Diversification refers to a process where a company grows outside its current category. Diversification assumed a significant job in the acquisitions and mergers. That occurred in the third merger wave, also known as the conglomerate era. In the 1960s, huge numbers of firms that developed into conglomerates. Were dismantled through different spin-offs and divestitures in the 70s and 80s. This procedure of de-conglomeration raises genuine questions with regards to the estimation of enhancement dependent on expansion.
Some companies gained significantly, while others didn’t. For instance, General Electric (GE) has not been just an electronics-oriented company despite the name. Through acquisitions and divestitures, the firm has gotten an expanded aggregate. With activities in protection, financial administrations, TV channels, plastics, clinical gear, and many more. Their profit rose significantly during the 80s and 90s when the firm was gaining and stripping multiple organizations. The market reacted well to these diversified acquisitions by following the rising pattern of earnings.
Diversification and the Acquisition of Leading Industry Positions
One of the many reasons why GE has been successful in diversifying is because of the types of companies it has acquired. General Electric looked to get leading positions. In which the different industries in which it claimed businesses. Leading is usually deciphered as the first or second position as indicated by market shares.
GE and other acquiring firms believe that leading positions like number one or two give a more dominant position. Offering more advantages over the smaller competitors. These advantages can show themselves in various manners. Such as a more extensive consumer awareness in the marketplace as leading positions in distribution. Corporations in secondary positions like number four or five, may here and there be at such an impediment. That it is hard for them to produce positive returns. Candidates for divestiture include companies within the overall company framework. That does not hold a leading position and those that don’t have reasonable prospects of cost-effectively acquiring such a position. The discharged resources obtained from such a divestiture would then be able to be reinvested in different companies. That is to exploit the advantages of their prevailing position or used to obtain leading companies in other ventures.
Dynamic Market
Considering that markets are dynamic, a business can be in an attractive industry and be a leader. In which a decade only to see the industry contract in response to changes in the market. Therefore, diversified companies should always examine their constituent units. And know if a business that used to be leading can still generate a return that’s consistent with the parent company’s goals. This evaluation process was experienced by GE in recent years. And shed many units, like consumer finance and media businesses. But in 2015, it acquired the energy business of Alstom SA in a return to the industrial orientation of the GE of the old.
Diversification to Enter More Gainful Industries
Management sometimes chooses to diversify. And expand because of their desire to enter more profitable markets than the acquiring firm’s current industry. The parent company’s industry may have reached maturity or that the competitive pressures within that industry preclude the possibility of raising prices to a level where extranormal profits may be enjoyed.
Profitable industries may not stay in the same profitable state in the future. Competitive pressures serve to achieve a development toward a drawn-out equalization of rates of return over industries. This obviously doesn’t imply that the paces of return in all industries at any second in time are equivalent. The competition that moves industries to have equivalent returns are balanced by restricting powers, for example, industrial development, that causes industries to have to change paces of return. Those with returns that are above average without imposing barriers to entry will have declining returns until they reach the cross-industry average.
In the long run, as implied by economic theory, those industries that are difficult to enter are the only ones that will have above-average returns. This means that diversifying to enter more profitable industries will not be successful after some time. The growing firm will be unable to enter those businesses that show better than expected returns due to obstructions that forestall entry and might have the option to enter just the industries with low barriers. When entering low-barrier industries, the growing company might be required to compete against other entrants who were attracted by the temporarily above-average returns and low barriers. The increased number of competitors will drive down returns and cause the expansion strategy to fail.
Benefits of Conglomerates
Various studies are skeptical of the risk-reduction benefits of conglomerates, although there is evidence that shows the wealth effects of conglomerates positively. For instance, Elger and Clark show that the returns stockholders get in conglomerate purchases are far better compared to those in non-conglomerate acquisitions. They examined 337 mergers from 1957 to 1975 and found that conglomerates offered superior gains compared to non-conglomerates. It also showed gains not just for the buyer, but for the seller firms as well. These significant gains are cataloged by stockholders of the firms who are selling, and the conservative gains are for buying company stockholders.
This was similar to a later study by Wansley, Lane, and Yang, who examined 52 non-conglomerates and 151 conglomerates. This research found that returns to shareholders were bigger in horizontal and vertical acquisitions than in chain acquisitions.
Diversification Discounts
In a study by Henri Servaes in the 1960s, a comparison between Tobin’s qs of diversified and those that were not diversified showed no evidence that diversification may increase corporate values. However, he found that Tobin’s qs for diversified firms were significantly lower than those for multi-segment companies. Other research has discovered that the diversification discount was not confined to the conglomerate era. A study by Berger and Ofek used a huge sample of firms over the 1986–1991 sample period and found that diversification came about in lost firms that averaged between 13% and 15%.35. This investigation assessed the imputed value of a diversified firm’s segments as though they were separate firms. The results show that the loss of firm worth was not influenced by the firm but was less at the point when diversification happened in the related industries.
The loss of firm value was buttressed by the fact that the diversified segments showed lower profitability than single-line businesses. They also showed that the diversified firms invested too much in the diversified segments than single-line businesses, meaning overinvestment may be a reason for the loss of value related to diversification.
Other Sources Influence Diversification
Lang and Stulz tracked value-reducing effects of diversification through a sample of over 1000 companies. They concluded that greater corporate diversification in the 1980s was inversely related to Tobin’s q of these firms. This supports Berger and Ofek’s study, showing that diversification often lowers the value of firms.
On the other hand, Villalonga believes that the diversification discount is just an artifact of the data used by these researchers. According to him, the data used by these researchers were artificially restricted by the Financial Accounting Standards Board definition of segments, as well as requirements that only segments that makeup 10% or more of a company’s business are required to be reported.
Using a source that is not influenced by the issue, Villalonga finds a diversification premium than a discount. This entangled issue can be complicated. It is also difficult to draw expansive speculations about diversification that apply universally.
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