Rethinking the “diversification Discount”

Source: http://blogs.ft.com/donsullblog/2010/01/30/rethinking-the-diversification-discount/#axzz1lpJKfiup

Rethinking the “diversification discount”

Academics, managers, and investors agree with near unanimity that corporate diversification destroys value. In their best-seller, In Search of Excellence, Tom Peters and Robert Waterman argued managers should “stick to the knitting” by focusing on the business they know best. Their argument presaged a series of management articles and books using different terms–including “core competency,” “unbundling the corporation” and “profit from the core“–to make the same point: Firms should focus on activities and markets where they have a sustainable competitive advantage. Diversification, according to this line of thought, dissipates attention and resources and breeds complexity. Outsourcing, off-shoring, and alliances allow firms to offload peripheral activities and focus narrowly on discreet activities where they excel.

A series of studies by financial economists documents a correlation between diversification economic value destruction. Philip Berger and Eli Ofek find that diversified firms trade at a discount of approximately 15% compared to focused competitors in the same industry. Larry Lang and René Stulz show that a firm’s diversification is negatively correlated with its Tobin’s Q (a firm’s market value divided by the book value of its assets). Hemang Desai and Prem Jain find that increasing corporate focus by selling divisions outside a company’s core business creates approximately 50% higher returns to shareholders over a three-year time frame compared to spin-offs that do not refocus the firm. Angela Morgan and her co-authors found mergers and acquisitions that decreased corporate focus, on average, reduced a firm’s relative shareholder valuation by 25% over a three year period, and that every 10% increase in diversification through M&A activity was correlated with a 9% decrease in valuation.

Financial economists attribute the “diversification discount,” in large part, to poor resource allocation within conglomerates.  Senior executives in diversified firms use the cash generated by profitable divisions to subsidize under-performing units. I refer to this as peanut butter approach to resource allocation, when managers spread resources evenly like peanut butter on a slice of bread. Executives often misallocate resources in an attempt to preserve a sense of fairness within a firm and to avoid the unpleasant consequences of disinvestment.  David Scharfstein finds that diversified conglomerates tend to under-invest in their most promising businesses (measured by Tobin’s Q) and over-invest in their declining businesses compared to pure play rivals. In another study of capital budgeting within the firm, Owen Lamont found that diversified oil firms scaled back their investments in non-oil subsidiaries, not because these units were less attractive, but because of cash flow constraints in the core business.  Another study by my colleague Henri Servaes and co-authors finds that misallocation of resources grows more likely as the the level of diversification increases.