General Motors looks as if it is about to make a three-point turn. The world's largest car company is in talks to sell its Electro-Motive locomotive division. If the sale goes ahead, GM will be able to concentrate on building cars and trucks for the first time since the 1920s.
The surprise is that it has taken so long. For 25 years, management gurus and investors have been imploring US companies to sell their non-core businesses. It has become an article of faith that focus is good.
But the choice between diversification and focus is less clear-cut than it might seem. Recent studies have cast doubt on the widely accepted notion that the stock market values diversified companies at a discount. Moreover, the way in which most investors measure diversification - by reference to broad industry sectors - can be misleading.
Diversification was not always unfashionable. Roll back to the 1970s and the US stock market was dominated by conglomerates such as General Electric, Westinghouse and Texas Instruments. As well as cars, trucks and locomotives, GM served up everything from Frigidaire home appliances to earthmoving equipment.
The poor performance of the US economy through the 1970s created pressure for change. Investors, angry at the dismal performance of US equities for much of the decade, pressed for radical action to improve returns - even if that meant the break-up of big companies.
Evidence also emerged that companies with focused strategies were more successful at withstanding the competitive onslaught from Japan. In In Search of Excellence, published in 1982 and arguably the first management blockbuster, Robert Waterman and Tom Peters advised companies to "stick to their knitting" - a recommendation based on a McKinsey survey of the best-performing US companies.
Thus the scene was set for the leveraged takeover boom of the 1980s, culminating in the forced, multi-billion dollar break-up of RJR Nabisco, the tobacco-to-cereals group. The proportion of US stock exchange-listed companies operating in a single industry increased from 38 per cent in 1979 to 58 per cent in 1988.
Unbundling continued during the 1990s, often through voluntary spin-offs rather than hostile takeovers. Thus Texas Instruments got out of home computers and defence electronics to focus on semiconductors; Westinghouse evolved into CBS, the media group; Imperial Chemical Industries spun out its pharmaceuticals business; and Hanson, a predator during the 1980s leveraged takeover boom, dismantled itself.
The snag for believers in focus is that conglomerates - GE, Berkshire Hathaway, Siemens - have continued to top polls of the world's most respected companies. Moreover, academics are divided on the question of whether diversified companies underperform on average.
In a landmark paper published in 1995, Philip Berger and Eli Ofek found that diversified companies were valued by the US stock market at a discount of between 13 per cent and 15 per cent to the imputed value of their parts. Evidence for a similar but smaller "diversification discount" was found in the UK and Japan.
There are many plausible reasons for such a discount. Most academics blame so-called "agency conflicts". A conglomerate structure, it is argued, gives managers opportunities to act in ways that are detrimental to shareholders. For example, they might allocate capital according to criteria that have more to do with empire-building than superior returns. Yet recent research has cast doubt on whether the discount exists at all. A study led by John Graham, a financial economist at Duke University, found that businesses acquired by conglomerates tend to be underperforming - and therefore valued at a discount - in the first place. This implies that diversification does not, in itself, destroy value. "Is there a diversification discount? The jury is still out," he says.
Moreover, there is scant evidence of agency conflicts. According to one recent paper by Chris McNeil and other academics, managers of poorly performing business units within diversified companies are more likely to lose their jobs than chief executives of stand-alone companies. This implies that conglomerates act more quickly than equity markets when faced with evidence of under-performance.
Another reason for caution is that each of these studies measured only one dimension of diversification: the number of industry sectors (measured by standard industrial classification codes) in which a company operates.
Managers deciding whether to expand into a new market must also consider the nature of the business in terms of capital intensity, purchasing behaviour, the competitive characteristics of the market and a host of other factors.
For example, International Business Machines would on many measures be viewed as highly focused, since it concentrates on selling information technology products and services to corporate customers. Yet the group spans everything from semiconductors - a deeply cyclical, capital-intensive business with long planning horizons - to management consulting. Does that make Big Blue a specialist or a quasi-conglomerate?
Gary Hamel, visiting professor at London Business School, says: "Diversification as it is classically defined [according to industry sector] tells you very little about how well a company is run. You need to drill down much, much deeper before deciding whether a strategy makes sense."
TAKE SLOW AND STEADY STEPS WHILE YOU GROW - OR YOU COULD FALL FLAT ON YOUR FACE
If focus is good and diversification bad, how are companies expected to grow?
• In ‘Beyond The Core’ (2004), Chris Zook, head of the strategy practice at Bain Co, the consultancy, argues that most successful growth initiatives take place in markets that are adjacent to a company’s existing business. This can mean finding new customers for existing products, offering new products to existing customers, offering existing products to existing customers through a new channel and so on.
Problems arisewhen companies try to take two or three steps at once - for example, offering existing customers a new product through a new channel.
His message is: think carefully and move steadily. Big leaps into unknown markets are likely to fail.
• In ‘Leading the Revolution’ (2000), Gary Hamel, avisiting professor at London Business School, argues for a more radical approach. He thinks ideas for new businesses are as likely to come from within companies asfrom a strategy committee. The trick is to findways to harness the creative energy.
But, like Mr Zook, he warns against big bets in markets where the organisation has little experience.
• Even measured moves into adjacent markets can end in disaster. A common pitfall is to allow management attention to be drawn away from the core business. In the 1990s, Ford expanded into automotive servicesand acquired brands such as Volvo and Jaguar. But it neglected to develop world-class models for its core car business. This cost Jac Nasser his job as chief executive.
GM faces similar issues in its core business, even as it starts to focus on cars and trucks. For evidence of how much work needs to be done, just get behind the wheel of a new Pontiac or Saturn.
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