Diversification has given way to focus in developed countries like the United States and the United Kingdom, and has often been correlated with lower performance. In contrast, diversified business groups have been hugely successful in most emerging markets, particularly in Asia.
Since the mid 1980s, strategists in countries like the United States and the United Kingdom have mostly advocated the use of focused strategies for businesses and have advised companies to ‘stick to their knitting’. Many diversified conglomerates in these advanced economies have been dismantled since 1980s to focus on one or a few core businesses.
A look at the motives with which companies diversify reveals some of the reasons why diversification by conglomerates yields benefits in the developing markets as against the discount associated with diversified conglomerates in the developed economies.
Growth is a primary motive for diversification
However growth does not always translate into higher profitability. Since management status and power is correlated more closely with the size of assets under management, management (the ‘agent’) may have the incentive to diversify for pursuing growth in preference to profitability, which is not in the best interest of shareholders.
Having different businesses in their portfolio can potentially balance differences in the industry cycles and thus it increases the stability of a company. But the value of diversification advantage to the company may be offset by the high transaction cost associated with acquisition. Moreover shareholders can themselves reduce the risk of their portfolio by holding diversified portfolios. This is another argument against diversification in the developed economies.
Corporate parenting advantage
Effective corporate management is given as the reason for existence and success of diversified conglomerates in the developing markets. The differences in the institutional context—i.e. a country’s capital markets, labour markets, consumer awareness, regulatory and legal system that influences business practices and ethics, infrastructure etc favours the presence of diversified conglomerates in developing countries.
Corporate advantage due to diversification exists if the portfolio performance is greater than sum of performances of individual businesses. In the developing economies, diversified conglomerates wield considerable economic and political clout. Being a part of a diversified group increases the overall stability of the company’s cash flow.
Thus, diversification is context specific. “Stick to your knitting” may not be the best recommendation for firms in high-growth markets or regions that have strong corporate advantages.