One reason so few of us achieve what we truly want is that we never direct our focus; we never concentrate our power. Most people dabble their way through life, never deciding to master anything in particular. –Tony Robbins
The Limits of Diversification
The article below reinforces our studies in strategic logic. Corporate diversification destroys value. “Diworsification” says the famous money manager, Peter Lynch. Teledyne posted here: http://wp.me/p1PgpH-2c) proves the rule.
https://www.mckinseyquarterly.com/Corporate_Finance/M_A/
Testing_the_limits_of_diversification_2924. The exhibit shows how the total return to shareholders of conglomerates has capped upside but unlimited downside.
Limited upside, unlimited downside
The argument that diversification benefits shareholders by reducing volatility (beta!) was never compelling. The rise of low-cost mutual funds underlined this point, since that made it easy even for small investors to diversify on their own. At an aggregate level, conglomerates have underperformed more focused companies both in the real economy (growth and returns on capital) and in the stock market. From 2002 to 2010, for example, the revenues of conglomerates grew by 6.3 percent a year; those of focused companies grew by 9.2 percent. Even adjusted for size differences, focused companies grew faster. They also expanded their returns on capital by three percentage points, while the ROCs of conglomerates fell by one percentage point. Finally, median total returns to shareholders (TRS) were 7.5 percent for conglomerates and 11.8 percent for focused companies.
As usual, the median doesn’t tell the entire story: some conglomerates did outperform many focused companies. And while the median return from conglomerates is lower, the distribution’s shape tells an instructive story: the upside is chopped off, but not the downside (exhibit). Upside gains are limited because it’s unlikely that all of a diverse conglomerate’s businesses will outperform at the same time. The returns of units that do are dwarfed by underperformers and therefore probably won’t affect the entire conglomerate’s returns in a meaningful way.
Moreover, conglomerates are usually made up of relatively mature businesses, well beyond the point where they would be likely to generate unexpected returns. But the downside isn’t limited, because the performance of the more mature businesses found in most conglomerates can fall a lot further than it can rise.
Consider a simple mathematical example: if a business unit accounting for a third of a conglomerate’s value earns a 20 percent TRS while other units earn 10 percent, the weighted average will be about 14 percent. But if that unit’s TRS is negative 50 percent, the weighted average TRS will be dragged down to about 2 percent, even before other units are affected. In addition, the poor aggregate performance can affect the motivation of the entire company and how the company is perceived by customers, suppliers, and potential employees.