Starting in the late 1980s, a de-diversification wave swept through corporate America, on the premise that conglomerates and highly diversified companies would perform better by focusing on their core businesses.
At first this strategic shift brought benefits: academic research undertaken at the time found that all this refocusing was, on balance, beneficial for companies. The rationale for it was clear enough: in developed economies where financial markets are quite efficient, investors do not need companies to diversify the risks for them, because they can do that more easily and efficiently themselves. And that, of course, is true: investors can create their own portfolios and divest and redeploy their financial resources at will.
But as time passed, corporate refocusing has started displaying the hallmarks of a management fad, and possibly even a harmful one: firms engage in refocusing because that is what everybody does. The fact that analysts find it easier to analyze and value single-business firms than diversified ones provided even more pressure to refocus.
Is it time to rethink the case for diversification?
The problem is that de-diversification has spread to companies that, from a strategic viewpoint, are already quite focused, even though they may be in different lines of business. For example, the Dutch electronics giant Philips used to be in businesses such as television, audio, consumer electronics, lightning, medical technology, semiconductors, and semiconductor printing machines. A diverse portfolio of businesses to be sure, but all of them connected by a common technology: electronics. Yet, Philips also felt the pressure to de-diversify and is nowadays firmly focused on health-tech. Many other companies have pretty much become single-business firms.
What analysts and consultants seem to have underestimated is that capital is not the only resource that can be redeployed and reconfigured within a diversified corporation. Business school academics have long argued that the logic of diversification is not only about risk reduction: companies diversify into new markets in order to exploit underutilized assets or competences from another business that they cannot easily sell or exploit in the open market.
Research on “institutional voids,” for example, has shown how intangible resources, such as reputation, can be better leveraged and exploited within the confines of a multi-divisional corporation than through a market mechanism. Innovation benefits as well: managers can more easily recognize and capitalize on business opportunities when they fall within the boundaries of a diversified firm than when they occur in the open market. Put differently, the markets for ideas, technologies, and intangible resources often fail and can be inefficient in comparison to sharing and coordination within an organization, even if this company consists of multiple, autonomous divisions.
Consider, for example, the company Euronet (disclosure: one of us has worked with them). The company has three divisions: an electronic funds transfer division (EFT), which is largely focused on operating ATMs; an epay division, which is focused on providing payment transactions for retailers, such as payment codes, vouchers, and digital wallets; and a money transfer business, which enables cross-border payments. These three divisions operate autonomously and Euronet’s top management has wisely refrained from formulating and issuing a joint strategy statement.
The international money transfer industry, however, has been undergoing enormous change over the past years, with more expected: new entrants and apps, by companies such as Wise, OFX and Moneycorp have been attracting large numbers of customers to their user-friendly platforms; cryptocurrencies are increasingly being used for international peer-to-peer money transfers; and the use of electronic payments has risen sharply, particularly in emerging economies.
Euronet’s money transfer business, however, has been able to innovate and respond to these changes in ways that it would not have been able to do had it not had access to the capabilities and resources of the EFT and epay divisions in the Euronet portfolio. It recently launched a new platform, called Dandelion, which not only transfers money abroad (as all other players in the industry do), but is able to do so in real-time because it uses the network and the regulatory framework of its parent’s EFT division, including credit, debit, and cash delivery functions. Moreover, by combining Dandelion with the products and technology of its epay division, Euronet gives customers the opportunity to link it directly to their digital wallets and make payments, top up mobile phones and pay bills.
What allowed Euronet to respond successfully to the significant changes taking place in its industry was its ability to quickly bring together people and technology from different parts of the firm and innovate. Such transfer and recombination of knowledge would have been almost impossible if the three divisions were spun off as independent companies.
Similarly, before Philips had spun off most of its divisions to focus on health tech alone, it had developed several breakthrough innovations by combining knowledge and technology from its different divisions. For example, the “ambient experience” innovation in its health tech division — something that led to very significant reductions in patient anxiety (and consequently to an 80% reduction in the use of sedatives and a 70% reduction in the need for re-scans) had originated from its lighting division (now spun off). Similarly, the Ambilight technology in its television division (now sold off) — a significant innovation and differentiator in an otherwise largely commoditized market — also came from the Lighting division. Furthermore, much of the technology necessary for the monitoring functions in its Health Watch range, which offers wearable devices for consumers, relied on knowledge and developers from its B2B Health tech division.
It is not just technology that gets leveraged across divisions: Philips has found that its brand and position in the professional sector enhanced the image and reputation of its products in its consumer products division (now partly sold off).
The examples of Euronet and Philips show that having multiple businesses, even when they are largely independent, creates superior options to potentially redeploy non-financial resources swiftly when environments change, or recombine them into novel innovative solutions.
Having options is particularly important in situations of uncertainty and creating them is not something the market, let alone individual investors, can easily do. Nor can we expect start-ups and corporate venture units to fill the void. Start-ups cannot easily tap into an array of existing technologies and knowledge sources at other companies, whereas corporate venturing and scouting units often struggle to apply the external technologies they have invested in. Consequently, the over-focusing of companies has resulted in an unfortunate decrease in a firm’s capability for change and adaptation, which owning a set of businesses can potentially bring. The continued emphasis on focus is particularly unfortunate because changes in the external context have now made diversification even more relevant than before.
Digital has made diversification more relevant.
Of course, there are costs to such diversification and to running a diversified firm: If the firm is seeking to exploit the intangible resource of reputation, for example, it will also have to acquire the complementary resources necessary for running the new business line. This may include technology, labor, or new supply chains. It might then have to operate a head office where all such expertise is present.
But these costs have been decreasing over the past decade, particularly because of the increased use of partnerships and business eco-systems to help implement a diversification strategy. For example, Vodafone can diversify into banking, in order to exploit its capabilities in mobile, without having to create banking products itself, because it operates with a constellation of partners. Of course, the option to work with other firms was available in the past as well, but coordination with other organizations has become easier, and with it more wide-spread, owing to digital technology, which has led to an increase in communication technology and technology standards, among others.
While digitization has decreased the costs of diversification, concurrently, it seems to have increased the benefits of diversification, particularly through the heightened importance of data as a strategic resource. Traditionally, underutilized resources become more difficult to exploit the further a company moves away from its core business. This is certainly the case for physical resources or technological knowledge, but even the benefits of an intangible resource such as reputation, for example, have limited spillovers if deployed in an industry very different from where it was originally created.
And then there’s data, which can often be leveraged in businesses very different from where it originated. For example, Alibaba has successfully moved into movies, using behavioral data generated through its e-commerce platform. Apple can harvest behavioral data from its Apple watch wearers, which it can analyze and utilize to develop insights about their nutrition, shopping, entertainment, or health.
The bottom line is this: with its costs decreasing and its benefits increasing thanks to digital technologies, the optimal level of diversification is rising. Hence, the de-diversification of firms over the past decade is taking place in a context where more diversification is warranted.
The focusing of many companies over the past decade, often done under pressure from boards, analysts and consultants, has gone too far. Innovative constellations of businesses may be difficult to analyze or value, but they also enable options for the future, for recombination and adaption in uncertain times. The forced focusing of companies over the past decades has deprived them of a crucial capability, and that is to be flexible enough to adapt to unpredictable changes. This, ultimately, affects their chances of success and survival.
This content was originally published here.