Does Diversification Always Improve

Financial Performance ?
George Paul

There have been very few studies evaluating how well diversification moves have
worked out in practice vis-a-vis
expectations at the time decisions are
taken to diversify. This is a difficult area
of research.
George Paul, based on a study of 28
MRTP companies, has addressed himself
to a related issue of what type of
diversification strategy has produced
superior long-term financial performance.
George Paui is a senior professional at
the Institute of Banking Studies, Kuwait.

Diversification is one of the most strategic decisions that managements take. Involving significant capital outflows and entry into new products
and markets, diversification has far-reaching implications for the organization's structure,
systems, processes, and performance.
Firms diversify for a variety of reasons, some
of which are listed below:
to mitigate the effects of decline or slow down
in sales and earnings in existing business,
especially in the mature phase of the business
life cycle.
to reduce competitive pressures.
to smooth out cyclical swings in business,
that is, to reduce risk.
to capitalize on distinctive technological ex
pertise in production.
to build a balanced portfolio of businesses,
using current 'cash generators' to finance
'cash takers' with potential for future
performance.
to develop new products that can be moved
through the existing distribution system or to
utilize the existing marketing and distribu
tion systems fully.
to exploit fruitful R&D efforts with new pro
duct ideas and prototypes.
to avoid takeovers by growing big and to re
tain control.
to reduce dependence on a few suppliers or a
few customers.
to attract and maintain first-rate managers as
well as to provide career opportunities for
managers.
to achieve sufficient size so as to have effi
cient access to capital markets.

 to satisfy the power and prestige motives

through economic power and control over hu
man resources.

diversification strategies.

to respond to the regulatory and tax policy

measures of the government.

By diversification strategies we mean the

cumulative effect of various diversification moves,
defined in terms of the relatedness of the businesses the diversified company is involved in. The
strengths, skills, and purposes that tie the various
businesses of a company are sought to be captured
in the concept of relatedness in diversification.

'to imitate others, as in keeping up with a

fashion.

Related Diversifies

to create an image as aggressive managers

who recognize opportunities.

Whatever the motivations, there is invariably

both a justification given and an expectation that
the investments needed for diversification would
improve the long-term financial performance of
the company. The extent to which such expectations have been fulfilled is not known and is not
easily determined. The impact of diversification
on financial performance is known only after a
long time. Meanwhile, a number of other conditions also change. Although not easy to determine,
top managers need to take an informed view of the
likely impact of a diversification decision on longterm financial performance.
This article examines whether companies
classified on their diversification strategies differ
in their long-term financial performance. Four
strategies of diversification have been examined to
see whether any strategy has produced consistently good or poor financial performance. We first
discuss whu- is diversification and how the
selected companies were classified on the basis of
their diversification strategies.

What is Diversification ?
Diversification involves introduction of a new product or entry into a new market or both. Mere expansion in existing products and markets does not
constitute diversification. We have followed the
definition of Steiner (1969) according to which diversification is producing a new product or
service, or entering new markets, which involves
importantly different skills, processes, and
knowledge from those associated with the present
product, services, or markets. While what constitutes a new product and a new market may not
always be clear, it is this relatedness that has been
found through research to be an important explanator of high and low performance of different
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A company has been categorized as a related diversifier, if it has entered into markets with similar
distribution and other marketing characteristics,
or manufactures products using common production facilities and technology, on has entered into
vertically integrated activities. Gwalior Rayon's
strategy of diversification into businesses that include synthetic yarn, fibre, rayon grade pulp,
caustic soda, and textile products is illustrative of
what we mean by a related diversification strategy.
The similarity of technology and markets and the
extent to which they provide opportunities to
utilize the facilities and resources of one business
in the other businesses distinguishes related from
unrelated diversification strategies.
A related diversifier's total sales of the related
group of products contribute to 90 per cent or
more of its aggregate sales (e.g., Gwalior Rayon).
Such a company may have some unrelated products but they would contribute to no more than
10 per cent of its total sales. Vertical integration in
which a large part of the output of one business
forms the input for the other, is also considered as
related diversification.
Unrelated Diversifiers

If the largest single group of related businesses contributes to less than 90 per cent of total sales, then
the diversification strategy is regarded as unrelated.
Among unrelated diversifies, three types have been
identified, again based on the extent of unrelatedness. The first type consists of companies with two
businessesone dominant (75 per cent or more of
sales) and one unrelated business activity which
provides between 10 and 25 per cent of total sales. A
good illustration of this type is Mafatlal Fine which
has two businessesa dominant cotton textiles (86
per cent) and the other, the flourine chemicals, contributing 14 per cent of the total sales.
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The second type of unrelated diversifiers also

has two unrelated businesses, but neither of them
is dominant. Each of the two businesses provides
less than 75 per cent of total sales. Standard Mills,
which has cotton textiles accounting for 69 per
cent of sales and caustic soda and caustic potash
accounting for 31 per cent, is illustrative of this
type of unrelated diversification strategy.
In the third type of unrelated diversifiers, the
companies have at least three unrelated businesses
accounting for 95 per cent of total sales. Illustrative of this type of diversification strategy is DCM
which has textiles (30 per cent), vanaspafi (25 per
cent), sugar (12 per cent), fertilizers (14 per cent),
PVC (8 per cent), data products (3 per cent), and
others (8 per cent).

Selection and Classification of Companies

Only large public limited manufacturing companies in the private sector listed in the Bombay
Stock Exchange were considered for the study.
Companies subject to the Foreign Exchange Regulation Act, or FERA companies were excluded as
government regulations restricted their diversification strategies to a greater extent than for others.
The list of 28 companies thus selected and
their classification strategy is shown in. Table 1.
All of them were MRTP companies subject to the
Monopolies and Restrictive Trade Practices Act.
Of the 28 companies, nine were classified as related and 19 as unrelated diversifiers. The
percentages to total sales of each product group
are also provided in the table. These are average
percentages for two years: 1974-75 and 1980-81.
Where data were available, the percentage to sales
during the middle year, that is, 1977-78 were also
used for averaging so that the strategy classifications are based on long-term trends.
Classifying companies on their strategy based
on the sales figures and the definitions given
above appears straightforward. However, there is
an element of judgement in deciding the "relatedness" in the businesses of a company. An examination of the list of 28 companies and their
business-wise sales figures, provided in Table 1
would show that the diversification strategy classifications are robust enough to withstand a fair
degree of difference in one's judgements on the
"relatedness" or otherwise of two businesses.

Rohtas Industries

Dalmia Cement

Paper and Paper Products (40)

Caustic Soda and Sulphuric
Acid (1)
Vanaspati (38)
Cement and Cement Products (16)
Steel Castings (5)
Cement (59)
Magnesite (26)
Iron Ore (5)
Cashew Products (10)

Managers, while evaluating diversification

into new businesses, often exercise difficult judgements on this aspect. It is precisely to help in this
judgement that the present study examines the
long-term performance of each of the four types of
diversification strategies using the following measures of performance.

Measures of Financial Performance

Eleven measures of financial performance were
considered to reflect corporate-wide performance
from the point of view of shareholders and financial markets and also to ensure comparability across companies. No composite measure of
performance was derived. The eleven measures together provide a profile of performance on growth,
profitability, risk, and market value. These measures were:
growth (six measures): growth rates in total
net assets, net sales, net worth, gross profit,
dividends, and market value of equity share;
profitability: I) percentage of gross profit be
fore depreciation, interest, and tax to capital
employed, and ii) percentage of net profit to
net worth;
risk: the coefficient of variation in return on
capital employed, that is, standard deviation
in return on capital employed expressed as a
percentage of the average return on capital
employed during the period; and
market vaJue: i) ratio of market price to book
value of an ordinary share, and ii) ratio of
market price to earnings per share.
Long-term growth rates were derived as continuously compunded growth rates using all the
annual figures for the period 1962 to 1981. Estimates

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companies belonged to a single group.* In other

words, the strategy classification we have used is
indeed a powerful indicator of the differences in
long-term performance.
Secondly, companies with many unrelated
businesses showed the poorest performance among
the four strategies of diversification. Not only did
the strategy of unrelated diversification into many
businesses record the lowest growth rate of assets
(8.2 per cent) and sales (10.9 per cent) compared to
14.5 per cent and 19.2 per cent for the dominant
business group with only one minor unrelated business diversification, but the fully unrelated diversification strategy also had the highest level of
variability in return on capital employed (60 per
cent) compared to only 24 per cent for the dominant
business group with one unrelated diversification.
Because of their poorer performance, the share
markets also gave the widely unrelated diversifiers
the lowest average price-earnings multiple of 5
compared to 6 or higher for the other three more
restricted diversification strategy groups.
The fully unrelated diversifiers performed
even worse than the non-diversified companies, en
the average. Table 2 provides average performance
data for 32 non-diversified companies such as
Khatau Makanji, India Cements, Titaghur Paper,
Reliance Jute, and Garware Nylon. The seven unrelated diversifiers with many businesses in our sample had lower rates of growth and profitability than
the average for the 32 non-diversified companies.
Also, they were not successful in reducing their
risk level.
The long-term financial performance data presented here raises serious questions regarding the
entry of companies into many unrelated businesses.

Implications
The research results presented above are similar to
those for certain US companies too where the
long-term financial performance of conglomerate
forms of diversification was worse than those of
related diversifiers (Rumelt, 1974).
Rumelt concluded as follows:
... firms that have diversified to some extent but have
restricted their range of activities to a central skill or
competence have shown substantially higher rates of profitability and growth than other types of firms, (p. 8)
* For a more detailed description of the tests and the results, see
P P George. Diversified Indian Companies: A Study of
Strategies and Financial Performance, unpublished doctoral
thesis, Indian Institute of Management, Ahmedabad. 1984.

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The dominant businesses with one unrelated business displayed the fact that the central skill or competence is the core for performance. This group,
including such companies as Mafatlal Fine,
Century Spinning, and J K Synthetics performed
even better than the related diversifiers in our classification which included Gwalior Rayon, Nirlon
Synthetics, and Orient Paper. But the related diversifiers performed better than the fully unrelated
or the non-diversifiers.
The identification, nurturing, and building of
the central skill or competence becomes increasingly difficult as companies progress in their range
of diversification. The dominant businesses with
only one unrelated business are in a better position
to do so than the related diversifiers who have to
integrate around their central skill, the diverse
technological, marketing, and production requirements of several related businesses. While exploiting the relatedness in markets they may have to
deal with some unrelatedness in production or
technology. Unifying such related and unrelated
dimensions under a central skill or competence is a
challenge. The caution of dominant businesses, entering only one unrelated business, and that too, to
a minor extent of their total sales, appears prudent.
They have been rewarded financially not only in
growth and profitability but also in terms of reducing the variability in their return on capital employed to the same extent as achieved by related
diversifiers.
As competition intensifies, managements
would do well to re-examine their diversification
strategies to ensure that the company's central skill
or competence is strengthened rather than diffused
by diversification. While where the precise line is
to be drawn is difficult to pre-determine, managements should be wary of unrelated diversification
into many businesses. They should not only avoid
too unrelated a diversification in their company but
also consider the long-term performance of their
company's strategy vis-a-vis alternative strategies.
Where managements find that their company is too
diversified for its central skill or competence to be
reflected fully, they would do well to divest the
weakening businesses.
References

Steiner, George A. Top Management Planning. London: The

Macmillan Company, 1969.
Rumelt, Richard P. Strategy. Structure and Economic Performance. Boston, Mass.: Division of Research, Graduate
School, of Business Administration. Harvard University,
1974.

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