What entrepreneurs should consider when diversifying

A banking survey shows that diversified lenders perform better than those that are not. PHOTO | FILE 

By SCOTT BELLOWS

In Summary

• Venturing into different industries entirely may even out your risk, but may stretch your operating capacity beyond quality implementation.

My students seemed transfixed by the American TV show Empire during its first season. I heard it spoken about quite often and even watched a few episodes myself that contained Lucious and Cookie Lyon and their children.

The main character, Lucious, obsesses about building a legacy and an almost feudal realm of business domination.

The firm diversified from purely a main-stream music label management company to various niche labels, consumer products, a sports agency, and a night club. So in technical terms, the Empire incorporated similar-industry diversification and pure financial diversification into completely different sectors.

In relation to the reality of business, the television show begs the question: Is it better to become highly specialised or create a diversified empire?

In the above line of thought, a major Kenyan insurance firm last week announced diversification into real estate.

The Kenyan business landscape retains several multi-industry conglomerates most notably Mumias Sugar with its main product line, sugar processing and distribution, as well as non-similar sectors such as water, real estate, and electricity, as examples.

Does diversification work?

Internationally, General Electric (GE) stands as one of the most notable multi-industry diversified companies. From consumer goods to electricity generation technology to insurance to financial institutions, GE’s legendary former CEO Jack Welch brought the company to dabble in multitudes of areas.

In contrast, GE stands juxtaposed against technology firm Apple which diversifies into related sectors with computers, laptops, phones, watches, and cloud computing, among others.

However, is it wise to diversify companies at all? If diversification does work, which type of diversification works best? Does the cliché question if it is better to be a jack of all trades and master of none ring true?

Intuition tells us that if a firm cannot take their retained earnings and reinvest it into their core business to make profits greater than others in the market, then should they be in that main industry any longer at all?

Social science research provides some answers. It depends on the nature and reason of the diversification.

A common type of diversification involves a venture into similar product lines, such as Coca-Cola also producing Dasani water, or related industries, such as Suraya Properties building residential apartments as well as office blocks.

Greater profitability

Researchers Amit and Livnat uncovered that firms venturing into similar industries allows the companies to leverage their business foundation to exploit operating synergies.

Coca-Cola could utilise the same bottlers for a variety of beverages, Suraya could take advantage of among others the same architects and receptionists, for both types of building engagements.

Inasmuch, firms that venture into similar-industry diversification enjoy greater profitability and generally lower consolidated average costs than do non-diversified entities.

Frederik Mergaerts and Rudi Vander Vennet published in February 2016 a study that covered 505 banks across Europe between 1998 and 2013 showing that a diversified business model, one that may include retail, commercial, investment banking performs better than non-diversified specialised banks.

High success chance

The higher performance largely stemmed from the similarity of sectors in the diversification.
Similarly, researchers Rosa and Scott studied Scottish high-growth companies and found that in entrepreneurs, those that started multiple similar firms stood a higher chance of success by amalgamating learning and skill across their startup entities than entrepreneurs with a single startup.

However, the Kenyan insurance firm’s desired foray into real estate represents a different type of diversification. Such a move represents an entirely new industry for one firm strongly established in another.

Amit and Livnat find that new industry diversification usually lowers firm performance.

First, operating synergies often do not occur due to the opposing nature of business models.

Second, firms usually diversify into less risky ventures than their core business.

Less risky endeavours in turn usually carry less reward. However, the pure return does not represent the main reason for diversification in most firms.

Companies seeking multi-industry diversification often seek to even out cashflows with more predictability.

Multiple business lines help eliminate prospective turbulence of cash coming in. In turn, such entities may often leverage their new stability with borrowers in order to bring in more debt funding.

Debt funding enables growth of new products, marketing, locations among others.

So entrepreneurs and business executives in established firms should think through the precise reasons for their intended diversification.

Venture formation

Entrepreneurs must watch out that they do not build an empire too early but rather strategic other business lines that complement the main product.

 

Most entrepreneurs get too excited with too many ideas that spread them too thin in the early stages of venture formation.

Established companies must explore the prospective operating synergies in-depth without merely assuming that such costs savings will appear.

Quality implementation

An entire diversification implementation plan must be developed and used.

Venturing into different industries entirely may even out your risk, but may stretch your operating capacity beyond quality implementation.

Share your diversification stories with other Business Daily readers through #KenyaInvestment on Twitter.

Prof Scott serves as the Director of the New Economy Venture Accelerator (NEVA) and Chair of the Faculty Senate at USIU, www.ScottProfessor.com, and may be reached on: info@scottprofessor.com or follow on Twitter: @ScottProfessor.