Diversification and portfolio management

1 . Introduction

Chapter 10 introduced Ansoff’s product/market matrix. Three of its quadrants – market penetration, product development and market development – keep the organisation reasonably close to what it already knows. The fourth quadrant, diversification, takes the organisation into new products in new markets, and it deserves a chapter of its own because it raises corporate-level questions: which businesses should the group be in at all, how should a portfolio of businesses or products be managed, and by what method (acquisition, alliance, organic growth) should expansion be achieved?

This chapter therefore covers three linked topics: the types of diversification, portfolio management (including the Boston Consulting Group matrix and value analysis), and the methods by which growth can be carried out. It ends with a syllabus requirement that is easy to overlook: choices made in different parts of the organisation must be integrated into one coherent strategy.

YouTube videoPlay video

2 . Types of diversification

Diversification can be related (the new activity has some genuine connection with the existing business) or unrelated. The diagram below places the four commonly examined types around an organisation’s position in its supply chain:

• Backward vertical integration – moving towards the sources of supply, for example by taking over or setting up a supplier.

• Forward vertical integration – moving towards the customer, for example by taking over or setting up a distributor or retail chain.

• Horizontal diversification – expanding into a related business at the same level of the supply chain, for example an airline acquiring a hotel chain.

• Conglomerate diversification – combining with a business that has no connection whatsoever with existing operations.

The first three are forms of related diversification; conglomerate diversification is unrelated. We deal with unrelated diversification first because it is the type an examiner (and an investor) should treat with the most suspicion.

3 . Conglomerate (unrelated) diversification

Conglomerate diversification means combining businesses which have no connection: a supermarket group joining with a house-building company, say. Ask the obvious strategic question: what is the benefit of putting these two businesses into one group?

The directors will usually offer two justifications, and both should be examined critically:

• ‘It gives shareholders a more stable pattern of returns.’ Diversification does tend to smooth the pattern of profits, because the two businesses’ fortunes are unlikely to move together. But this overlooks the fact that shareholders can diversify far more cheaply themselves: if they want a stake in both a supermarket and a house-builder they can simply buy shares in both companies. They do not need the companies to merge to enjoy a portfolio effect.

• ‘There will be synergy and cost savings.’ If the businesses are truly different it is hard to see where synergy would come from. Suppliers, processes, customers and skills are entirely different; there are few economies of scale in manufacturing, few opportunities for cross-marketing, and it is unlikely that even the head offices can usefully be combined.

Worse, unrelated diversification often destroys value. Head-office managers, almost to justify their existence, start meddling in subsidiaries whose industries they do not understand, applying inappropriate management styles to what had been a successful business. Groups that overpay for unrelated acquisitions frequently end up selling them back – sometimes to the original owners – at a fraction of the purchase price.

4 . Related diversification

4.1 Horizontal diversification

Horizontal diversification means expanding into a related business. A real example: the Scandinavian airline SAS at one time owned an international hotel chain. The link works commercially. Both businesses serve the travelling public, so knowledge and marketing skills can be shared, and cross-marketing is easy – a passenger booking a 6 a.m. flight on the airline’s website can be offered a room at the airport hotel the night before. Because the businesses are genuinely related there is a real chance that the combination achieves efficiencies through cost savings, shared expertise or better marketing.

4.2 Backward and forward vertical integration

Vertical integration looks superficially attractive. A manufacturer sells goods to a retailer for $10 and sees them on the shelf at $25, and thinks: ‘If I owned the shops, I could have my profit and their profit too.’ But strategy is rarely that simple. Consider the drawbacks:

• Different management skills. Making goods and retailing goods are different businesses. Being good at manufacturing does not make a company good at running shops, and there is a real danger of meddling inappropriately in the new subsidiary’s business.

• Loss of the discipline of the market. An in-house supplier knows that whatever it produces will be bought, so the pressure to control costs, maintain quality and innovate weakens. Compare that with keeping five independent suppliers competing for every order on price, quality and delivery – competition keeps them on their toes.

• Being locked in. If an outside supplier achieves a technical breakthrough – a better component, more cheaply made – a company tied to its own in-house supplier loses the freedom to switch.

Largely for these reasons, the modern preference runs the other way: concentrate on the core business – the activities where the organisation’s core competences really generate profit – and outsource the rest (component supply, payroll, the receivables ledger, internal audit, IT) to the best available specialist. Vertical integration can still be worthwhile in particular circumstances, for example where there is only one supplier of an essential component and integration is the only way to guarantee security of supply.

5 . Portfolio management: the Boston Consulting Group (BCG) matrix

Once an organisation has a collection – a portfolio – of products, subsidiaries or divisions, it needs a way of managing them as a set. The BCG matrix is the best-known portfolio analysis tool. It positions each product or business unit on two axes:

• Market (industry) growth rate – how fast the market as a whole is growing.

• Relative market share – the organisation’s market share divided by the market share of the largest competitor. A relative market share above 1 means the organisation is the market leader.

Take each quadrant in turn, and notice how the product life cycle runs underneath the whole model: products typically enter as question marks, become stars, mature into cash cows and are eventually divested.

• Question mark (problem child): build or get out. High market growth, but low relative market share. The high growth means the product has a future worth fighting for – but BCG’s argument is that a small player has no long-term future against competitors with dominant shares, whose economies of scale let them cut prices or outspend the small player on marketing and development almost at will. So the question is: divest, or invest to build market share towards a star position? Building is heavily cash-negative – promotion, product development and keen pricing all cost money before they pay back.

• Star: hold. High growth and high relative market share. This is less comfortable than it sounds. Precisely because the market is growing and the product is prominent, competitors are trying to take its share, so heavy spending on marketing, innovation and defence continues. Cash flow is therefore usually around zero: the strategy is to hold position until market growth slows.

• Cash cow: harvest. Market growth has slowed but the high market share remains. Development costs were written off long ago, the organisation is far down the learning curve and enjoys economies of scale – and competitors see little point attacking a product they regard as being near the end of its life, so defence is cheap. The product generates strong positive cash flow with only modest spending: harvest it.

• Dog: divest. Low growth and low share. There is no point spending time and money building share in a declining market, so exit – close the operation down or sell it to someone else. Note that cash cows do not turn into dogs: a cash cow keeps its high relative share, whereas a dog never had one.

5.1 Criticisms of the BCG matrix

• High market share is not everything. Many companies with small market shares are highly successful in the long term – Porsche’s share of the car market is tiny beside Ford, General Motors or Toyota, yet per car sold it is one of the most profitable manufacturers in the world. Much depends on how the market is defined: there is room for small, specialist suppliers making good profits year after year.

• Interpretation must not be black and white. If the dividing line between ‘high’ and ‘low’ growth is 10%, a fall in market growth from 10.1% to 9.9% reclassifies a star as a cash cow – but in reality almost nothing has changed, and it would be absurd to slash promotion and development spending overnight.

• The axes are crude proxies. Relative market share really stands for competitive strength, but brand, location, technology and other factors also confer strength. Market growth really stands for market attractiveness, which also depends on risk and the intensity of competition – a lower-growth but low-risk market might be preferred.

These criticisms do not make BCG useless, but – as with any model – care is needed in interpreting the results. No model guarantees the truth.

5.2 A balanced portfolio

Finally, return to the word ‘portfolio’. A portfolio consisting only of question marks has a funding problem: every product needs cash and nothing generates it. A portfolio consisting only of cash cows looks comfortable today, but in a few years those markets will decline and there is nothing coming through to replace the cash flows. A well-balanced portfolio therefore contains some cash cows and some question marks: the cash generated by the cows funds the building of the question marks, giving the organisation a succession of products coming through and securing its long-term future.

6 . Value analysis and value drivers

The syllabus asks for value analysis alongside portfolio analysis when choices are integrated into strategy. Value chain analysis (Chapter 7) asks where in the organisation’s chain of activities value is created. Value analysis asks a sharper question about each product, business unit or proposed option: what exactly do customers value in this offering, what does each element of that value cost to provide, and could the same value be delivered more cheaply – or more value delivered for the same cost? Features that cost money but that customers do not value are candidates for removal; features customers value highly are candidates for investment.

Behind any assessment of value sit value drivers – the factors that generate value for the organisation. These are examined further with the forecasting toolkit in Chapter 13, but note the distinction now:

• Tangible value drivers – physical and financial factors such as revenue growth, margins, capital efficiency and asset utilisation. These are relatively easy to measure from accounting data.

• Intangible value drivers – brand reputation, customer relationships, know-how, data, culture and innovation capability. These often create the majority of modern corporate value but need deliberately chosen non-financial measures (Chapter 12) if they are to be managed.

7 . Integrating choices into a coherent strategy

Strategic choices are generated and evaluated in many places: corporate level (which businesses?), business level (how do we compete?) and functional level (marketing, operations, HR, IT). The syllabus requires these individual choices to be integrated into a coherent whole. Integration means checking that:

• the choices are consistent with each other – a differentiation strategy in marketing is undermined by an operations plan built purely around cost-cutting;

• the portfolio as a whole is balanced and fundable – the BCG logic above: cash generators must cover cash users;

• trade-offs between choices are made explicitly – resources committed to one option are not available to another, so priorities must be agreed rather than left to emerge;

• the combined strategy still serves the organisation’s purpose, vision and values (Chapter 3).

The modern CGMA term for the mindset this requires is integrated thinking: deliberately breaking down silos so that decisions in one part of the organisation are taken with an understanding of their effect on all the resources and relationships – the ‘capitals’ – the organisation depends on. Integrated thinking, and the integrated reporting framework that grew out of it, are covered in Chapter 12 as part of strategic performance measurement.

8 . Methods of growth

Whatever direction of growth is chosen, there is a separate choice of method. Each method trades off speed, cost, risk and control differently.

8.1 Organic (internal) growth

The organisation builds the new activity itself: developing products, hiring staff and opening facilities using its own resources. Organic growth is comparatively low-risk and preserves culture and control, and the investment can be increased or halted in stages. It is, however, slow – often too slow where a market opportunity is closing or competitors are consolidating – and the organisation must already possess (or be able to develop) the competences the new activity needs.

8.2 Purchase of subsidiaries and mergers

Acquisition means buying 100% – or at least a controlling interest – in a supplier, distributor, competitor or unrelated company; in a merger two companies combine. Growth is immediate: market share, brands, staff and know-how arrive on day one. But cash has to be paid, or shares issued, to the owners of the acquired business, with funding implications, and acquirers commonly overpay. Integration of systems, cultures and management is where many acquisitions fail.

8.3 Joint ventures

In a joint venture, two (or more) companies typically establish a third company, contributing cash, assets, know-how and personnel. Joint ventures suit large projects requiring high amounts of capital, high risk-bearing capacity and a mix of skills: the burden of finance and risk is spread, and choosing partners carefully assembles the right combination of skills. It is important at the outset that all parties know exactly what is expected of them, how profits are to be shared, how decisions will be made and how exit from the venture will be managed – disputes between partners are the classic cause of failure.

8.4 Licensing

Under a licensing arrangement one company grants another the right to use a process, product design or trade name in return for royalties. Brewing is a common example: a Belgian brewer licenses a UK brewery to make its beer for the UK market. For the licensor this is a low-risk, low-investment way to grow – income is earned from royalties without the cost and risk of building production and distribution overseas – though quality and brand reputation are placed partly in the licensee’s hands.

8.5 Franchising

A franchise is a more involved type of licensing agreement, common in retail and fast food. The franchisee buys the franchise and runs the day-to-day operations; the franchisor provides the trade name, the business format, advice and often raw materials, and imposes strict operating rules so that the brand is not damaged by poor local operation. The franchisee usually pays a royalty based on turnover or profit. For the franchisor, franchising buys rapid expansion using the franchisees’ capital and local energy; for the franchisee, it buys a proven format and brand.

8.6 Strategic alliances

A strategic alliance is co-operation between organisations that stops short of a merger or joint-venture company. Airlines provide the classic example: alliances such as Star Alliance let passengers connect between member airlines, share lounges and pool frequent-flyer miles reasonably seamlessly. Alliances are particularly useful where a full takeover is not permitted or not wise – airline takeovers, for instance, are often resisted on competition or nationalistic grounds.

8.7 Strategic networks

A network is an organisation’s set of relationships with other organisations:

• Vertical relationships – with suppliers and customers.

• Horizontal relationships – with competitors and complementary businesses.

The term encompasses strategic alliances, joint ventures, long-term supplier/buyer relationships, and relationships with research and development consultancies and logistics companies. The idea is that goods, services and information flow freely within the network as required. A product might be designed and tested by a consultancy, which makes recommendations to component manufacturers, which co-ordinate production among themselves and with logistics companies so that components arrive at the final assembler exactly as needed – with distribution to buyers handled by further logistics partners.

Each organisation in the network has its own set of skills, but acting together they create capabilities – and therefore profits – that none could achieve in isolation. Co-ordination is everything, and IT plays a central role in making it accurate, efficient and fast: members share information through a common database (probably held in the cloud) or through extranets giving controlled access to each other’s systems.

9 . Choosing a method of growth

The table below summarises the trade-offs. In the exam, always match the method to the scenario: how fast must the organisation move, how much capital and risk can it bear, which competences does it lack, and how much control does it need?

10 Test your knowledge

Two short exercises close the chapter in the online notes: ten flashcards on the terms and frameworks above, and ten practice questions with worked feedback on every option. Work through the cards first, then the questions.