Challenge of Diversification
By TA News Bureau:
World-renowned for his expertise on global strategy, emerging markets (including India and South Asia), the energy sector, corporate governance, mergers and acquisitions, Dr Kannan Ramaswamy is the William D. Hacker Chair of Management Strategy at Thunderbird School of Global Management at Arizona State University. In a recent study on Indian business groups responding to the pro-market reforms that the government had initiated, he explored their diversification choices at the group level and the consequences of these choices as they adjust to the rising competition unleashed by market reforms. His research found that corporates that focused their portfolios in the early stages of institutional reforms tended to perform worse than their counterparts that did not do so. However, as market reforms became more established, business groups that made the transition from an unfocused to a more focused portfolio experienced superior performances. Changing strategy by refocusing business portfolio too early or waiting too long to refocus can hurt performance outcomes. In this interview to Tyre Asia, he explains his views on how CEOs should draw up strategies when the company is compelled under market pressure to diversify
Global firms seek the advice of Dr Kannan Ramaswamy, the William D. Hacker Chair of Management Strategy at Thunderbird School of Global Management at Arizona State University, when they rework strategies and compelled to go for diversification under market pressure. He works with senior management levels to help firms design and implement global strategy. He is sought by organisations to work with them at the intersection of strategy and leadership. He provides counsel to management teams and executive committees. He has developed a range of tools and techniques anchored in robust research with an eye on relevance.
In this interview to Tyre Asia, he explains how CEOs should handle situations arising out of diversification that is forced on companies under market pressure. “Value enhancing diversification in the true sense is getting to be quite rare,” he says. “Although relatively more common in countries like India, contextual factors such as poor infrastructure or weak institutions do not drive firms to diversify as much as they used to in the past. Thus, diversification is more of a deliberate choice in contemporary times.”
However, when a CEO is confronted with a diversified portfolio, taming the negative effects of such moves requires three key actions. First, the CEO ought to consider the true areas of overlaps across the diversified portfolio. Often, these overlaps are not necessarily limited to the product/market sphere alone.
Some businesses might benefit from using the same or similar technologies, same or similar business strategies that can be used to position the offerings in the marketplace. “Careful consideration of the overlaps is the first step towards harvesting the real synergies in the portfolio,” he says.
Second, the CEO should emphasize the intangible elements of competitive advantage ranging from the benefits of using a common brand, leveraging corporate reputation to help all business under the corporate umbrella, or the pros associated with common systems and practices as it relates to areas such as talent development. These common elements then become the foundations that can help realize intangible synergies across the diversified portfolio.
Third, the CEO should be quite ruthless in using the right set of performance metrics to ensure that cross-subsidization of activities across businesses is indeed value-creating and if they are not, there should be little hesitation in taming the diversified portfolio through selective divestment. The three crucial steps that he outlined should be incorporated in the diversification plans that are put into operation.
Commenting on the key findings of his study on diversification following economic liberalisation in India, Dr Ramaswamy said that he had done a series of studies set in India that have yielded a rich set of insights into the process of economic liberalization, institution building, and the process of rejuvenating an economy that had been dormant for far too long. “I will share with you three findings that succinctly capture what we found.”
The series of economic reforms that India undertook starting in 1990 was unprecedented. Thus, while some business groups changed their strategies and portfolios to reflect the newly emerging market context, others did not. “Interestingly, we found that those groups that did not change their portfolios actually benefited much more than others that did.”
He attributed this to the fact that the outcomes of the reforms process were far from evident during the early years and thus the environment continued to provide opportunities to groups that had already mastered their ways of dealing with uncertainty through diversification.
“However, with the passage of time, the groups that trimmed their portfolios around a more focused core set of related businesses such as TVS Group, MRF etc started to outperform their unrelated diversified peers.”
Well over a decade after the initial reforms were enacted, the diversified groups were beginning to see performance declines that were noticeable compared to their focused peers. This underscores the fact that the market context was a lot more vibrant that it was in the early 1990s and India’s institutions such as its capital markets, labour markets, and product markets have been far more efficient than they used to be.
This does not however suggest that unrelated diversification does not occur or that it is always detrimental. In today’s India, such moves are more likely the product of deliberate strategic thinking where they can benefit from group level synergies in a concerted fashion.
When asked what would be his advice to CEOs when they enter untested waters deviating from the firm’s core competencies, Dr Ramaswamy has some insightful comments to offer.
“Much of the low hanging fruits of diversification have faded away as the country has improved market efficiency and institutional strengths. Thus, any CEO undertaking unrelated diversification without clear demonstration of value premiums and a path to sustain such premiums is clearly inviting trouble. Markets today are less likely to continue their indulgent attitude that used to prevail before economic reforms were initiated.
Dr Ramaswamy noted that in contemporary India, business group CEOs are under pressure to actively tame undiversified portfolios. Several studies have clearly demonstrated that the sources of abnormal returns that used to accrue to unrelated diversified business groups by virtue of advantages such as access to licences, cheaper capital, brand name and reputation, and legislative lobbying have started to attenuate.
The only tangible benefits that remain from strategies are associated with internal advantages from unique organizational structures that promote cross-business synergies, sharing technological benefits arising from positive blowbacks of innovations from one business to another, or the ability to capture unique value by training talent in ways that the external market may not be capable of doing.
Referring to major management challenges that CEOs are likely to face when the board compels them to diversify based on perceived market developments, Dr Ramaswamy has this to say: “The challenges of managing a diversified company, especially in the long term, are indeed quite immense.”
Witness the anguish in boardrooms across the world where conglomerates have been challenged to change their ways. The shining stars of years gone by such as Siemens and GE are but two examples of firms that have been facing the wrath of the market for their inability to manage value-adding growth.
The management challenges typically focus on the ability of the senior leadership to clearly articulate the rationale behind the diversified portfolio and their ability to demonstrate value over the long haul. GE lost its lustre largely because of questionable bets it placed on its oil business that was headed down when GE acquired Baker Hughes, an oilfield services company. Siemens and GE both made very large bets in their turbines businesses when the energy landscape started to change.
These examples reflect how difficult it is to read markets correctly in a consistent fashion and place more wining bets than losing ones. In India, perhaps the Aditya Birla Group and Mahindra & Mahindra are examples of groups that have shown resilience in the long term with an ability to weather some of the setbacks they have been dealt with. Despite challenges, they seem to have identified specific ways in which they can seize value premiums in tough businesses.
It appears that their resilience and consistency in adding value originates in the way they are structured, the systems and processes that they religiously follow in order to drive cross-business synergies, and their zealous pursuit of a common culture that permeates all their group companies. CEOs of groups that are not up for this long slog would perhaps be better off running a focused set of businesses or even a stand-alone one, Dr Ramaswamy said.