I keep coming up against a logical fallacy in strategy that I feel compelled to address. The logic holds that when a company has a shareholder-unfriendly component of its portfolio – e.g. the business in question is cyclical, or it is low-growth or low margin – the company should diversify to make that business less-shareholder unfriendly. I take on the fallacy in this Playing to Win/Practitioner Insights (PTW/PI) piece entitled Diversification Can’t Disappear a Strategy Problem: It Just Creates a Different Problem. And as always, you can find all the previous PTW/PI here.
The argument
The usual motivator of this argument is cyclicality: We have a cyclical business, and shareholders don’t like the ups and downs of that business across the cycle, so they discount our stock because of the volatility of our earnings.
A memorable example of this for me was Alcan in the 1980’s, at that time the world’s best aluminum company and arguably Canada’s finest company. But it didn’t like the cyclicality of its core business, which was making and selling aluminum ingots. The downstream industries that used aluminum in some way appeared alluringly less cyclical. So, Alcan invested in a number of those businesses including packaging and aluminum structured automobiles.
Other shareholder-unfriendly attributes include being a slow-growth business. This causes companies like News Corporation to buy MySpace to get into a fast-growing business – Internet services. Another is a business that has experienced a drop in structural attractiveness and hence inherent profitability level, perhaps because buyers are getting more powerful or a supplied input becomes much more expensive.
Unfortunately, these diversification efforts don’t often succeed. For Alcan, these downstream businesses turned out to have very little in common with the skills and capabilities involved in making ingots of aluminum and were eventually sold off. For example, the packaging portfolio was sold off to Amcor, a global packaging company that knew how to run a packaging business. And News Corporation exited MySpace with its tail between its legs, selling it for $35 million six years after buying it for $580 million
I am not opposed to the intent
I am in favor of improving one’s portfolio of businesses. In fact, I was part of one of the greatest such efforts in recent memory. I was on the board of Thomson Corporation, which started its transformation as the world’s largest newspaper company, the world’s largest textbook publisher (tied with Pearson), Europe’s largest travel company, and a major player in North Sea oil. It concluded the transformation as Thomson Reuters, the leading supplier of on-line, subscription-based must-have information, analytics, and workflow solutions for legal, financial, accounting, and investor relations professionals – having exited its entire starting portfolio.
So, I get it. I like investing in good businesses as much as the next person.
I just hate the logic regarding shareholders
Shareholders aren’t geniuses – I have said that on numerous occasions (e.g. here and here).
But they are not stupid either. Let’s say the company is correct that shareholders don’t like something about an important business in its portfolio – it is cyclical or growing slowly or its industry is becoming less structurally attractive.
If that is true, shareholders will collectively price that negative feature into their valuation of that business as part of their overall valuation of the stock. Let’s say the contribution of that shareholder-unfriendly business to corporate earnings per share (EPS) is $4/share and that if it wasn’t cyclical, shareholders would put a 20X multiple on those earnings. So, it would have contributed $80 towards the company’s overall share price. But let’s say that because it is cyclical, shareholders discount the value of those earning to a 15X multiple, meaning that the cyclicality of the business costs the company $20 on its share price (i.e., $4 of EPS X 5 times lower multiple). And if there are 50 million shares outstanding, that is a cost of $1 billion in shareholder value due to the cyclicality of that business. The same calculation would hold if it were a slower growing business on which the shareholders similarly put a 15X multiple instead of 20X. Or if a business has experienced a sharp structural drop in future profit potential.
The bottom line is that because of the features of the existing business, shareholders subtract $1 billion of value from the overall valuation of the business.
Let’s continue with the logic. Imagine the company diversifies into a non-cyclical business or fast-growing business or higher profit business. If it is a great business, the shareholders will put a high valuation on it. Let’s say that the company buys such a business for $2 billion and it performs so well that shareholders soon value it at $5 billion – which makes it a great diversification investment.
But the logic of this argument holds further (implicitly) that over and above the value that shareholders will give to the great new business into which the company diversified, the shareholders will reduce the $1 billion valuation hit that they are applying to the problematic business. Not only can I not think of any reason why shareholders would do that, I have never seen them do it – because there is no reason.
In the words of the great Nobel Laureate, the late George Stigler, when I met him in his Chicago apartment, “Roger, a company can’t use its competitive advantage twice” – brilliant insight from a brilliant man. In this case, it can’t use the plus-$5 billion to disappear the minus-$1 billion. In essence, it will be a plus $5 billion and an unchanged minus $1 billion.
What is the problem?
As I said, I like investing in great new businesses. If there is a $5 billion opportunity available for a $2 billion price, a company is foolish not to grab it. The problem is a company putting itself in the position of believing the presence of the undesirable business creates a requirement to diversify. This is especially the case because the tool used is typically acquisition because organic growth is viewed as taking too long to “solve the problem.”
And the failure rate in acquisitions is legendarily high – in the general case. This is a very specific case that makes doing a successful acquisition even harder. There is a very specific requirement of the acquisition – it must reduce our overall cyclicality, or increase our overall growth rate, or increase our overall profit margin. These are hard criteria to meet in an exercise that already has a high degree of difficulty.
Additionally, it works against a key principle that helps determine acquisition success. As I have written about previously in Harvard Business Review, acquisitions are more financially and strategically successful if they are more about what the acquiring company can do to help the acquired company than the other way around. When the focus is on what the acquired company can do for the acquirer, the acquirer tends to have to pay top dollar for the acquired company and the acquirer can do little to help pay for the high takeover premium, as with the News Corporation-MySpace acquisition above. News Corporation paid absolutely top dollar and it had no idea how to help MySpace as it faced withering competition.
Thus, in the failure-ridden world of acquisitions, the logic of this diversify-to-eliminate-the-shareholder-problem drives companies toward very low success rate approaches.
Net, there are compounding shortcomings of the approach. First, it doesn’t actually solve the problem for which it is designed to solve. And second, it involves engaging in a very high-risk activity. That is not a good combination.
Implications for strategy
As I pointed out previously in yet another Harvard Business Review article, companies are better off if they simply value businesses at what they are worth – not their value on the books. They may wish that a business was worth as much as or more than the amount of investment put into it. But the instant the investment is irreversibly made into the business in question, its value becomes a function of its future prospects, not its book value. If it was a poor investment, its true value will go down, and the opposite if it was a good investment.
That is the valuation that shareholders make every trading minute. They revalue your assets continuously by collectively buying and selling your shares. Why shouldn’t you revalue similarly? Bad businesses don’t have bad shareholder returns – shareholders have long since revalued them downwards. And great businesses don’t automatically have great shareholder returns – shareholders have long since revalued them upwards. Shareholders get valuation.
If you can make a business better – great, just do it. But don’t try to disguise the shortcomings of a business through diversification. You aren’t fooling anyone but yourself – and certainly not the shareholders.
A far better plan is to suck it up and recognize the true value. And if you don’t like what you have, sell it and move on. That is what we did at Thomson Reuters. We didn’t attempt to disguise the negative attributes of portfolio companies. We got rid of them – to companies that liked their attributes better than we did. For example, we sold our newspaper business to the world’s biggest newspaper company, Gannett, for US$2.2 billion. They were enthusiastic but it ended up being a deal that a Gannett CFO later confessed to me was the worst acquisition deal in his company’s history. And even better, we sold the textbook business to a pair of delusional private equity firms for US$7.75 billion, and they resold it three years later for a reported US$2.25 billion – ouch! The combined divestiture proceeds of US$10 billion were really helpful in bringing the transformation to fruition.
Practitioner insights
I try hard not to be disrespectful to the status quo. Most things that stick around for a long time do so because they have shown themselves to make sense. But in the world of business ideas, a minority – like SWOT, strategies not strategy, and revenue forecasting – stick around even if they fail to make any logical sense. You must be ready to reject them when they are demonstrably dumb ideas.
This is one of them. Don’t invest in big and high-risk ways to disguise a problem that can’t be disguised. It is one of the silliest and most wasteful activities in company life. And there are lots of folks hanging around that make huge returns by whispering in corporate executive ears about this kind of diversification. They are the (so-called) strategy consultants, investment bankers, and M&A lawyers who make countless billions promoting stupid deals, like the disastrous AT&T takeover of Time Warner – which AT&T bought for $85 billion and sold for $43 billion three years later. That was the equivalent of the AT&T executive team making a $38 million stack of shareholder money outside AT&T corporate headquarters, pouring gasoline on it and lighting it on fire – and repeating that exercise every day for three years. The “brilliant deal” was purportedly going to get the boring AT&T into the exciting, faster growing and higher margin content business. I predicted at the time that it would be an epic disaster – and it most certainly was. It is what happens when you adhere to a loser theory.
Instead, either love a business or get rid of it to someone who will love it more. You can’t win in a business that you don’t love. Competitors who love their business will wipe the floor with you and yours. Only spend time and resources on businesses that you love. Those are the only ones that will get the care, attention and investment that they need and deserve.
