Introduction: Reason for diversification
Every company in its life reaches a stage where management is faced with the dilemma of whether to diversify or launch new products in the existing range in order to survive in the market. It’s almost inevitable: To fuel growth when a company reaches a certain size and maturity, executives will be tempted to diversify. Companies implement diversification strategies to improve or increase the strategic competitiveness of the organization as a whole. If they are successful, the value of the company increases. Value can be created through related or unrelated diversification if the strategies enable the company’s business combination to increase revenue and/or reduce costs by implementing their respective strategies at the business level.
Companies can also implement a diversification strategy to gain market power relative to their competitors. Companies can implement diversification strategies that are value neutral or result in the devaluation of the company. They may try to diversify to neutralize a competitor’s market power or reduce managers’ employment risk or increase managerial compensation because of the positive relationships between diversification, company size, and compensation.
While some talented individuals have proven over time to be capable of managing diverse portfolios of businesses, today most executives and boards realize how difficult it is to add value to companies that are not connected to each other. somehow. As a result, the unlikely pairings have largely disappeared. In the United States, for example, at the end of 2010, there were only 22 true conglomerates. Since then, 3 have announced that they too would be disbanding.
Achievements in the past:
The argument that diversification benefits shareholders by reducing volatility has never been convincing. The rise of low-cost mutual funds underscored this point, making it easier for even small investors to diversify on their own. At the aggregate level, conglomerates have underperformed companies more focused on both the real economy (growth and return on capital) and the stock market. From 2002 to 2010, for example, conglomerate revenue grew 6.3 percent annually; those of focused companies grew 9.2 percent. Even adjusting for size differences, focused companies grew faster. They also expanded their returns on equity by three percentage points, while ROCs for conglomerates fell by one percentage point. Finally, the median total shareholder return (TRS) was 7.5 percent for conglomerates and 11.8 percent for focused companies.
Creating value:
What matters in a diversification strategy is whether managers have the skills to add value to businesses in unrelated industries, allocating capital to competing investments, managing their portfolios, or cutting costs. Over the past 20 years, the TRS of top performers and underperformers among the remaining 22 conglomerates in 2010 clearly differed on exactly these points. Although the number of companies is too small for statistical analysis, three characteristics are generally observed for high-performing companies:
1. Disciplined (and sometimes contrarian) investors –
High-performing conglomerates continually rebalance their portfolios by buying companies they believe are undervalued by the market and whose performance can improve.
2. Aggressive money managers –
Many large companies base a company’s capital allocation for a given year on its prior year’s allocation or the cash flow it generates. High performing conglomerates, by contrast, aggressively manage interunit capital allocation at the corporate level. Any cash in excess of what is needed for operational requirements is transferred to the parent company, which decides how to allocate it to current and new business or investment opportunities, based on their growth potential and return on invested capital.
3. Rigorous “Tight” Corporate Centers –
High-performing conglomerates operate much like the best private equity firms do: with a thin corporate center that restricts its involvement in the management of business units to the selection of leaders, the allocation of capital, the strategy research, performance goal setting, and performance monitoring. Just as important, these companies don’t create extensive corporate processes or large shared service centers.
Future of the Conglomerate: Growth vs. Risk mitigation:
The economic situation in emerging markets is distinctive enough to make us wary of applying insights gleaned from US companies. The cluster structure will face tests in the near future, the level of which will vary from country to country and industry to industry.
In emerging markets, large conglomerates have economic benefits that do not exist in the developed world. These countries still need to develop their infrastructure; such projects usually require large amounts of capital that smaller companies cannot muster. Companies also often need government approval to buy land and build factories, as well as government guarantees that there will be enough infrastructure to transport products to and from the factories and enough electricity to keep them running. Large conglomerates often have the resources and relationships necessary to navigate the maze of government regulations and ensure relatively smooth operations. Finally, in many emerging markets, large conglomerates are more attractive to potential managers because they offer greater career development opportunities.
Infrastructure and other capital-intensive businesses are likely to be part of large conglomerates as long as access to capital and connections are important. By contrast, companies, including export-oriented ones such as IT services and pharmaceuticals, that are less dependent on access to capital and connections tend to concentrate in rather than be part of large conglomerates. The rise of IT services and pharmaceuticals in India and Internet companies in China show that the advantage of large conglomerates in access to managerial talent has already diminished. As emerging markets open up to more foreign investors, the advantage of these companies in access to capital will also diminish. That will leave access to the government as its last remaining force, further restricting its opportunities to industries where its influence remains important. Although the time could be decades away, the sheer size and diversification of conglomerates will eventually become impediments rather than advantages.
As the dynamics of doing business become more complicated, managing these conglomerates just as efficiently becomes a problem.
Taking as an example one of the large engineering and construction conglomerates, L&T. As for the performance of the company, the share price has fallen close to 25% in the last two years to date. If that were any exception, let’s take a look at another corporate powerhouse, Adani Enterprises. The company’s share has fallen to about 75% in the past two years.
ITC, on the other hand, has shown a good performance in the last two years, that is, its share price has grown close to 65%. This seems to contradict our discussion. But if we look closely the company has generated about 65% of its Cigarette business.
So what can be the possible solutions for this?
1. Consolidation –
Previously, during the Raj license, there were restrictions on companies not expanding their capabilities beyond a certain point. Therefore, they were unable to expand their business. And so, in some cases, companies sat on excess cash, and in other cases, they chose to diversify by seeking higher returns on excess cash than they could have earned from the bank’s interest. In some cases, the results were in comparison to the income they would have earned from banks’ interest, while in many cases they destroyed their core business values.
Now with dismantled raj license so no need to have multiple businesses. In fact, consolidation occurred in various industries such as cement, where major players such as Ultratech, where the parent company increased its capacity by investing heavily, acquiring businesses, etc.
2. Investment –
Another type of structure that can work here is a divestiture, that is, the sale of existing non-core businesses to raise funds to focus on your core business. This can be a big help, especially in cases where side businesses have underperformed and, as a result, the entire company has suffered and its stock prices are undervalued. It can also be of great help when the company had plans but did not have enough funds to expand. For example, IBM decided to sell its PC business to focus on IT solutions and services.
3. Constitution of Separate Companies –
Another way to deal with this situation is to separate the businesses and manage them as if they were different companies so that each company can focus on its business without being influenced by other sister companies. By doing this, management and the company as a whole can be held accountable for their actions. For example, TATA Group has been following this model for a long time. Each of his companies operates independently as a separate company.
Conclution:
Many companies in the past dreamed of becoming conglomerates to show their skills and talents to run different businesses. But looking at the current scenario, the concept of “Conglomerate” is becoming a thing of the past, that is, a corporate dinosaur on the way to extinction. This is mainly due to the changing dynamism of the business world where competition has made companies think less about profitability and more about sustainability. Other previous general business management skills and having core competency in finance, human resources and other general functions were enough to give many businesses long-term sustainability. But today’s complexity of doing business, superior skill sets in support roles, will not allow any company to deliver long-term sustainable performance across multiple businesses. Therefore, focused infrastructure and team are the key to success for any company in today’s fast-changing and dynamic business environment. Therefore, companies are being forced to rethink their established strategies for growth from diversifying towards more focused businesses.