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Diversification Strategy. OUTLINE. Introduction: The Basic Issues The Trend over Time Motives for Diversification - Growth and R isk Reduction - Shareholder Value: Porter’s Essential Tests. Competitive Advantage from Diversification Diversification and Performance: Empirical Evidence

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Diversification strategy
Diversification Strategy

OUTLINE

  • Introduction: The Basic Issues

  • The Trend over Time

  • Motives for Diversification

    - Growth and Risk Reduction

    - Shareholder Value: Porter’s Essential Tests.

  • Competitive Advantage from Diversification

  • Diversification and Performance: Empirical Evidence

  • Relatedness in Diversification


The Basic Issues in Diversification Decisions

Superior profit derives from two sources:

INDUSTRY

ATTRACTIVENESS

RATE OF PROFIT

>COST OF CAPITAL

COMPETITIVE

ADVANTAGE

  • Diversification decisions involve these same two issues:

  • How attractive is the sector to be entered?

  • Can the firm achieve a competitive advantage?


Diversifi cation among the us fortune 500 1949 74
Diversification among the US Fortune 500, 1949-74

70.2 63.5 53.7 53.9 39.9 37.0

29.8 36.5 46.3 46.1 60.1 63.0

Percentage of Specialized Companies (single-business,

vertically-integrated and dominant-business)

Percentage of Diversified Companies (related-business

and unrelated business)

Note: During the 1980s and 1990s the trend reversed as large

companies refocused upon their core businesses

1949 1954 1959 1964 1969 1974


Diversification among Large UK Corporations, 1950-93


Diversification the evolution of management thinking a nd management practice
Diversification: The Evolution of Management Thinking and Management Practice

MANAGEMENT

GOALS

Quest for Growth

Financial

problems of

conglomerates

Refocusing on

shareholder

value

Competitive

advantage through

Speed, flexibility,

and capability

Rise of conglomerates

Related diversification

by industrial firms

Emphasis on“related’

& “concentric”

diversification

Refocusing on

core businesses

Divestment

Joint ventures,

Alliance, corporate

venturing

COMPANY

DEVELOPMENTS

Value based

management

Transaction

cost analysis

Portfolio

planning

models

Analysis of

economies of

scope &

“synergy”

Financial Analysis

STRATEGY TOOLS

& CONCEPTS

Diffusion of

M form structures

Core

competences

Dynamic

capability

Capital asset

pricing model

Development of corporate planning systems

Dominant logic

1950 1960 1970 1980 1990


Motives for diversification
Motives for Diversification

GROWTH --The desire to escape stagnant or declining industries a powerful motives for diversification (e.g. tobacco,

oil, newspapers).

--But, growth satisfies managers not shareholders.

--Growth strategies (esp. by acquisition), tend to

destroy shareholder value

RISK --Diversification reduces variance of profit flows

SPREADING --But, doesn’t create value forshareholders—they can

hold diversified portfolios of securities.

--Capital Asset Pricing Model shows that diversification

lowers unsystematic risk not systematic risk.

PROFIT --For diversification to create shareholder value, then

bringing together of different businesses under

common ownership & must somehow increase

their profitability.


Diversification and shareholder value porter s three essential tests
Diversification and Shareholder Value: Porter’s Three Essential Tests

If diversification is to create shareholder value, it must meet three tests:

1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive).

2. The Cost of Entry Test: the cost of entry must not capitalize all future profits.

3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa. (i.e. some form of “synergy”must be present)

Additional source of value from diversification: Option value


Competitive advantage from diversification
Competitive Advantage from Diversification Essential Tests

  • Predatory pricing/tie-in sales Evidence

  • Reciprocal buying of these

  • Mutual forbearance is sparse

MARKET

POWER

  • Sharing tangible resources (research labs, distribution systems) across multiple businesses

  • Sharing intangible resources (brands, technology) across multiple businesses

  • Transferring functional capabilities (marketing, product development) across businesses

  • Applying general management capabilities to multiple businesses

ECONOMIES

OF

SCOPE

  • Economies of scope not a sufficient basis for diversification ----must be supported by transaction costs

  • Diversification firm can avoid transaction costs by operating internal capital and labor markets

  • Key advantage of diversified firm over external markets--- superior access to information

ECONOMIES

FROM

INTERNALIZING

TRANSACTIONS


Competitive advantage from diversification1
Competitive Advantage from Diversification Essential Tests

  • Predatory pricing Evidence

  • Reciprocal buying of these

  • Mutual forbearance is sparse

MARKET

POWER

  • Sharing tangible resources (research labs, distribution

  • systems) across multiple businesses

  • Sharing intangible resources (brands, technology) across

  • multiple businesses

  • Transferring functional capabilities (marketing, product

  • development) across businesses

  • Applying general management capabilities to multiple

  • businesses

ECONOMIES

OF

SCOPE

  • Economies of scope not a sufficient basis for diversification—must be supported by transaction costs

  • Diversification firm can avoid transaction costs by operating internal capital and labor markets

  • Key advantage of diversified firm over external markets--- superior access to information

ECONOMIES

FROM

INTERNALIZING

TRANSACTIONS


Relatedness in diversification
Relatedness in Essential TestsDiversification

Economies of scope in diversification derive from two types of relatedness:

  • Operational Relatedness-- synergies from sharing resources across businesses (common distribution facilities, brands, joint R&D)

  • Strategic Relatedness-- synergies at the corporate level deriving from the ability to apply common management capabilities to different businesses.

    Problem of operational relatedness:- the benefits in terms of economies of scope may be dwarfed by the administrative costs involved in their exploitation.


Branson & the Virgin Companies: Making strategic Essential Tests

sense of apparent entrepreneurial chaos

  • KEY RESOURCES

  • Virgin brand

  • Branson

  • -charisma/image

  • --PR skills

  • -networking skills

  • -entrepreneurial flair

  • DOMINANT LOGIC

  • Seek competitive advantage by start-up cos.

  • pursuing innovative differentiation in

  • underserved market with sleepy incumbents

  • CHARACTERISTICS OF

  • MARKETSTHAT CONFORM

  • TO THIS LOGIC

  • consumer

  • dominant incumbent

  • scope for new approaches

  • to customer service

  • high entry barriers to other

  • start-ups

  • Branson/Virgin image

  • appeals to customers

  • DESIGNING A CORPORATE STRATEGY

  • & STRUCTURE

  • What’s the business model?

  • (Does Virgin create value by

  • being an entrepreneurial incubator,

  • a venture capital fund, a

  • diversified corporation, or what?)

  • Which businesses to divest?

  • Criteria for future diversification

  • What type of structure?—Is there

  • a need for greater formalization?


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