Testing the limits of diversification summary notes
Testing the limits of diversification
This strategy can create value, but only if a company is the best possible owner of businesses outside its core industry.
To boost growth when a company reaches a certain size and maturity, executives will be tempted to diversify. Although a few talented people have proved capable of managing diverse business portfolios, most executives and boards today realize how difficult it is to add value to businesses that aren’t connected to each other in some way. As a result, unlikely pairings have largely disappeared.
Still many executives believe that diversifying into unrelated industries reduces risks for investors or that diversified businesses can better allocate capital across businesses than the market does – without regard to the skills needed to achieve these goals. Because few have such skills, diversification instead often caps the upside potential for shareholders but doens’t limit the downside risk. In practice, the best-performing conglomerates do well not because they’re diversified but because they’re best owners, even of businesses outside their core industries.
Limited upside, unlimited downside
Reducing volatility by diversification doesn’t benefit the shareholder. The shareholder can do this by for example an mutual fund. At an aggregrate level, conglomerates have underperformed more focused companies both in the real economy (growth and returns on capital) and in the stock market.
But the median doens’t tell the entire story:
Some conglomerates did outperform many focused companies. The distribution’s shape of the conglomerates is chopped off on the upside, but not on the downside. Upside gains are limited because it’s unlikely that all of a diverse conglomerate’s businesses will outperform at the same time. Conglomerates are also usually made up of relatively mature businesses. This means they would not be likely to generate unexpected returns. But the downside isn’t limited, because the
This strategy can create value, but only if a company is the best possible owner of businesses outside its core industry.
To boost growth when a company reaches a certain size and maturity, executives will be tempted to diversify. Although a few talented people have proved capable of managing diverse business portfolios, most executives and boards today realize how difficult it is to add value to businesses that aren’t connected to each other in some way. As a result, unlikely pairings have largely disappeared.
Still many executives believe that diversifying into unrelated industries reduces risks for investors or that diversified businesses can better allocate capital across businesses than the market does – without regard to the skills needed to achieve these goals. Because few have such skills, diversification instead often caps the upside potential for shareholders but doens’t limit the downside risk. In practice, the best-performing conglomerates do well not because they’re diversified but because they’re best owners, even of businesses outside their core industries.
Limited upside, unlimited downside
Reducing volatility by diversification doesn’t benefit the shareholder. The shareholder can do this by for example an mutual fund. At an aggregrate level, conglomerates have underperformed more focused companies both in the real economy (growth and returns on capital) and in the stock market.
But the median doens’t tell the entire story:
Some conglomerates did outperform many focused companies. The distribution’s shape of the conglomerates is chopped off on the upside, but not on the downside. Upside gains are limited because it’s unlikely that all of a diverse conglomerate’s businesses will outperform at the same time. Conglomerates are also usually made up of relatively mature businesses. This means they would not be likely to generate unexpected returns. But the downside isn’t limited, because the