premium-priced Smirnoff vodka, the fourth largest and fastest growing liquor brand also in the USA.

The 1968 acquisition of United Vintners, the marketing arm of a big grape growers’ cooperative that owned 2 of California’s best-well-known wine brands, gave Heublein the chance to raise its investment in an market wbelow it had actually some suffer (it was the UNITED STATE distributor for Lancers wine) and to extend the application of its prstove abilities in cultivating specialty products. By identifying and then exploiting an emerging consumer choice for lighter-bodied, frequently slightly flavored assets, Heublein assisted United Vintners launch two brand-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 actually raised sales by over 2.5 million cases and also augmented the subsidiary’s profitability. Heublein’s marketing strategy was so successful that throughout the 1960s and also early on 1970s its rerotate on equity averaged over 30% and the marketarea valued Heublein at over 35 times its earnings. Heublein uncovered in its diversification initiatives, but, that its strategy of aggressive proclaiming was not the vital success element in either brewing (Hamm’s beer) or rapid foodstuffs (Kentucky Fried Chicken), and its market valuation suffered appropriately. By 1977, Heublein had watched its P/E loss to 10 and its stock price to one-third of its previous high.

2. Investments in markets closely pertained to present fields of operation have the right to reduce long-run average costs. A reduction in average costs deserve to accrue from scale results, rationalization of manufacturing and various other managerial initiatives, and technical creation. For instance, a marketing department’s budget as a percent of sales will decline if existing resources can be used to industry new or related commodities.

Similarly, a large company choose Procter & Gamble have the right to mean its per-unit circulation prices to decline as soon as it augments the use of its existing circulation mechanism to move commodities to the marketarea. This concept has been the basis of many kind of acquisitions made by customer assets carriers.

3. Firm growth in an area of competence have the right to bring about the generation of a “critical mass” of resources necessary to outpercreate the competition. In many kind of sectors, providers need to accomplish a specific size, or important mass, prior to they have the right to contend properly with their competitors.

For example, the major means many kind of tiny laboratory instrumentation providers hope to market continual competition against such entrenched companies as Hewlett-Packard, Tektronix, Beckmale Instruments, and also Technsymbol is to attain a size providing them enough cash flow to underwrite competitive research study and development programs. One way to reach this dimension is to make carefully associated diversifying acquisitions.

4. Diversification right into associated product industries have the right to permit a firm to mitigate systematic threats. Many of the possibilities for reducing threat via diversification are implicit in the previous three methods to boost retransforms because hazard and also return are closely related measurements. However before, diversifying by getting a company in a connected product industry deserve to permit a company to reduce its technical, manufacturing, or marketing risks. If these reduced service dangers can be translated into a less variable revenue stream for the firm, value is developed.

Although there is no proof that General Motors’ strategy was developed via this idea in mind, an important result of GM’s diversification within the motor automobile industry has actually been its capacity to easily absorb transforms in demand also for any one automotive product. GM’s extensive related-product line reduces the company’s marketing threat and allows 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, providers.

5. The diversified agency deserve to route cash from devices operating via a surplus to units operating via a deficit and also have the right to thereby reduce the require of individual businesses to purchase working capital funds from exterior sources. Through centralizing cash balances, corporate headquarters deserve to act as the banker for its operating subsidiaries and also can for this reason balance the cyclical functioning capital needs of its departments as the economic situation progresses through a organization cycle or as its departments suffer seasonal fluctuations. This form of working funding administration is, of course, an operating advantage entirely separate from the recycling of cash on an investment basis.

6. Managers of a diversified company deserve to direct its presently high net cash flow businesses to move investment funds to the businesses in which net cash circulation is zero or negative but in which administration expects positive cash flow to build. The aim is to boost the long-run profitcapacity of the corporation. This potential benefit is a by-product of the U.S. taxation code, which imposes double taxation of dividends—as soon as using corporate revenues taxes and also when via personal income taxes. By reinvesting its excess cash circulation, the company defers taxes that stockholders otherwise would have to pay on the company’s dividends.

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In November 1975, Genstar, Ltd. of Canada justified this method of creating worth in a entry to the Royal Commission on Corporate Concentration. There Genstar suggested that the well-regulated, commonly diversified agency can call on its low-development businesses to maximize net cash flow and also earnings in order to allow it to realfind funds to the high-expansion businesses needing investment. By so doing, the agency will ultimately gain benefits using a higher ROI and the public will benefit via lower costs and also, presumably, through reduced prices.

As Exhilittle bit II reflects, two of Genstar’s major company areas—cement and chemicals and also fertilizers—offered far less cash (for functioning funding and reinvestment) in 1971–1974 than they produced (cash generated being defined as net earnings after taxes plus depreciation and also deferred taxes). Genstar recycled the excess cash circulation into its real estate and also land also breakthrough, construction, and marine activities. So Genstar was able not only to employ its assets even more productively than prior to yet also to reap economic benefits beyond those possible from a equivalent securities portfolio.