By Richard Friberg, the Jacob Wallenberg Professor of Economics, Stockholm School of Economics
“Don’t put all your eggs in one basket” is classic advice for managing risk. Diversification is key to risk management for financial markets and insurance companies. But what about the product portfolios of firms? What are the links between the diversification of product portfolios and risk exposure for firms that sell goods and services? That is the focus of this article. In this short discussion, we will first cover the intuition then briefly look at the foundation of the view that “focus” beats diversification before turning to a nuanced discussion of the benefits from diversification and examining a specific case, showing how the benefits of within-industry diversification can be quantified.
Diversification of product portfolios
We can think of the overall cash flow of a firm as the sum of cash flows from individual products. Consider, for instance, a firm that produces skis. Its sales will depend on how cost and demand shocks interact with its product assortment—a winter with little snow in its main market or an overall downturn in the economy will tend to be associated with lower cash flows. If the firm produces only premium products in one market, a recession and a winter with little snow will tend to hurt cash flows from all of its products at the same time. If, on the other hand, the firm is diversified, the shocks will tend to “wash out”. Such diversification can come from selling in several geographic markets, from having presence both in premium and budget segments, and from branching out into other product markets, for instance, markets for summer sports. Clearly, firms in the same industry might be following different strategies—compare, for instance, Apple, the profits of which largely come from iPhone sales, with the Samsung conglomerate.
That the diversification of its product portfolio matters for the firm’s response to shocks is thus hardly controversial. The broader question is: Should a firm diversify? And if so, how should it measure the benefits of diversification?
Should a firm diversify?
Whether a firm should diversify or not has been the subject of great swings in the debate. The 1960s and 1970s saw many pundits hailing the benefits of diversification and celebrating the robustness of a conglomerate. Since then, the pendulum has swung, and there has been a strong tendency towards focus. The arguments against diversification have essentially followed from two tenets: one, that average performance weakens as a firm expands from its core business; second, that a firm can rely on markets to finance itself.
A representative quote by Birger Wernerfelt (1985, p. 510) argues that “[such reasoning] suggest that firms should buy or sell divisions based solely on their risk/return properties…. [instead] such businesses will on the average be valued accurately by the market, such that our firm gains nothing in the trade. Instead, the stockholders can diversify individually. Firms can only do better than stockholders if there are operating synergies between the divisions such that returns or systematic risks change.” Empirically, many studies have also found a “diversification discount”, that a focused business is valued higher as a stand-alone than as part of a conglomerate. For instance, influential articles by Lang and Stulz (1994) and Berger and Ofek (1995) found that the implied value of business segments in diversified firms is substantially below their imputed stand-alone value, thereby pointing to a negative view of diversification.
Should one, therefore, draw the conclusion that focus is always better than diversification? No. Let us point out three reasons for caution.
First, research has increasingly pointed out that low overall cash flows hurt future profits when firms are constrained in their ability to access capital [Froot et al. (1993) is a key reference]. Thus, if a firm is able to raise new funds easily if needed, or has access to good hedging instruments, it makes sense to follow a focused strategy; but if that is not the case, the cost of diversification needs to be weighed against the risk of long-lasting effects of weak profitability as well as the costs of other means by which risk can be managed. Against this backdrop, it is perhaps no coincidence that Apple (with its focused strategy) is based in the United States with its liquid financial markets, whereas the conglomerate Samsung is based in the much smaller South Korea. Furthermore, it might not be a coincidence that Apple sits on a mountain of cash. Precautionary-cash holding is an alternative to diversification in managing risk, and much research shows that less diversified firms hold more cash [see, for example, Duchin (2010)]. The conclusion thus being that diversification should be evaluated on a case-by-case basis rather than as a blanket proposition. As such, the implication is hardly astounding, but the research also points to key elements of the decision: What are the consequences of low cash flows, and what are other means of assuring survival and continuing investment in challenging times? Decisions thus depend both on the characteristics of the firm and of the financial markets in its environment.
A second caveat is that several more recent articles suggest that the evidence of a diversification discount is less robust than once believed. Villalonga (2004), for instance, argues that when using more accurate industry classifications than those of previous research, the diversification discount vanishes and even turns into a premium [see also Maksimovic and Phillips (2013)]. More fundamentally, and echoing our arguments from the previous paragraph, Mackey et al. (2017) argue that the search for an average diversification discount is likely to be in vain. If firms differ in their characteristics, the optimal strategy is also likely to differ, and each diversification strategy may be rational for the firms that adopt it. Even so, Mackey et al. (2017) confirm a common result on the performance effect of diversification: diversification to closely related industries tends to outperform diversification to unrelated industries.
A third caveat is that the literature on diversification discounts has overwhelmingly studied across-industry diversification. An example would be a bike manufacturer that branches out into garden equipment. Within-industry diversification is much less studied. This would be the case in which a bike manufacturer does not simply focus on one segment but instead has a wide proposition with products in both budget and premium segments of bicycles or wider geographical coverage. Such diversification has been little studied, presumably because there is a lack of data available to researchers at this fine level.
One exception is a recent working paper that focuses on the Swedish market for alcoholic beverages [Friberg (2019)]. Let us highlight some results from this paper.
Friberg (2019) examines the portfolio choices of wholesalers in the Swedish market for alcoholic beverages. Sweden has a governmental retail monopoly on sales of alcohol—similar to Norway and Finland and several US states such as Pennsylvania and New Hampshire. Wholesalers are private, profit-maximizing firms, and the paper studies their product portfolios. There are more than 150 wholesalers, and many of these have no more than 10 products in their portfolios. For concreteness, we may compare a firm that wholesales five high-end French wines with a firm that imports a mix of wines, beers and spirits from different origins. The first firm is going to be fully exposed to the euro exchange rate as well as to any demand or supply shocks that affect French wines (such as labour strikes or consumer boycotts), whereas the diversified firm is going to be less exposed. Furthermore, the law of large numbers from statistics implies that the number of products is going to play a role. Importing five French wines is expected to be riskier than importing ten smaller French wines that together make up the same cash flow. Some shocks to demand and cost are going to be specific to the individual product, and if shocks are not perfectly correlated, offering a larger number of products implies more stable developments.
The question then becomes: How can we quantify the gains of diversifying in such a market? One alternative would be to examine the history of cash-flow volatility in this market. We might link the volatility to the number of products and the diversity in terms of origins and segments, for instance. A concern with such an approach is that, even with a comparatively large number of products, we have access to only a small sliver of the potential outcomes. Say that we have access to five years of data. That period includes a strong euro exchange rate but with a high probability that the euro might have taken on other values in that same period.
One way to deal with such issues is to use what is known as Monte Carlo simulation, an approach that is pursued in Friberg (2019). Say that we have data on a long-time series of exchange-rate shocks. Based on that, we can consider a probability distribution of exchange-rate shocks. Taking a large number of counterfactual random draws on exchange rates, and other random variables that affect profits, we can then sum up these random draws to generate counterfactual profit distributions. Summing up, we can then see how the probability distribution of cash flows depends on exchange rates, other shocks and the number of products. The paper, for instance, shows that diversification benefits are also available at a very fine-grained level—for instance, lowering risk by focusing on white wine in bottles rather than white wine sold in the more volatile bag-in-box segment. It also shows that an important element of risk is the number of products when more products are associated with lower risk. Overall, this study shows how Monte Carlo simulation techniques, combined with regression analysis, can be used to evaluate the risk consequences of different product portfolios.
References
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