A Thread on Diversification

Posted on by fundooprofessor

My friend Shyam, wrote an excellent column on diversification. I agree with everything he has written and have some additional thoughts.

Thread…

A Thread on Diversification

  • Diversified conglomerates get a bad rap for very good reasons. One big one, as Shyam points out, is capital misallocation.Companies in diverse industries have, for the most part, destroyed value by allocating precious capital into businesses in which they had little experience.
  • We know this for sure. If a standalone business misallocates capital, then over time, it will wither and die and its value will become zero. This does not happen with businesses residing inside large conglomerates. The capital misallocation continues and the value actually becomes negative.
  • This is an important aspect regarding valuation in conglomerates. The value of a lousy, stand-alone business can never be negative. The least it can go to is zero. But that’s not true for lousy businesses residing INSIDE a conglomerate.
  • Management continues to throw good money after bad and markets punish such companies by valuing them at a discount to their break-up values. We call this “conglomerate discount.” By applying this discount, markets, in effect, assign a negative value to the lousy businesses which should have been shut long ago but which continue to operate thanks to funding from the good businesses in the conglomerate.
  • In markets like India, where many listed conglomerates are controlled by families which have significant equity stakes in them, this “conglomerate discount” persists because activist investors cannot take them over, eliminate the cross subsidies, and break them up.
  • For investors, these situations are what we call as an illustration of “value traps.”
  • The STATED intention of the management for diversification is always the same: that it’s a shareholder-friendly act. But, it’s almost always not a shareholder-friendly act. The UNSTATED intention is that through diversification, controlling stockholders can build bigger empires which is what, deep down, they really want and that’s why they almost never compare the economics of retaining earnings for diversification with that of giving the money to stockholders so they could compound it themselves.
  • Indeed, for value investors who don’t believe in Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT) with all their greek letters (me included), there is one big and important lesson from these theories. And that lesson is this: Investors can get the benefit of diversification in their own portfolios more efficiently than companies can do on their behalf.
  • But there is one aspect of the stated rationale for diversification which requires our attention. Managements state that diversification will make cash flows more stable. If a steel company gets into the retail business and if two earnings streams have low co-relation, then the combined cash flows will be less volatile that the volatility of each earning stream.
  • Why do we need to pay attention to this rationale? Because it’s the key for understanding the benefits of diversification if we broaden our understanding of the term.
  • Think of a hotel or a theme park company which has one property. Or a B2B manufacturing business with only 5 customers in the same industry. Or a manufacturing company which requires a critical raw material for its operations but has only two vendors for it. Or an FMCG company with just one product.
  • We know that often, this type of concentration – geographical, customer, vendor, or product can have devastating outcomes.
  • In a brilliant interview, value investor Anthony Deden talks about the risk from this “dependence.”  He says: “Dependence makes a system fragile. The more independent an organism is from external weaknesses, the more likely it will endure.”
  • When we think of risk, we should think of worst case scenarios and the CONSEQUENCES of those scenarios materialising. A lot of the people don’t like to think about remote loss scenarios. They like to think along these lines: “Oh that’s scenario is never gonna happen, so there’s not point thinking about its consequences.”
  • Wrong. That’s a totally wrong way to think. People massively underestimate the importance of remote loss scenarios by focusing on the low PROBABILITY of their occurrence instead of focusing on the CONSEQUENCES of their occurrence.
  • What’s the risk of having just one hotel, or just one theme park, or only 5 customers, or only 2 vendors, or just one product? The risk, of course, is that if something adverse happened to any of those “things”, the financial consequences could be deadly.
  • To be sure, there will always be examples of such situations where there was acute concentration and yet it lead to huge success. Coca Cola, for example. In fact it can be argued that intense focus is good. And that people with intense concentration do better than those who are distracted by diversification. And there’s an element of truth in that.
  • But even if it’s true that extreme focus is good, it’s even more true that averaged-out outcomes of over-dependence on a key variable makes the over-dependent entity fragile, it makes it accident prone and accidents happen.
  • The NORMAL outcomes in these situations are not good. If you take a hundred fragile businesses which have just one product, once in a while, you will find a Coca Cola, but a huge majority of those business would have died because of over-dependence on just one product.
  • So, let’s focus on the AVERAGE outcomes or the MOST LIKELY outcomes instead of the exceptional ones which stand out. How should businesses deal with this fragility?
  • Through diversification of course. Any business leader who is acutely aware of a source of fragility in his or her business model, will work towards finding ways to mitigate it.
  • For that business leader, this almost always involves taking very tough decisions. Saying no to a very large customer who wants to give you additional business is never going to be easy. Sacrificing near term profitability for longevity is never going to be an easy trade-off. But it is exactly here that you separate the men from the boys.
  • Which brings me to an important valuation principle which is this: Given two, otherwise identical investment situations, you should pay more for the one which is less fragile.
  • Example: Take two companies A and B. Both are in the same industry. Both have identical fundamental ratios – margins, capital turns, return ratios, revenues, market share, capital structure, etc. The only difference is that A has 5 customers and B has 15.
  • Which one should you should pay more for? Company B, of course. The reason is that the downside risk is lower for Company B.
  • Ok, now here is one of my key points. What’s the difference between diversification of the type that Shyam has written about and the diversification that reduces fragility from geographical concentration, customer concentration, vendor concentration or product concentration?
  • Conceptually, don’t the two appear to be the same? After all, both reduce dependence. In the type of diversification Shyam wrote about, the stated logic is that through diversification into other industries, the company becomes less dependent on a single source of earnings.
  • Similarly, when a company moves from one income producing asset to multiples one, from just five customers to 15, from just two vendors for a critical input to 5, and from making and selling one product to 7 products, isn’t it reducing dependence on a key business variable?
  • If these two situations are the same, then a question arises and they question is this: Why, on one hand, should investors pay more for a company which reduces fragility from dependence on a single variable, while on the other hand, pay a discounted price for a diversified conglomerate?
  • This is a seemingly paradoxical question which I will not answer here because I want to leave some mystery for you to work on. 🙂 One hint though: The answer is there in Shyam’s column.
  • Will end this thread by two examples. One is that of a company called Western India Palm Refined Oils. A few decades ago, if that company had not diversified from edible oils into IT Services, we would not have heard much about that same Indian company now called WIPRO having a current market cap of USD 25 billion.
  • Finally, if a guy called Jeff had not diversified away from books, we would not have seen an American company reach a market cap of almost one trillion dollars.

End

Published by fundooprofessor

I am Distinguished Adjunct Professor at Flame University, Pune. Previosuly, I was Adjunct Professor at MDI, Gurgaon, where I taught MBA students two popular courses titled “Behavioral Finance & Business Valuation"(BFBV) and Forensic Accounting and Corporate Governance (FACG) for many years. I am also Managing Partner at ValueQuest Capital LLP— an investment advisory boutique which helps its clients invest their capital in good quality businesses.

18 thoughts on “A Thread on Diversification”

  2. Diversification and concentration – both involve huge risk, intelligence to understand the variables underlying and how to mitigate them.
    In fact, all promoters/industrialists every where in the world would always like to ‘diversify’ and therefore ‘expand’ their businesses and the only way to ‘nurture’ those new businesses is to ‘append’ them an existing, large, profit making business so that it can crawl, come up, face initial teething troubles and then come on its own when probably, it would be right time to hive it off into a separate company.
    Look at the way, HDFC Ltd has/had nurtured some of the great companies (though in the same BFSI space), like, HDFC Bank, HDFC AMC, HDFC Life, etc.
    Look at Bajaj Auto (the earlier undivided Bajaj Auto) which nurtured all the new businesses and finally (though more probably due to family separation then with an intended objective) spun off these new businesses into separate companies.
    Look at Aditya Birla Capital (which is a holding company/conglomerate into all kinds of BFSI space); which will eventually hive off all the verticals at an opportune time to unlock value.
    Look at RIL – the mega conglomerate. Do you think Reliance Jio would have come off on its own with a staggering investment of more than $40 bn into it – on its own. No way. It needed the strong balance sheet, cash flow and support of RIL to make that massive investment. Now, at an opportune time, it is trying to hive off/disinvest these new verticals into separate companies.
    And on of that, the most important argument in favour of conglomerate is that it reduces the tax liability because of initial year losses incurred by the young business verticals which are negated at the company level balance sheet consolidation and net tax liability thereby not only lowering the tax liability but increasing the cash flow also.
    We did not have the luxury of VC/PE funding some 20-30-40 years ago who would ‘pump’ in colossal sum of money into new business ventures like what owners/investors of Flipkart did. Do you think Flipkart would have survived even its first year of operation if it was not backed by VC/PE investors. But these are new concepts in this modern era which did not exist some 40 years back.

  3. Hi Prof. Bakshi,

    Do investors pay more for a company that reduces fragility from dependence on a single variable because the company is diversifying within its circle of competence?

    Similarly they pay a discounted price for a diversified conglomerate because the conglomerate has diversified into an industry that’s outside its domain of expertise in an area where it has little or no experience?

  4. Was Alok Industries the textile company that Mr. Shyam Sekhar was referring to in his article?

  6. My few cents here…

    What makes understanding a conglomerate difficult is that – there are not only multiple businesses – but multiple sectors involved
    When multiple sectors get involved, then various moving parts come to play which makes it difficult to get hold on to the biz model
    Each sector could be of different types – stable and predictable, cyclical, govt and policies dependent, forex fluctuation or crude dependent etc., etc.,
    Then comes the management – each business’ management has to be analysed separately in light of the related sectors.
    Then comes the valuation – SOTP valuation – each business has to be valued separately / DCFed, arrive at a number and compare with market cap.

    Then comes the management – each business’ management has to be analysed separately in light of the related sectors.
    Then comes the valuation – SOTP valuation – each business has to be valued separately / DCFed, arrive at a number and compare with market cap.

    But, I think unrelated diversification is the problem.
    For ex, When a pharma company gets into real estate Or, an infrastructure company venturing into specialty chemicals business could possibly seen as a problem.

    But, what about related diversification?

    I don’t think that would be much of a problem
    For ex, a paint company moving to varnishes, adhesives etc., a hospital business getting into medical devices or chain of medical stores business, a hotel business getting into online travel agency etc.,
    Such companies can be comparatively easier to analyse and understand and value.

    Amazon is one example who was into both unrelated and related business and successful in both
    Related – Online selling of books and moved to selling anything online – core ecommerce biz model like, buy – store – sell (or) aggregator
    Unrelated – AWS/Cloud, Devops tools, Primevideo, Tablets, Kindle, Alexa, Music etc.,

    Even in investing, many great investors have suggested concentrated portfolio & within circle of competence. That is, diversify only within your circle of competence – the easier way to do this is to keep our circle of competence in related sectors and to diversify into those for investing.

    Comments are welcome…

    1. Yes, diversifying in your circle of competence is of course a prerequisite. But, then, what about RIL going into Jio. There is absolutely no synergy and circle of competence.

      1. My point is not that unrelated diversification will never work. It is rare…
        High probability of success is with related diversification
        Thanks

    2. There’s a beautiful passage in a wonderful chapter called The Adjacent Possible in Steven Johnson’s book, Where Good Ideas Come From and it goes like this:

      “The strange and beautiful truth about the adjacent possible is that its boundaries grow as you explore those boundaries. Each new combination ushers new combinations into the adjacent possible. Think of it as a house that magically expands with each door you open. You begin in a room with four doors, each leading to a new room that you haven’t visited yet. Those four rooms are the adjacent possible. But once you open one of those doors and stroll into that room, three new doors appear, each leading to a brand-new room that you couldn’t have reached from your original starting point. Keep opening new doors and eventually you’ll have built a palace.”

      This is how Amazon was built…

      1. Many thanks for your reply sir…

        I understand this as a sort of related diversification to start with – you get hold of one business and slowly and steadily move into related areas (adjacent doors)…

        For ex., a company runs chain of hospitals – can move into – medical devices – pharma – medical devices – etc., etc., – all these are adjacent doors

        As they keep doing this they may also land up having their own software developed or customized to manage their conglomerate – then sell that software to other hospital chains etc.,

        This may be an unrelated diversification – but, eventually came into being because of continuous related diversification

        Sorry if my example is not perfect.

        Also, noted the book Sir… will find an opportunity to read asap.

  7. Sir,
    I think the clue you are referring to is availability of cheap capital.

    At the outset of a new venture, it’s very very hard to say how the new ‘diversifying’ venture is going to work out. So how do we then assess?

    In my opinion the way to assess is to look at the track record. Does the management have a track record of diversifying? Have they closed unpromising ventures? A capital allocator like Jeff Bezos probably puts a very high hurdle rate on capital. Therefore ventures that don’t generate IRR more than the hurdle rate are closed down while those that show promise get more funding. So, you see, Amazon has available capital but does not treat it as cheap.

    Unlike Bezos, when capital allocators treat retained earnings as a source of cheap capital, they are unwilling or unlikely to spot diversification mistakes and take longer to rectify them.

    Reminds me of what Buffett said:

    “Unrestricted earnings should be retained only where there is a reasonable prospect — backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future — that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

  8. amazon may be diversifying on the surface, but its all tightly coupled to true customer obsession and the flywheel effect. amazon always plays in markets which are humungous -trillions of dollars and big enough to have multiple winners. they take outsize bets -experiments many of which flop spectacularly. but when one of the succeeds, it hits the jackpot providing more experience and capital to do more experiments. most companies diversify because some external consultant tells them to do so. all in all, its the amazon culture which drives its capital allocation .its very unique. google for example is a technology led company. amazon is not. amazon’s true north star is customer obsession

  9. Sir – thank you sharing your wisdom through this post!

    “If these two situations are the same, then a question arises and they question is this: Why, on one hand, should investors pay more for a company which reduces fragility from dependence on a single variable, while on the other hand, pay a discounted price for a diversified conglomerate?”

    My guess is – pay more for prudent capital allocation which reduces fragility while at the same time creating value for the investors. Pay less because of capital allocation blunders in conglomerate.

  10. Good Morning Professor,

    Thanks for wisdom packed articles to you as well as to Shyam.

    Seems, IBC is the factor you are pointing to.

    In “Diversification that reduces fragility from geographical concentration, customer concentration, vendor concentration or product concentration”, will require comparatively less capital and can be easily funded from internal accruals by a company having strong cash flow that we are talking about, hence, least requirement of additional debt and even in worst case if it failed in its attempt of diversification, no fear of getting draged to IBC as there is no much debt.

    However, in another scenario, when diversification is fueled by cheap debt (as capital) and if it failed then consequences are “Zero Equity” under Post IBC era. No matter how cheaply debt was raised, one realises it’s cost (especially minority shareholders) only when it’s dragged in IBC by lenders.

    Regards,
    Gaurav.

  11. Sir,

    What about the companies that focus on their core business but create unnecessary Subsidiaries/JVs/Associates in the name of ‘optimisation’ of operations and then enter into very nominal transactions with them?

    How to value these kinds of companies? (Most of the time Financials of these are not given separately with the financials of Parent co.)

    BTW, how creating subsidiaries/JVs etc. results in ‘optimisation’? If you can please throw some light on this?

    Regards
    Nitin Singhal

  14. Dear Professor,
    Many thanks for your valuable pointers on “Diversification”.

Comments are closed.