Does Diversification Always Improve Financial Performance

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Does Diversification Always ImproveFinancial Performance ?

George Paul

There have been very few studies evaluat-ing how well diversification moves haveworked out in practice vis-a-vis

expectations at the time decisions aretaken to diversify. This is a difficult areaof research.

George Paul, based on a study of 28MRTP companies, has addressed himselfto a related issue of what type ofdiversification strategy has producedsuperior long-term financial performance.

George Paui is a senior professional atthe Institute of Banking Studies, Kuwait.

Diversification is one of the most strategic deci-sions that managements take. Involving signifi-cant capital outflows and entry into new productsand markets, diversification has far-reaching im-

plications for the organization's structure,systems, processes, and performance.

Firms diversify for a variety of reasons, someof which are listed below:

to mitigate the effects of decline or slow downin sales and earnings in existing business,especially in the mature phase of the businesslife cycle.

to reduce competitive pressures. to smooth out cyclical swings in business,

that is, to reduce risk. to capitalize on distinctive technological ex

pertise in production. to build a balanced portfolio of businesses,

using current 'cash generators' to finance

'cash takers' with potential for future performance. to develop new products that can be moved

through the existing distribution system or toutilize the existing marketing and distribution systems fully.

to exploit fruitful R&D efforts with new product ideas and prototypes.

to avoid takeovers by growing big and to retain control.

to reduce dependence on a few suppliers or a

few customers. to attract and maintain first-rate managers as

well as to provide career opportunities formanagers.

to achieve sufficient size so as to have efficient access to capital markets.


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to satisfy the power and prestige motivesthrough economic power and control over human resources.

to create an image as aggressive managerswho recognize opportunities.

to respond to the regulatory and tax policymeasures of the government.

'to imitate others, as in keeping up with afashion.

Whatever the motivations, there is invariably both a justification given and an expectation thatthe investments needed for diversification wouldimprove the long-term financial performance ofthe company. The extent to which such expecta-tions have been fulfilled is not known and is noteasily determined. The impact of diversificationon financial performance is known only after along time. Meanwhile, a number of other condi-tions also change. Although not easy to determine,top managers need to take an informed view of thelikely impact of a diversification decision on long-term financial performance.

This article examines whether companiesclassified on their diversification strategies differin their long-term financial performance. Fourstrategies of diversification have been examined tosee whether any strategy has produced consist-ently good or poor financial performance. We firstdiscuss whu- is diversification and how the

selected companies were classified on the basis oftheir diversification strategies.

What is Diversification ?

Diversification involves introduction of a new pro-duct or entry into a new market or both. Mere ex-

pansion in existing products and markets does notconstitute diversification. We have followed thedefinition of Steiner (1969) according to which di-versification is producing a new product orservice, or entering new markets, which involvesimportantly different skills, processes, andknowledge from those associated with the present

product, services, or markets. While what consti-tutes a new product and a new market may notalways be clear, it is this relatedness that has beenfound through research to be an important ex-

planator of high and low performance of different

diversification strategies.

By diversification strategies we mean thecumulative effect of various diversification moves,defined in terms of the relatedness of the busines-ses the diversified company is involved in. Thestrengths, skills, and purposes that tie the various

businesses of a company are sought to be capturedin the concept of relatedness in diversification.

Related Diversifies

A company has been categorized as a related di-versifier, if it has entered into markets with similardistribution and other marketing characteristics,or manufactures products using common produc-tion facilities and technology, on has entered intovertically integrated activities. Gwalior Rayon'sstrategy of diversification into businesses that in-clude synthetic yarn, fibre, rayon grade pulp,caustic soda, and textile products is illustrative ofwhat we mean by a related diversification strategy.The similarity of technology and markets and theextent to which they provide opportunities toutilize the facilities and resources of one businessin the other businesses distinguishes related fromunrelated diversification strategies.

A related diversifier's total sales of the relatedgroup of products contribute to 90 per cent ormore of its aggregate sales (e.g., Gwalior Rayon).Such a company may have some unrelated pro-ducts but they would contribute to no more than

10 per cent of its total sales. Vertical integration inwhich a large part of the output of one businessforms the input for the other, is also considered asrelated diversification.

Unrelated Diversifiers

If the largest single group of related businesses con-tributes to less than 90 per cent of total sales, thenthe diversification strategy is regarded as unrelated.Among unrelated diversifies, three types have beenidentified, again based on the extent of unrelated-ness. The first type consists of companies with two

businessesone dominant (75 per cent or more ofsales) and one unrelated business activity which provides between 10 and 25 per cent of total sales. Agood illustration of this type is Mafatlal Fine whichhas two businessesa dominant cotton textiles (86

per cent) and the other, the flourine chemicals, con-tributing 14 per cent of the total sales.

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The second type of unrelated diversifiers alsohas two unrelated businesses, but neither of themis dominant. Each of the two businesses providesless than 75 per cent of total sales. Standard Mills,which has cotton textiles accounting for 69 percent of sales and caustic soda and caustic potashaccounting for 31 per cent, is illustrative of this

type of unrelated diversification strategy. In the third type of unrelated diversifiers, the

companies have at least three unrelated businessesaccounting for 95 per cent of total sales. Illustra-tive of this type of diversification strategy is DCMwhich has textiles (30 per cent), vanaspafi (25 percent), sugar (12 per cent), fertilizers (14 per cent),PVC (8 per cent), data products (3 per cent), andothers (8 per cent).

Selection and Classification of Companies

Only large public limited manufacturing companies in the private sector listed in the BombayStock Exchange were considered for the study.Companies subject to the Foreign Exchange Regu-lation Act, or FERA companies were excluded asgovernment regulations restricted their diversifi-cation strategies to a greater extent than for others.

The list of 28 companies thus selected andtheir classification strategy is shown in. Table 1.All of them were MRTP companies subject to theMonopolies and Restrictive Trade Practices Act.Of the 28 companies, nine were classified as re-lated and 19 as unrelated diversifiers. The

percentages to total sales of each product groupare also provided in the table. These are average

percentages for two years: 1974-75 and 1980-81.Where data were available, the percentage to salesduring the middle year, that is, 1977-78 were alsoused for averaging so that the strategy classifica-tions are based on long-term trends.

Classifying companies on their strategy basedon the sales figures and the definitions givenabove appears straightforward. However, there isan element of judgement in deciding the "related-

ness" in the businesses of a company. An exami-nation of the list of 28 companies and their business-wise sales figures, provided in Table 1would show that the diversification strategy clas-sifications are robust enough to withstand a fairdegree of difference in one's judgements on the"relatedness" or otherwise of two businesses.


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companies belonged to a single group.* In otherwords, the strategy classification we have used isindeed a powerful indicator of the differences inlong-term performance.

Secondly, companies with many unrelated businesses showed the poorest performance amongthe four strategies of diversification. Not only didthe strategy of unrelated diversification into many

businesses record the lowest growth rate of assets(8.2 per cent) and sales (10.9 per cent) compared to14.5 per cent and 19.2 per cent for the dominant

business group with only one minor unrelated busi-ness diversification, but the fully unrelated di-versification strategy also had the highest level ofvariability in return on capital employed (60 percent) compared to only 24 per cent for the dominant

business group with one unrelated diversification.Because of their poorer performance, the sharemarkets also gave the widely unrelated diversifiersthe lowest average price-earnings multiple of 5compared to 6 or higher for the other three morerestricted diversification strategy groups.

The fully unrelated diversifiers performedeven worse than the non-diversified companies, enthe average. Table 2 provides average performancedata for 32 non-diversified companies such asKhatau Makanji, India Cements, Titaghur Paper,Reliance Jute, and Garware Nylon. The seven unre-lated diversifiers with many businesses in our sam-

ple had lower rates of growth and profitability thanthe average for the 32 non-diversified companies.Also, they were not successful in reducing theirrisk level.

The long-term financial performance data pre-sented here raises serious questions regarding theentry of companies into many unrelated businesses.

Implications The research results presented above are similar tothose for certain US companies too where thelong-term financial performance of conglomerateforms of diversification was worse than those ofrelated diversifiers (Rumelt, 1974).

Rumelt concluded as follows: ... firms that have diversified to some extent but haverestricted their range of activities to a central skill orcompetence have shown substantially higher rates of pro-fitability and growth than other types of firms, (p. 8)

* For a more detailed description of the tests and the results, seeP P George. Diversified Indian Companies: A Study ofStrategies and Financial Performance, unpublished doctoralthesis, Indian Institute of Management, Ahmedabad. 1984.

The dominant businesses with one unrelated busi-ness displayed the fact that the central skill or com-

petence is the core for performance. This group,including such companies as Mafatlal Fine,Century Spinning, and J K Synthetics performedeven better than the related diversifiers in our clas-sification which included Gwalior Rayon, NirlonSynthetics, and Orient Paper. But the related di-versifiers performed better than the fully unrelatedor the non-diversifiers.

The identification, nurturing, and building ofthe central skill or competence becomes increas-ingly difficult as companies progress in their rangeof diversification. The dominant businesses withonly one unrelated business are in a better positionto do so than the related diversifiers who have tointegrate around their central skill, the diversetechnological, marketing, and production require-ments of several related businesses. While exploit-ing the relatedness in markets they may have todeal with some unrelatedness in production ortechnology. Unifying such related and unrelateddimensions under a central skill or competence is achallenge. The caution of dominant businesses, en-tering only one unrelated business, and that too, toa minor extent of their total sales, appears prudent.They have been rewarded financially not only ingrowth and profitability but also in terms of reduc-ing the variability in their return on capital emp-loyed to the same extent as achieved by relateddiversifiers.

As competition intensifies, managementswould do well to re-examine their diversificationstrategies to ensure that the company's central skillor competence is strengthened rather than diffused

by diversification. While where the precise line isto be drawn is difficult to pre-determine, manage-ments should be wary of unrelated diversificationinto many businesses. They should not only avoidtoo unrelated a diversification in their company butalso consider the long-term performance of theircompany's strategy vis-a-vis alternative strategies.Where managements find that their company is toodiversified for its central skill or competence to bereflected fully, they would do well to divest theweakening businesses. References

Steiner, George A. Top Management Planning. London: TheMacmillan Company, 1969.

Rumelt, Richard P. Strategy. Structure and Economic Perfor-mance. Boston, Mass.: Division of Research, GraduateSchool, of Business Administration. Harvard University,1974.

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Does Diversification Always Improve Financial Performance

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