September 1997

Sense and nonsense about diversification – The market in volatility

Sense and nonsense about diversification

Diversification, the policy of companies to move in areas which do not belong to their core or traditional activities. Most of the larger and successfull companies in the western hemisphere at some time tried to diminish their dependency on their traditional activities and increase their sales and profits by buying into or start on their own capabilities in new very promising markets.

In Asia a number of companies started as diversified companies and they became very succesfull in their operations. These conglomerates are active in numerous fields ranging from financing to steelmills and electronics.

What is the right or better policy to pursue, concentrate on the core activities of your company as most business consultants will tell you or diversify or stay diversified as some especially Asian companies do.

The western experience

The activities of companies in the western hemisphere were mostly limited to the fields in which they started. Only if the company was successfull they started to move in to other businesses. Those businesses where in the first time mostly related to their original activities.

The move into other areas was out of a surplus of cash which needed to be invested and the success some new trades, like technology, had shown which was very attractive to an investor.

Only a few companies started as a conglomerate, mostly they where involved in the trading business or put together through acquisitions of an investment house.

The basic idea behind the conglomerate was that the different divisions of the holding could support eachother. The element of synergy should deliver a better and more profitable company. And being involved in more than one business means being less dependent on the well being of that particular business.

The results of those conglomerates were mostly disappointing. Some divisions did very well but the profits of these were used to cover the losses of the loss making divisions. After some time the decision was taken to sell or close down the loss making or worser perfoming divisions and return to the core activities.

A number of respectable companies followed this path like Exxon, AT&T and Daimler Benz. They all tried to move into areas which were new to them. After some time they have sold those divisions which did not deliver what was expected.

The synergy did not produce better results, the divisions could not work together, the costs were going up every month or the divisions were inadequately managed to deliver the return which was expected.

And these four elements are the main problem why diversification did not bring the expected advantages. Synergy is only working if the elements which should work together can do something for eachother. If this is not the case, there is no reason to combine them.

To make diversification effective and create synergy the different divisions should be able to work together. But the divisions mostly have a different business climate and hierarchy. A particular climate and hierarchy can be very succesfull for one business but could be absolutely disastrous in another business. The management team of the holding company should consider this and create and stimulate a system which is best for each business but at the same time be the impartial broker to induce cooperation between the divisions.

If you enter a new business the start up costs can be high and the returns in the first years can be disappointing. These high cost and low returns combined by a incapable system of cost control will make diversification look like a horror trip. Some knowledge and financial stamina is therefore necessary to enter a new business. The new operation should be like a chrystal ball to control the financial situation. At every moment the holding company should be able to evaluate and question the policy of the management but at the same time give them enough space to run the operation.

The management of the holding company and the divisions is equally important to make a conglomerate work. The holding company should support the management of the divisions. They are the specialists and know what is needed to make a certain operation successfull. To much meddling of the holding company will destroy the creativity and profitability of the division. The management of the division should on the first place improve the position of the division and only after that look what it can do for the group or holding.

The conglomerate is not a grouping in which one part is saving the other part but a business concept were one division maybe helping the other division. Each division stays responsible to deliver sales and profits and at the end create a financially strong and independent holding company.

Most of the multinationals in the West considered their diversification plans as a way to support the core activities and become more independent from one business. They were not able or willing to accept the idea that diversification would change the business structure of the company. The management did not behave as the management of a holding company should do. The intrests of the core activities were still the center of there attention.

Only a few companies became successfull conglomerates. A company like General Electric behaves as a good holding company. Another example is General Motors which had a bad start because they wanted to use the capabilities of new acquired companies to support their main car business but later changed their policy after some big disappointments. GM let companies like EDS and Hughes manage themselves with little interference of the GM management and consequently they became very profitable operations.

Conglomerates in Asia

The rise of the Asian economies is based on the performance of a number of large conglomerates in each of the tiger economies. Everybody knows them; Mitsubihi, Matsushita, Mitsui, Hyundai, Samsung, etc. These large companies were build with the help of the goverments in each of these countries. The goverments furnaced them capital, a protected home market and support inresearch and legislation.

The conglomerates operate in nearly sectors of the economy. They have chemical, electronic, steel mills and processing, services, financing companies.

The wide spread of operations where for one part a necessity and one part wanted. It was necessary because all those companies started in relatively backward economies they had to take care that all parts which were needed for the production had to come together at the right time. The only way to do that was to start and operate so many companies themselves.

It was a wanted development because the goverments of those countries sensed that if they wanted to promote the economic development, the economy had to be supported as efficient as possible. To support only a few companies would bring the highest returns and the fastest economical development.

Most of these heavily diversified companies proved to be efficient and successfull. Even when these economies and companies belong now to the developed world the performance of most of those conglomerates did not loose their dynamics and profitability.

The diversified company has proved to be a successfull concept in Asia. The conglomerates could develop itself into global players and the national economies could get out of the misery which was effectively left behind after the second world war.

The conglomerate?

After considering the western and eastern conglomerate it can be stated that a pro or contra is not possible. In the West a conglomerate can be successfull if the conditions are right and the rules as mentioned above are implemented. The return to core activities is easy and profitable but to become or stay a conglomerate can be as profitable and will promise an even brighter future. But the companies in the holding should be in the best case complemental/supplemental, independent, have the appropriate management and the support of the holding company.

In Asia the conglomerate was a necessary and wanted developement to promote the the economical development. But even now the conglomerate is still an efficient and profitable company.

The conglomerate will be in existence in the future and probably with better results on the long term but it is more difficult to manage.

The market in volatility

The Western stock markets showed there volatile behaviour in the last two weeks of August. The markets reached their best marks but also had two corrections. But the market could nearly regain their former position before turning down again.

The US stock market was under the influence of a bad bond market, threats of inflation and computer sell programs. At the same time many investors became nervous about the large caps and started to rotate their holdings into mid and small cap stocks.

The mid and small cap stocks had shown an impressive performance in the last three months. Where as the S&P 500 had a return of 6 % the Russel 2000 showed a healthy 12 %. The situation seems the same as a year ago when the nifty fifty of the Dow became appearently exhausted, the small cap stocks were the one which promised the bigger growth.

It is therefore not a bad policy to look into the stocks of the Russel 2000 to spread the risk in your portfolio. But on the long term, three to five years, the Russel 2000 will not be able to outperform the Dow.

The big players of the Dow could be less performing in the second part of the year but there are still a lot of companies with low P/E ratio which still offer some growth. You could think about Salomon Brothers, NCR, ITT industries and Rowan companies.

The correction of these weeks will not last forever, the economic forecasts are simply to good to make the correction lasting to long. But however do not expect the same impressive growth as in the first half of the year. At the end of the year we expect the Dow at around 8000.

It is however possible to increase your stock holdings, in that case we favour the above mentioned stocks with a low P/E ratio and a number of the stocks we mentioned in our last update.

The volatility will however continue to harass the stock market with even a larger correction, possibly around October, but do not get exited about that, the losses will be recovered within a month. If you want to be on the safe side you could however hedge your holdings but only if you are in need of money in the last quarter of the year. Otherways it is only a waste of money.