Many people assume diversification is good because it minimizes risks…
The word diversification has a slight positive connotation to it. To diversify is often thought of to minimize our risks, to expand, to enlarge. Rarely is it thought of to be as a survival gesture.
Just so I don’t continue to mislead anyone, this post will focus on diversification of a company’s businesses, not an investment portfolio. But in your investment portfolio, you should be cautious of companies that have decided to diversify.
Diversification can come in many forms, including market penetration, product development, market development, and diversification (for more info please go to Wikipedia – Diversification (marketing strategy)). Obviously the less you venture out of your existing products or markets, the less risk you are taking, and the more resources that are available and interchangeable, and vice versa. This is step one – be aware of the strategy the company you invested in has chosen and understand why they are doing it. Ask yourself if it makes sense.
I’ve personally invested in a company that was somewhat due to hype – insider buyback (heard from a source, not from data I’ve looked at), CEO making big on his expectations, and the company’s plan in diversifying its businesses so that they can cross sell their new businesses with their existing clients. (Disclaimer: I have already sold the company’s stock, and at this current date it’s business and stock price has been lackluster).
Thinking back, I shouldn’t have bitten on the bait. Just when were CEOS not optimistic? Their goal is to make their company grow and it’d be conflicting if they said anything but (we do hear about the CEOs that are brutally honest or even pessimistic but they make up the exceptions).
More importantly, why was the company diversifying? At that time, I thought to myself all diversification was good. Diversification meant another source of income, it meant expansion, it meant minimizing risk when their other businesses failed.
And it’s true, that is what diversification means! But I didn’t notice that this strategy was used as a defensive gesture. Had I asked myself why they were trying to diversify, I would have avoided this stock in the first place. With this company, I believed that their core operations were going through a plateau caused by disruptive technologies, and so they weren’t able to grow their earnings as much as they and the investors wanted to. They wanted to diversify because they realized that their core business wasn’t the rising star or the cash cow it used to be, and so they were trying to engage in a new business that may or may not succeed for a secondary source of income.
So when is diversification good? Well first we must understand capital allocation (borrowing this concept from Warren Buffett’s essays). As a simple example, you have two stocks to invest in, and you see the future 2 years ahead of you. For stock A, for every $1 you invest, you get $2 back. For stock B, for every $1 you invest, you get $5 back. No shit you’d choose stock B right? Basically you want your capital allocation to maximize your returns.
When a company diversifies because they realize that investing $1 in their core business may result in a return of less than $1, you want to avoid these companies, especially when their stock valuation is overpriced. Not only do they no longer believe in their own core operations, but you and them are facing the uncertainty of their new businesses.
In contrast, a good business is when they decide to diversify because they simply don’t see the point in investing in their core operations more than they already have. What’s the difference? Well let’s say the company knows that their core business is doing well, fabulous in fact, that they invest lots of money into their core business, expecting every $1 to generate at least $3. But here’s the catch. Faced with the law of diminishing returns, the amount of return they will receive will start to decline as they continue to invest more as they are faced with limited labor, resources etc. so the capital becomes less and less effectively and efficiently used. Faced with this reality, the company may then decide to diversify since diversification may prove a better return for their capital in the long run (and even short run). In this case, this is a good company; it continues to have the foundation of their core competencies and enjoy massive returns if their diversification prospers.
Now I must warn you just because it’s a good company doesn’t make it a good stock. If a good company has a market valuation way above what you think it’s worth, it may mean that now may not be the best time to invest in it. But, it’s a company you want to continue looking at.
So always remember… diversification may often be masked as something positive. The astute investor in you knows that it is with sound logic and reasoning that will help you identify the real reasons behind a company’s diversification.
Have you ever been duped by a company’s optimism in their diversifications?