Real  Types of Diversification Strategies Kai Hanitsch (K21)  

I Table of Contents

I  Table of Contents  II

II  Table of Abbreviations  V

III  Table of Figures  VI

IV  Table of Tables  VIII

1  Introduction  9

1.1  Problem Definition  9

1.2  Goal  10

1.3  Approach  11

2  Fundamentals of Corporate Strategy  13

2.1  Definition  13

2.2  Portfolio Design  13

2.3  Diversification  15

2.3.1  Focused Diversification  16

2.3.2  Relational Diversification  17

2.3.3  Conglomerate Diversification  17

3  Diversification and Success  19

3.1  Theoretical Approaches to explain Success  19

3.1.1  Industrial Economics Perspective.  19

3.1.2  Market-based View  20

3.1.3  Resource-based View  21

3.2  Success Factors  22

3.2.1  Business Relatedness  22

3.2.2  Resource Transferability  25

3.2.3  Corporate Leadership  28

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Real  Types of Diversification Strategies Kai Hanitsch (K21)  

4  Systematization and Measurement of Diversification  30

4.1  Classical Approaches to Measurement.  31

4.1.1  Degree of diversification  31

4.1.2  Type of diversification  35

4.2  Measurement Problems  37

4.3  Measurement according to WULF  39

5  Analysis of Real Types of Diversification Strategies  42

5.1  Dataset Characteristics  42

5.2  Classical Measurements  43

5.2.1  Berry-Index  43

5.2.2  Entropy Measure  44

5.3  Measurement according to WULF  46

5.3.1  General Types of Relatedness  46

5.3.2  Real Types of Relatedness according to Factor Analysis  48

5.4  Real Types of Diversification Strategies  53

5.4.1  According to Relative Factor Dominance  54

5.4.2  According to Absolute Factor Dominance  58

5.5  Real Types of Diversification Strategies and Success  61

5.5.1  Measures of Success  61

5.5.2  Success based on Relative Factor Dominance  62

5.5.3  Success based on Absolute Factor Dominance  63

5.5.4  Factor Regression Analysis  65

6  Conclusion  67

V  Table of Annexes  LXIX

Annex A:  List of Analyzed Companies  LXX

Annex B:  Survey Questionnaire  LXXI

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Real Types of Diversification Strategies Kai Hanitsch (K21)

Annex C: Total Variance Explained by Factor Analysis ............................. LXXV

Annex D: Distribution of Factor Values according to Companies ............ LXXVI

Annex E: Reproduced Correlations .......................................................... LXXXV

VI Bibliography ........................................................................................ LXXXIX

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Real Types of Diversification Strategies Kai Hanitsch (K21)

II Table of Abbreviations

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Real Types of Diversification Strategies Kai Hanitsch (K21)

III Table of Figures

Figure 1 - Underlying model of diversification and success. ................................ 11 Figure 2 - BCG Growth/Share-Matrix for a fictional case. .................................... 14 Figure 3 - Types of diversification strategies. ....................................................... 16 Figure 4 - Criteria of relatedness based on a survey by Stimpert & Duhaime

(Figures represent correlation coefficients). .......................................................... 24 Figure 5 - Criteria to assess business relatedness according to Wulf. ................. 24 Figure 6 - Synergy potential of specific and unspecific resources. ....................... 26 Figure 7 - Combination matrix of relatedness/leadership-types. .......................... 29 Figure 8 - Types of Diversification according to Rumelt. ...................................... 37 Figure 9 - Criteria to assess business relatedness according to Wulf. .................. 41 Figure 10 - Overall Berry Index values distribution (n=47). .................................. 44 Figure 11 - Overall Entropy-Measure values distribution (n=47). ......................... 45 Figure 12 - Sums of answers categories „Applies completely“ and „Applies“ given

in section A2 of the questionnaire (n=47).............................................................. 46 Figure 13 - Answers given to the question of management relatedness (n=47). . 47 Figure 14 - Answers given to the question of product/process relatedness (n=47).

.............................................................................................................................. 47 Figure 15 - Answers given to the question of no kind of relatedness (n=47). ....... 48 Figure 17 - Relatedness hierarchy. ...................................................................... 53

Figure 18 - Distribution of 1 ^st Quantile Memberships (n=47). ............................... 54 Figure 19 - Relative factor dominance compared to the Entropy measure. (n=47).

.............................................................................................................................. 55 Figure 20 - Real Types of Diversification Strategies according to relative factor

dominance (n=47). ................................................................................................ 56 Figure 21 - Relatedness Classes and Diversification Measures (n=47). .............. 57 Figure 22 - Dominant Factors Occurrence and Classical Diversification Measures

(n=46). .................................................................................................................. 59 Figure 23 - Real Types of diversification strategies according to absolute factor

dominance (n=46). ................................................................................................ 60

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Figure 24 - Relatedness according to relative factor dominance and performance

(n=46). .................................................................................................................. 63 Figure 25 - Performance figures based on absolute factor dominance (n=46). .... 64

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Real Types of Diversification Strategies Kai Hanitsch (K21)

IV Table of Tables

Table 1 - Scale levels overview. ........................................................................... 49 Table 2 - KMO and Bartlett's Test (n=47). ............................................................ 50 Table 3 - Rotated Component Matrix (n=47). ....................................................... 52

Table 4 - Correlations between number of 1 ^st quantile memberships (Firstqmemb)

and profitability measures. .................................................................................... 63 Table 5 - Correlation analysis model summary. ................................................... 65 Table 6 - Regression coefficients of factors towards dependant variable ROA

(n=47). .................................................................................................................. 66

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Real Types of Diversification Strategies Kai Hanitsch (K21)

1 Introduction

1.1 Problem Definition

On corporate level main strategic decisions involve the question which businesses are to be pursued and which to be neglected, thus how the portfolio of businesses

is designed ¹ . The ultimate goal is a value adding business portfolio, meaning every single business is better off being part of this very portfolio instead of

operating as a totally separate entity ² .

This added value arises from synergies among the businesses and the role of the corporate center ³ . In the case of success this would lead to a conglomerate premium (the conglomerate is of higher value than the sum of its parts) in terms of company value instead of a conglomerate discount.

Corporate managers are generally very free in deciding what businesses they want to add to their portfolio and which to divest. This raises two questions: one regarding the type of businesses in a portfolio (i.e. what industries do they serve) and the other regarding the optimal size of a portfolio (i.e. how many businesses can be managed at once). The term diversification deals with both questions: it describes how broad and how diverse a company’s business portfolio is. On the one hand it can be very narrow or focused in a barely diversified company, on the other it can be very broad in a highly diversified company. Three forms of diversification strategies are commonly distinguished: focused, relational and conglomerate diversification ⁴ .

Many researchers in the field of strategic management have dealt with the

question of diversification and the pros and cons involved ⁵ . Yet there is no clear

¹ See Hungenberg, Wulf (2007), p. 111.

² See Goold, Campbell & Alexander (1994), p. 12, and Campbell, Goold & Alexander (1995), pp. 120-132.

³ See e.g. Chandler (1991), pp. 31-50, or Goold & Campbell (1987) who addresses corporate center functions in greater detail and e.g. Wulf (2007), p. 38 regarding synergies.

⁴ See Hungenberg, Wulf (2007), p. 138.

⁵ See Ramanujam & Varadarajan (1989), pp. 523-551 for an exhaustive overview on diversification research up until that time.

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hint on the likelihood of superior performance of more or less diversified firms.

Rather success stories for both extremes can be told ⁶ .

Further findings indicate: not the degree of diversification is relevant for success but the relatedness among the strategic business units (SBUs) a company

operates ⁷ . Portfolios of somehow related SBUs obviously perform better than those completely unrelated ⁸ . This is due to the fact the success is explained by the ability to transfer core competencies (“resources”) between the business units of a company.

Yet relatedness is a manifold concept. At least two main types have to be distinguished: relatedness on the level of products and processes and such on the

level of management requirements ⁹ . But which type of relatedness is the most promising in terms of superior company performance? Although many researchers have approached this question by empirical examinations, there is yet no clear answer to that question.

Since earlier research work is insufficient to fully explain the phenomenon of diversification further research is indicated. This especially applies to German conglomerates since most research work focused on US firms mainly ¹⁰ .

1.2 Goal

The thesis at hand constitutes one part of that proceeding research. Its aim is to gain further insights on diversification and relatedness by empirically identifying and exploring real types of relatedness and their respective diversification strategies.

⁶ See Comment & Jarrell (1995), pp. 67-87, for a study seemingly favouring a focussed strategy and Shulman (1999), who empirically proves that there can very well be a conglomerate strategy resulting in superior performance.

⁷ For this and the following see e.g. an empirical study by Palich, Cardinal & Miller (2000), pp. 155-174, or Varadarajan & Ramanujam (1987), pp. 380-393, who found further support, yet also raise concerns about generalization.

⁸ See e.g. Mayer & Whittington (2003), pp. 773-781.

⁹ See Wulf (2007), p.163.

¹⁰ See Wulf (2007), p. 3.

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This includes a discussion on comprehensive diversification measurement and the implications that arise from the empirical analysis conducted in this case.

The general character of this work is explorative; findings are primarily supposed to form a basis for further research rather than having direct and significant practical implications.

1.3 Approach

This goal will be achieved by using a two step approach: Firstly, an overview on the relevant theoretical framework of diversification strategies and their success will be given. This part is based on a vast set of literature comprising books, papers and journal articles. Secondly, an empirical study of 47 German conglomerates will be analyzed.

The general underlying notion to the thesis is depicted in Figure 1. It is believed that according to the resource-based view of the firm ¹¹ a diversification strategy is derived by the type of resources a company possesses and how they can be transferred to other business units. This strategy then requires a certain style of leadership meaning how the relation among business units and business units and corporate center is. Only the adequate combination of those four factors yields diversification success.

¹¹ See Bamberger & Wrona (1996), pp. 130-153.

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In detail the work’s structure is as follows: the work starts with an introduction to strategic management on corporate level (chapter 2). Here it turns out that planning and design of a business portfolio is the core of strategy work and diversification is closely related to that since it refers to the fact of how broad and diverse such a portfolio is. As the main question is what kind of diversification strategy is most successful, chapter 3 deals with success. Here approaches to explain success in diversification are discussed. Based on earlier research an

approach following the “resourced-based view” ¹² to analyze corporate performance seems most adequate to explain success (also) in a diversification

context ¹³ . Based on that insight, crucial success factors are presented. Chapter 4 concludes the theoretical part and is supposed to lay a foundation for the upcoming analysis by dealing with the crucial question of systematization and measurement of diversification. Various ways of measurement, both classical and new, are introduced. Overall the insights gained here will be a solid basis for the upcoming empirical part.

This empirical part, that forms the thesis’ core, will use a given set of primary data on German conglomerates. Those data will be analyzed in an explorative way using factor analysis. This culminated in an empirical identification of real types of relatedness among German conglomerates in chapter 5. Based on those relatedness types it is analyzed how strongly and in what combinations they appear across the sample thereby illustrating real types of diversification strategies. These strategies are confronted with traditional measures of diversification that only measure a limited type of relatedness and may thus have limitations in use in such a context. Furthermore performance figures of those real types of diversification are incorporated.

Chapter 6 lastly reflects findings and highlights the work’s results as well as the need for further research.

¹² See Mahoney & Pandian (1992), pp. 363-380 or Bamberger & Wrona (1996), pp. 130-153, for

an appreciation of the RBV within the field of strategic management.

¹³ See Chatterjee & Wernerfelt (1991), pp. 33-48.

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2 Fundamentals of Corporate Strategy

2.1 Definition

Strategic management on corporate level differs significantly from that performed on business level. A business strategy always aims for a sustainable competitive advantage in a given industry ¹⁴ . Due to that fact strategic actions taken there ¹⁵ are also different from those concerning the corporation as a whole ¹⁶ . Corporate strategy strives for a “parenting advantage” ¹⁷ . This means designing a portfolio of businesses in various industries that creates superior value in that very constellation. Every single business ¹⁸ being a member of that portfolio has to be better off compared to the alternative of operating as a stand-alone company or as part of an alternative corporation. At the same time the parent at hand must add superior value to what other alternative parents could possibly add.

This would ultimately lead to a conglomerate premium, meaning the market value of the corporation exceeds the sum of values of all SBUs if they were standing alone. In the contrary case, the conglomerate discount, the corporation actually

destroys value; hence a break-up is indicated ¹⁹ .

2.2 Portfolio Design

The process of strategic management, comprising the steps strategy analysis, strategy formulation and strategy implementation, is essentially quite similar as on the level of one single business ²⁰ . The core task here however is designing the

¹⁴ Therefore it is also known as “competitive strategy”. See Grant (2005), p. 388.

¹⁵ For a basic overview on business level strategies see e.g. the widely recognized fundamental

work by Porter (1980) or as a standard reference in German language Hungenberg (2006).

¹⁶ Business strategies are essentially derived from greater corporate strategies.

¹⁷ For this and the following see Goold, Campbell, & Alexander (1994), pp. 12. Throughout the

literature the term “Corporate Advantage” is used equivalently (see e.g. Collis & Montgomery [1998], pp. 71-83).

¹⁸ In the organizational setup of a multibusiness firm also called Strategic Business Unit (SBU).

This stems from the fact that they are to a large extent operated separately and independently. A business basically stands for a distinct product/market combination.

¹⁹ However this might not always be realized due to significant break-up-cost. Also problems

measuring the discount were being brought forward, that might deter break-ups, e.g. by Reimund & Schwetzler (2003).

²⁰ See e.g. Johnson, Scholes, & Whittington (2008).

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business portfolio. This ultimately means “the choice, prioritization and alignment

of the diverse businesses” ²¹ . Or very bluntly: “what businesses should a corporation compete in?” 22

For that purpose portfolio planning tools are a core tool. These allow an easy comparison of all operational SBUs at once. To highlight this notion a selected and exemplary portfolio concept, namely the BCG growth-share matrix ²³ , is presented in Figure 2.

The basic idea behind those concepts is to depict the strategic positioning of SBUs in a two dimensional grid. While one axis indicates the positioning from an internal perspective (here market strength measured by market share), the other uses an external perspective (in this case market attractiveness measured by market growth). The grid breaks into four areas (here clockwise starting from the upper left hand corner: “Question Marks”, “Stars”, “Dogs” and “Cash Cows”). For each of them specific strategic implications are considered to be appropriate, e.g. concerning investment or divestment actions.

Market Growth in %

²¹ Hungenberg (2006), p. 453.

²² Dess, Lumpkin, & Eisner (2006), p. 191.

²³ See The Boston Consulting Group (1970). Although there are a vast variety of similar concepts,

^{a complete overview is neglected at this point since the presented one is sufficient to give an impression on the general structure and value of such tools within corporate strategy. 24} Source: Own illustration of a fictional case. Bubble sizes are supposed to represent turnover

contribution by a BU.

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These kinds of portfolio analysis tools generate valuable strategic implications. This concerns not only measures of developing certain existing businesses but also evidence on potential new ventures or divestitures of business that offer only poor future potential. Resulting strategic actions lead directly to the diversification of a business portfolio. Thus the next section is designated to explore this in detail.

2.3 Diversification

Earlier, multiple definitions of the term have been used by researchers ²⁵ . Some scholars have even asserted “confusion through terminology” ²⁶ . Now the term is commonly considered as the extent to which a company offers different products, is active in different markets while using various resources and abilities as well as management requirements ²⁷ .

The term is used for the process of entering new economic sectors as well as for a state, meaning when a company is already operational in various industries. Mixing both meanings up is unlikely though, at the same time it is unproblematic, since the underlying concept is the same. Therefore a strict distinction between process and state is not necessary.

But why do companies diversify at all? The main reasons discussed are: growth opportunities, risk spreading, synergy exploitation among businesses, market power and superior efficiency of internal capital markets ²⁸ . These factors are seen as major drivers for a value adding business portfolio ²⁹ .

Certainly due to its fundamental implications for corporations, diversification has over time become one of the major fields in strategic management. First research

²⁵ One of the most recognized among them being Ansoff, who started defining diversification

within his matrix concept (see Ansoff [1987]) as a move into new markets and development of new products at the same time.

²⁶ Reed & Luffmann (1986), pp. 29-35.

²⁷ For this and the following see Wulf (2007), pp. 7.

²⁸ See e.g. Davies (1996), p. 168, Goold & Sommers Luchs (1996), p. 2, and Hungenberg & Wulf

(2007), p. 140. However also other factors might influence diversification decisions, as Bowen & Wiersema (2005), pp. 1153-1171 have shown for the case of increased foreign-based competition. It is also frequently argued that underutilized core resources actually drive diversification (see e.g. Penrose [1959]). Since such alternative explanations can be very widespread, only the commonly discussed main reasons are presented at this point.

²⁹ See e.g. Montgomery (1994), pp. 163-178.

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dates back decades ³⁰ , and still today it is intensely discussed within the scholar community ³¹ . The dominant question is what diversification strategy is the most beneficial (i.e. successful) one and under what conditions, hence called

diversification success research ³² .

Since also this work deals with that question it is worthwhile first to describe possible diversification strategies. Three main ones can be distinguished (see

Figure 3) ³³ , they will be further discussed in the following subsections.

Relationship of Businesses

(markets, processes)

Heteroge neous

Homogen

eous

2.3.1 Focused Diversification

The strategy closest to a single business firm (SBF), thus the least diversified one, is the focused diversification strategy.

Not only the number of businesses the corporation encompasses is limited, but also the heterogeneity among them. Businesses are essentially relatively similar in

³⁰ See e.g. Penrose (1959), who first wrote about diversified firms or Coase (1937), who at least

talked indirectly about the matter while arguing that based on transaction cost there is an optimal size of a firm.

³¹ See some very recent contributions e.g. by Wiersema & Bowen (2008), pp. 115-132, Goranova

et al. (2007), pp. 211-225, Barnes & Hardie-Brown (2006), pp. 1508-1534, Miller (2006), pp. 601-619, or Pehersson (2006), pp. 265-282.

³² See Wulf (2007), pp. 25.

³³ For this and the following see Hungenberg (2006), pp. 491.

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terms of the products they offer, the markets they serve or the processes they use. Furthermore clients and competitors that businesses encounter are to a large extent the same.

The overall degree of similarity is therefore very high. The goal of this strategy is to gain advantages due to improved efficiency and shared (specific) know-how within the business portfolio.

2.3.2 Relational Diversification

This strategy involves diverse product/market-combinations while at the same time different processes are used within each business. Yet they way the businesses are run, i.e. management requirements, are quite similar.

Operated businesses are somewhat different but also related. This relatedness comes from the fact, that those businesses share the same stage in the value chain (in case of a horizontal relation) or they have direct business relations as subsequent partners in the value chain (vertical relation). Overall only a moderate number of businesses is operated.

The goal is to gain advantages for all businesses by connecting them and transferring core competencies.

2.3.3 Conglomerate Diversification

This is the extremist form of a diversification strategy. It involves businesses with strong differences in all areas: products/markets, processes and management requirements. At the same time the number of businesses held is very high.

By being present in a vast number of branches, the corporation following that strategy aims to reduce risk and generate a steady cash flow. As a text book example of a conglomerate US-based General Electric (GE) can be mentioned. GE offers a product/service range as diverse as aircraft engines, power generation, water processing, security, medical equipment, financing, media and

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industrial products ³⁴ . By doing so, over a timeframe of more than 100 years, it became one of the world’s largest companies ³⁵ .

This already serves as an indication for the economic relevance of conglomerates. In fact after World War II they have gained a significant share in all western

economies’ production ³⁶ . Technical progress, such as the development of the telephone, decreased effort and cost of coordination thus allowing the

management of large sized corporations for the first time in history ³⁷ .

However experience showed excessive diversification strategies were not without downsides, which again would favor a more focused approach. With increased corporation size operational inefficiencies became more and more a problem. Also

the advantage of risk distribution by diversification became less important ³⁸ . Due to an overestimation of synergies in the first place or higher cost of coordination and resource allocation in bigger corporations, unexpected cost occurred when synergies actually should be exploited ³⁹ . Overall those pitfalls caused a rollback movement towards refocusing in the late 1980s ⁴⁰ .

Yet, today the question remains still unanswered, which diversification strategy

generally bears the greatest potential for success ⁴¹ . Chapter 3 is dedicated to present approaches striving to explain diversification success, thus serving as a basis for the upcoming empirical analysis in the preceding chapters.

³⁴ See General Electric.

³⁵ Ranked 6th in terms of market capitalization in Financial Times‘ Global 500 Ranking, see

Financial Times (2008).

³⁶ See Rumelt (1974), who computed that among Fortune’s 500 the percentage of diversified

companies rose from 24% (1949) to 80% (1969).

³⁷ Due to the popularity of large diversified firms at that time, the period is also known as “merger

mania”; see Hoskisson & Hitt (1994), p. 5.

³⁸ See Levy & Sarnat (1970), pp. 795-802.

³⁹ This was due to the increased efficiency of capital markets. That resulted in the fact that

shareholders could spread risk more efficiently themselves by designing their specific stock portfolio (see Hungenberg [2006], p. 495).

⁴⁰ See e.g. Bhide (1990), pp.70-81, Lichtenberg (1992), p. 427, Markides (1995), pp. 101-118, or

Prahalad & Hamel (1990), pp. 79-91.

⁴¹ See Hungenberg & Wulf (2007), p. 140.

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3 Diversification and Success

3.1 Theoretical Approaches to explain Success

The scientific community has intensively discussed the causality of different forms

of diversification strategies and resulting success ⁴² . Subsequently theoretical approaches to explain success have been developed: the industrial economics

perspective, the market-based view and the resource based-view ⁴³ . Differences occur mainly regarding the underlying assumptions on market characteristics and the root cause of superior returns. In the following section those approaches are introduced and critically reflected, ending up with an appropriate one as a tool for the thesis’ analysis.

3.1.1 Industrial Economics Perspective

The main underlying assumption of this research trait is the existence of a perfect market. This suggests information is widely available at no cost to every market

participant and product offerings are relatively similar ⁴⁴ . Since this is widely not the case in real life this approach seems already inadequate to explain diversification success.

The general basis of this perspective is the so called structure-conduct-performance paradigm of strategic management. It assumes that success is mainly a result of characteristics of a given industry and a company’s positioning within that industry. Thus this view has a focus outside a company.

In terms of diversification, the general logic here is that there is no connection whatsoever between diversification and success of a corporation. Any company could be successful or unsuccessful, whether diversified or focused.

⁴² See e.g. Hoskisson & Hitt (1990), pp. 461-509.

⁴³ For this and the following see Wulf (2007), pp. 28.

⁴⁴ Dominant representatives of this stream are e.g. Bain (1956), Bain (1968) and Porter (1981),

pp. 609-620.

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3.1.2 Market-based View

Both of the following theoretical approaches are distinct to the industrial economics perspectives as they assume market imperfection. This implies information is believed to be unevenly distributed, market participants’ rationality is bounded and rights of disposal of goods are given.

Both approaches believe in a connection between diversification and success. Yet they differ in its root cause.

The market-based-view (MBV), as the industrial economics perspective, which actually is its theoretic predecessor, focuses more on external factors. Industry characteristics are brought forward as the major cause for a specific performance. A superior way of positioning in and across industries is believed to yield success.

Especially when looking at diversification, this is always then the case when advantages in one industry can be leveraged and transferred also to other industries. The relatedness of those is in this case irrelevant. As Grant argues those advantages are results of superior market power ⁴⁵ .

Four sources of such an advantage can be distinguished, namely predatory pricing, mutual forbearance, bundling and reciprocal pricing. In the following they are briefly described.

Predatory pricing comes down to the ability of large enterprises, active in many industries, to cross-subsidize their offerings. As an effect of that they are able to offer products or services at very competitive prices (even below production cost), squeezing industry margins and thus forcing others participants, that lack these options, to dismiss operations.

Mutual forbearance refers to a situation of multiple market competition between two conglomerates. Extreme tactics in single markets might be avoided by both players in order to cultivate a relationship of live and let live in all other markets.

⁴⁵ For this and the following see Grant (2005), pp. 455.

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