Tuesday, July 03, 2007

A finger in every pie

Every bull market bring back some old ghosts. Unrelated diversification - as they came to be known is slowly making a comeback. As a strategy, if you thought it had been restricted to giants such as Bharti, Reliance, the UB Group and ITC, think again. Smaller Indian companies, too, are expanding their portfolios.

But there are arguments for and against.

John Matsusaka’s “Corporate Diversification, Value Maximization, and Organizational Capabilities” (Journal of Business, 2001) develops a model in which firm capabilities are unknown ex ante, must be discovered over time as entrepreneurs experiment with different combinations of business units. Hence in a cross-sectional analysis diversified firms may appear to underperform more focused firms, but the unrelated diversification is a necessary step toward the discovery of future capabilities, and is thus value creating.

My own experience tells me unrelated diversification may occur when firms possess excess capacity in “headquarter services.” The conglomerate’s central office, like a consulting firm, provides specialized support and advising services to its portfolio companies, creating value even when there are no operational synergies among the operating units.

Bet big on luck too…

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