Diversification – Is it the way forward?
Compared to the late 1970s era of the economy when big companies slowly began diversifying but essentially connected to core operations, today it has changed completely. Now new conglomerates are reaching all over irrespective whether there is expertise in th company or not and becoming ‘seemingly’ successful.
But the moot point is – by delving into hitherto in-experienced business lines, are companies – particularly those listed putting their shareholders at risk because the risk is greater in such acquisitions and a longer return on investment or, are they?
Forced to diversify
According to Deshan Pushparajah, Head of Corporate Finance Capital Alliance, conglomerates have historically been significant in Sri Lanka and in frontier markets in general for two specific reasons. One is because frontier market companies generally wouldn't have scale in operations in one business area, hence they diversified into many and some examples are Aitken Spence and John Keells Holdings. "Tourism or plantations weren't big enough on their own. Without being big enough they couldn't make best use of their expertise. Banks wouldn't lend as much to them, etc which is why they were forced to diversify,” he explained.
The second reason Mr. Pushparajah noted was that there is very little venture capital available in Sri Lanka. “And banks are not willing to lend much to start ups either. Because conglomerates have large balance sheets, they could borrow/ source equity much faster and cheaper for start up ventures,” he noted, adding that some years ago only conglomerates could support fledgling businesses in frontier markets such as Sri Lanka.
However, he also noted that things are changing fast in Sri Lanka. “With operations scaling up, I think in four to five years you are going to see a fast de-conglomerizing (dropping non-core units) of companies. Whilst even in today's context conglomerates make sense, it won't in a few years. Most frontier markets (South Africa is a case in point) have gone through this phase,” he explained. According to him, once competition arrives in core business areas for these groups and volume and scale becomes demanding, they will start shedding non-core business areas.
Sattar Kassim, Director Expolanka Group said that diversifying is more to do with economies of scale. “For example just by building one hotel the economies of scale won’t be achieved. The real scale will come only by managing hotels and increasing the room capacity," he said.
He added that today is a specialist world where in the long run haphazard diversification won’t be a sustainable model.” One day they’ll be forced to scale down and divest the particular business or really go up the ladder and get proper economies of scale,” he added.
Mr. Pushparajah noted that early conglomerates have subscribed to this thought and have slowly started shedding non-core businesses.
A business analyst noted that one can diversify his/ her business by natural progression. For instance, if you sell men’s shirts, adding ties and cufflinks to the range are an obvious next step. More radically, you extend the brand by offering a much wider range of products that will nonetheless appeal to the same customers. Alternatively, you can use the strength of a brand to move into new markets.
According to a researcher on capital markets, stock prices track productivity of firms and this tracking is equally strong for diversified and stand-alone firms.
Conglomerates don’t add value
He also highlighted that on a long term basis, conglomerates don't add much value to shareholders and in most instances they tend to destroy value. He added that this is especially so when firms diversify into business areas totally foreign to their own.“it is true that expertise can be bought, so can businesses and track records, but they will (a) come at a steep price and (b) would take on capital which could have been more effectively used by reinvesting in one's own core business,” he stressed.
What isn’t a moot point is that while expertise could be there, focus may not. This is why Mr. Pushparajah noted that shareholders stand a great chance of losing value when a firm diversifies without focus. The new age conglomerates, he added seem to be building empires instead of adding value to shareholders.
As far as risk goes - there is risk added on two fronts. The first is in terms of business risk. As much needed capital for core operations could be identified for a non-related venture, Mr. Pushparajah stressed that this is also putting the company at risk of competition and falling behind.
Second, most of the new age conglomerates are leveraged buyers. “Huge amounts of leverage could enhance return for shareholders, but also put shareholders at much greater risk. Hence the risk premium attached to the business should be much more. This is what rating agencies are warning against,” he highlighted.
On the longer term, he added that markets and investors would rationalize towards shareholders diversification viz a viz conglomerates. “This is always a much better way of diversifying risks and returns.”
The chairman of a heavily diversified