This article is part of a series on what causes a firm’s value to increase
General Electric Company is probably the most diversified corporation in the world. GE is involved in many different kinds of businesses: locomotive engines, broadcasting, cat scanners, wind turbines, and medical devices to name just a very few.
This article will discuss the evolving views behind why a single product business should diversify into more different kinds of businesses. As I look at our great businesses here in the Northwest Louisiana region, I notice that most are single product or a bundle of tightly related products. Perhaps this article can stimulate thought about whether or not they should consider diversifying. The payoff is high in terms of increasing firm valuation but so are the risks.
There are two kinds of strategy in the for-profit firm – business unit level strategy which answers the question how we will compete against known competitors in our current space. Corporate level strategy answers the question where we should compete – different geographies and different businesses in different industries. Thus corporate level strategy is the strategy of multiple business units inside a corporate shell.
Nearly all of the Fortune 1000 businesses are portfolios of multiple business units. The distinction is how related the businesses are to the core business. GE is a conglomerate as its business units are very unrelated. Marriot’s diversification is a tightly related set of hotel brands. Textron falls somewhere in between.
The history of the thinking of why and how a dominant product business should diversify is interesting. A key aspect is whether a company should diversify through acquisition or building its own businesses or a mixture of both. The track record on acquisitions is generally not good. Firms typically pay too high of a premium and then have trouble integrating the acquisition into the processes and culture of the corporation. Building your own new businesses is much better but takes longer.
After World War II, the Go-Go Conglomerate view of diversification prevailed. Its main aim was to diversify risk. If the dominant business was seasonal or cyclical, a portfolio of businesses units could be made that would offset these kinds of risk. A “corporate center” was set up and this very small group of corporate executives and staff acted like an internal bank for the business units. It would move cash from one to another or allocate newly raised debt or equity funding based on some predetermined criteria. If 16 to 18 businesses were assembled in a portfolio, nearly all risk could be diversified away. If one business was up, another could be down to offset each other. Of course businesses could be sold out of the portfolio and make room for others that were seen as a “better fit”.
This view however became much out of favor. The Go-Go years assumed that all businesses could be managed operationally pretty much the same. The view emerged that there were huge differences among industries and that corporate center executives could not understand them enough to make much of a management or strategic difference. The view also said that individual stockholders could diversify their risks easier and better than a corporate center could.
This view evolved slightly over the years. The current view is that if a corporate center cannot create a “parenting advantage” it should not endeavor to build portfolios of multiple businesses in the first place. In a famous article published by Campbell, Gould and Alexander in the Harvard Business Review (HBR) in 1995, they state:
“Multi-business companies create value by influencing – or parenting – the businesses they own. The best parent companies create more value than any of their rivals would if they owned the same businesses. Those companies have what we call a parenting advantage”.
So what is involved with bringing about a parenting advantage? Cynthia Montgomery of the Harvard Business School has been on the Newell/Rubbermaid board of directors for more than 25 years. In 1998 she wrote about the “formula” in another famous Harvard Business Review article titled Creating Corporate Advantage. Essentially the formula is that a corporate center group of executives creates this parenting advantage by helping the businesses entice suppliers to each business to supply at lower costs than would be the norm and to help the businesses add value to customers that allows them to have a higher willingness to pay than the norm. Lower input costs and higher customer willingness to pay price points equal higher profits and cash flow than any rival who would own the same businesses. Newell/Rubbermaid grew via acquisitions and their formula also has these elements:
1. A process that rapidly integrates the acquisitions into the systems, processes, culture and compensation systems of Newell/Rubbermaid.
2. The processes and disciplines include key contributions from the corporate center and each of the business unit CEOs and their staff.
Sounds like a huge bar to get into the business of multi-business units doesn’t it? Yes, but the payoff can be huge if led and managed well. Faster growth, higher profit margins and free cash flow can really accelerate the growth in the market value of your firm.
Bill Bigler is Director of MBA Programs and associate professor of strategy at LSU Shreveport. He spent twenty five years in the strategy consulting industry before returning to academia full time at LSUS. He is involved with several global professional strategy organizations and can be reached at firstname.lastname@example.org and www.strategybest.com