Board directors need to know the risks of diversification

There are risks involved in diversifying. Here's what board directors need to know before becoming a conglomerate.

There is a basic truth underpinning good performance that captains of industry often forget: Australia’s most profitable businesses operate in only one industry. Over the past half-century since the end of the Industrial Age, there have not been more than six diversified companies in the Best 100 in any given period. However, only two of the most profitable 100 companies over the past five years to 2017 were diversified — Dulux and Nestlé — and they at least operated within one major industry division (manufacturing) and can be termed theme conglomerates.

A conglomerate that is very profitable for some years — even if not in the Best 100 list — is usually run by the CEO and board that created it, based upon an understanding of the diverse businesses in the portfolio. Sometimes these conglomerates work for a while with succession CEOs, boards and cultures, but always with high degrees of autonomy. However, they must remain on a short leash when it comes to achieving budgets and developing strategies. Alternately, multi-diversified classic conglomerates (in many classes of industry across several divisions) always fail (see breakout).

In 2016–17, several of Australia’s most diversified classic conglomerates began selling off subsidiaries to become closer in composition to theme conglomerates; or they narrowed their wide span of investments, having witnessed years of underperformance. This has continued into 2018 with conglomerates such as Wesfarmers, whose profitability has averaged less than eight per cent over the past six years. Rob Scott, the new CEO of Wesfarmers, is setting out to reduce its degree of conglomeration by splitting off the Coles retail business — and perhaps others.

Classic conglomerates don't work for long

In short, classic conglomerates don’t make sense and don’t work — at least not for long — in a developed post-industrial economy like Australia. They struggle in other countries, as we saw in 2017 with General Electric (GE) in the US. New CEO John Flannery has said any GE asset, even its big aviation, health and power divisions, could be spun off into independent companies.

So why do boards and CEOs choose to diversify? As businesses grow via good management, new products and increasing locations within a state or nation, there is often a preference to stay within self-imposed borders. When they saturate a market, they will often diversify into another of the nation’s industry classes, as opposed to expanding into overseas markets with the same business in the same industry. Most often, local diversification proves a costly, sometimes ruinous mistake, as seen in the list of the failed five.

A decision to stay within national borders could be based on barriers to entry in other countries involving foreign ownership, qualification differences, spectrum licences, uneconomic market size, cartels and corruption, among a range of factors. Such barriers are rarely universal and businesses facing this situation should really just keep looking.

However, Australia’s economy is tiny compared with the rest of the world. So if a corporation is good enough, the world is a very prospective place to harvest growth.

There are many success stories of focused companies succeeding internationally; Westfield, for starters. Australian companies have also enjoyed success in such areas as software (Atlassian) and medical equipment (Cochlear) — all focused on just the one industry class.

Corporations in service industries once imagined they were safe from international competition, unlike those in primary (agriculture and mining) and secondary industries such as manufacturing. That myth has exploded, as we have witnessed in retailing, fast food, funeral services, personnel services, entertainment and education when confronted by competitive foreign multinationals. If a corporation is not good enough to go overseas, it’s not good enough to survive the challenge of foreign competition inside Australia.

A shrinking minority of industries are safe inside their national borders; and diversifying within Australia as a form of protection or as a strategy to expand simply compounds the risk. Diversifying means facing different competitors.

The lesson is: stay in one class of industry, but ensure the business meets world’s best practice and has developed unique intellectual property. This equips the business to win the competitive battles onshore, and succeed abroad.

Read about Amazon and other conglomerates from our November 2017 issue here.