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Davis/Devinney The Essence of Corporate Strategy 1996

CHAPTER 9: THE STRATEGIC GAINS FROMHORIZONTAL INTEGRATION AND DIVERSIFICATION

Work, itself, is not organised as it used to be. Organisations are not now drawn as pyramids of boxes. [They] now have circles and amoeba-like blobs where boxes used to be. It isn’t even clear where

the organisation begins and ends, with customers, suppliers and allied organisations linked into a varying ‘network organisation?

Charles Handy, The Empty Raincoat (1994)

The acid test of competitive success is the ability of the firm to generate cashflow for the shareholders in the long run. Yet the successful firm ultimately runs intobarriers defined by the natural limits of expansion in its chosen domain. Somecompanies, such as General Motors, Toyota, Boeing and Microsoft, have remainedfocused due to the unique nature of their business. GM, Toyota and Boeing are inlarge fixed cost businesses with little relevant spillovers and mature demand, whileMicrosoft operates in a market still in the growth phase of its industry life cycle. Itwould hardly pay for Microsoft to abandon the growing software market to move onto some other venture. However, even these companies have ‘diversified’ themselvesover the years. Boeing moved from military applications to civilian airline productionafter World War II. Although done at different points in time, both Toyota and GMhave expanded their model base and moved production to new markets. Microsoftmoved out of operating systems into spreadsheets, word processing and databasemanagement programs, and is now expanding its presence in the network architecturemarket.

At some stage in the firm’s development, management face a critical decision:do we pay the net cash flows out as dividends or do we seek new investmentopportunities? Rarely, if ever, does management make the decision to liquidate thecompany, believing that new investment opportunities always exist. Some expertsview this as little more than managerial hubris sustainable only by the inability ofshareholders to police management effectively.1 Classic examples of unjustifiedinvestment include the expansion of American cigarette companies, Philip Morris andR. J. Reynolds, into food operations. In both cases, the companies were generatingenormous positive cash flows due to the structure of their tobacco operations. Ratherthan pay out the money to shareholders (who could have reinvested it and achieved areturn of around 14 percent), both companies expanded into food operations that earn,at best, 5 percent. Of course, management is not so naive as to believe that they cansimply spend shareholder’s money without some justification. Therefore, they justifytheir investments based on synergy. In both the Philip Morris and R. J. Reynoldsexpansions, the synergies were argued to be in marketing and distribution, althoughone would be hard pressed to find Nabisco managers or workers who knew anythingrelated to cigarette production or sales and R. J. Reynolds executives and managerswho understood the intricacies of the biscuit and cracker market. The same can besaid of Philip Morris. Which capabilities built up in cigarette production and salescan be transferred to the beer (Miller Brewing) and cheese (Kraft) markets?

1 This is Jensen’s free cash flow argument. See M. Jensen, The Eclipse of the Public Corporation,Harvard Business Review, 67, September/October 1989, 61–74.


The differences between the Boeing-GM-Toyota and Microsoft examples andthe Philip Morris-R. J. Reynolds example is that the former based their expansion intonew products and markets on the distinctive skills and competencies of the firm asthey related to new markets or products while the latter based their expansion on thenecessity of spending the cash that was pouring out of their base operations incigarettes.2 The Boeing-GM-Toyota diversification was purposeful and rationaldiversification that shareholders alone could not achieve through diversification in thefinancial markets. There is every indication that Philip Morris’s and RJR Nabisco’sstructures could easily have been duplicated through financial market diversificationhad investors chosen to go that route.3

The remainder of this chapter will focus on the conditions under whichhorizontal integration (HI) and diversification make sense. Like our discussion ofvertical integration in the previous chapter, HI will be justified only in circumstanceswhere expansion into new products or markets utilises existing assets orcompetencies, expands the firm’s unique asset base, or resolves a market failureproblem. In the next section, we outline rational diversification in more detail. Thisdiscussion will apply not only to HI but to our prior coverage of VI. A discussion ofthe role of the corporate centre follows. The chapter concludes with a criticalsummary of the managerial portfolio models that have been used to traditionallyjustify expansion into new products and markets along with a short coverage of theimpact of related diversification on firm risk.

Related vs Unrelated DiversificationThe Financial Returns to Diversification

Chapter 4 outlined results of a study by Rumelt that showed the returns torelated diversification far outweigh the returns to unrelated diversification. Morerecent evidence paints an even more negative picture of the impact of unrelateddiversification on firm performance. Comment and Jarrell4 find that a firm’s marketvalue of equity rises during the period in which it chooses to become more focused(less diversified). Case 9.1 highlights this fact with respect to the Australian companyParbury. In a more comprehensive analysis of 1,449 US firms, Lang and Stulz5

estimated the impact of the degree of firm unrelated diversification and its long-termperformance. The results are shown in table 9.1 and indicate that the greater thedegree of a firm’s diversification, as measured by the number of different industrysegments in which the company operates, the lower the premium afforded the firm, asmeasured by a ratio of market value to book value (of equity and debt).6 The secondline shows the discount in this ratio as associated with greater diversification within

2 Although recent numbers aren’t public for RJR Nabisco, Philip Morris currently earns an ROA of28% on its cigarette operations and only 9.5% on its food operations.3 What is most illustrative about this point is that Ross Johnson, RJR Nabisco’s chairman in 1980s,proposed breaking the company up into separate food and tobacco operations as a basis of hismanagement buyout of the company.4 R. Comment and G. Jarrell (1993), Corporate Focus and Stock Returns, Rochester NY: BradleyPolicy Research Center Working Paper, University of Rochester (unpublished).5 L. Lang and R. Stulz (1994), Tobin’s q, Corporate Diversification, and Firm Performance,Cambridge MA: National Bureau of Economics Working Paper (unpublished).6 The ratio market value:book value is an approximation of what is known as Tobin’s q. Tobin’s q istechnically the ratio of replacement value to purchase value of assets for which market value to bookvalue is a good proxy. Tobin’s q is a much better measure of accumulated value than accounting basedmeasures such as ROA and ROE.


the same industry. In other words, having accounted for the main industry ofoperation, companies operating in five or more different segments have a market tobook value ratio that is 50 percent below a focused firm! Even operating in twounrelated sectors is sufficient to lead to a discounting of 35 percent over the value of afocused firm.

Table 9.1: Diversification and Firm Performance

Number of Segments Firm Operating In

1 2 3 4 5+

Market Value:Book Value 1.53 0.91 0.91 0.77 0.66

Discount Relative to aFocused Firm -- 35% 43% 43% 49%

Source: Lang and Stultz

In all this discussion, we have failed to account for the definition of what wemean by related or unrelated diversification? Academic economic and finance studiestypically define relatedness based on industry definitions. Therefore, a company’sdegree of diversification would be greater the closer the industry definitions were andthis would be based on standard industrial classifications.7 However, managementsurveys show that the gains to merger or expansion come from the ability of thecompany to gain synergies in a host of areas, with the number one source of synergybeing in managerial skills.8

If something as nebulous as managerial skills is the main source of synergybetween divisions of a company, how do we decide ex ante when a merger orexpansion is related or not? For example, during the 1980s many managers andanalysts thought that computer software and hardware were sufficiently synergisticthat to be successful a company had to do both well. Only in hindsight do we knowthat this is not the case. A more recent example raises the same puzzling question. Isthe purchase of Paramount Pictures by Viacom (a US cable operator) truly relateddiversification? Although Home Box Office (the number one pay television stationin the United States) owns its own movie production operations, most of the majornetworks in the United States spent the 1970s and 1980s reducing their in-houseproduction of movies and television programs. It was easier and cheaper for them tocontract with independent producers. Which move is more rational?

The above examples point out the difficulty of deciding when products oroperations are related. The same logic applies to markets as well. CSR went througha restructuring in the late 1980s that led to a greater focus on building materials butincluded the company’s expansion into the United States (see figure 9.1). Thesupposition of CSR management was that the building materials markets in Australia /New Zealand and the United States were more similar than were the buildingmaterials and minerals markets in Australia / New Zealand. Is it not equally plausible

7 Standard industrial classification (SIC) codes define industries based on hierarchical 4-digit codes.For example, 28-- is chemical and related processes while 2834 is pharmaceuticals and 29-- ispetroleum and 2911 is petroleum refining. See chapter 12 for a discussion of industry definition.8 V. Mahajan and Y. Wind, Business Synergy Does Not Always Pay Off, Long Range Planning, 21,February 1988, 59–65.


that CSR’s managerial skills related to Australian and New Zealand operations inbuilding materials and minerals had distinctive inter-relations that we haven’t beenable to adequately quantify while the American and Australian building materialsmarkets require skills that are distinctly local?

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

1985 1990

Per

cent

age

of A

sset

s (T

otal

= 1

00%

) Building (US)

Building (AUS/NZ)

Timber

Sugar

Aluminium

Iron Ore

Minerals/Chemicals

Coal

Oil and Gas

Unallocated

Source: CSR, Annual Reports

Figure 9.1: Asset Distribution at CSR (1985 and 1990)

So what do we learn from all of this? Firstly, how we define relatedness is quitevague but is ideally based on the degree of inter-relationship between differentcompany divisions operations, generally defined. Secondly, even with quite imprecisedefinitions, the empirical evidence indicates that ‘sticking to one’s knitting’ is a morefinancially rewarding strategy. However, whether one chooses to knit jumpers orsocks is less important than the fact that one knits!

CASE 9.1: Bringing Focus and Performance to Parbury*

Parbury Limited was a classicAustralian conglomerate. Thecompany’s troubles began with acorporate diversification strategyconceived in the 1950s, when itexpanded into leather goods andfabrics, engineering, plastics, mining,metals and paints, and, not to mention,foods. Parbury became the traditionalrevolving door conglomerate. Under-performing units were sold only to bereplaced by other unrelatedacquisitions.

By the late 1980s, the companywas operating in a number of unrelated

sectors using the cash from theprofitable divisions to keep theunprofitable ones funded. Althoughthe company was still turning a profit,there was no indication that any valuewas being created by the company thatits shareholders could not haveachieved more efficiently by simplyholding the independent parts.

Phil Cave’s Minstar Corporationpurchased 8.5 percent of Parbury inlate 1990 and the company quicklyadopted a plan to narrow its primaryfocus to the building materials andsignage business. Minstar’s control of


Parbury was assured when Cave wasappointed Managing Director in Aprilof the following year. Conducting amassive sell-off and close-down, Caveand his management team disposed ofthe company’s hardware stores (1992),its timber projects (1992), several of itssawmills (1991), its metal and plasticoperations (1993), and its gold mine inPapua New Guinea (1991). In 1992,the company’s acquisition of IdealStandard’s distribution business and

Aakronite, Australia’s leadingproducer of vanity cabinets, solidifiedParbury’s product range, allowing it tobecome a comprehensive supplier offinished bathroom, kitchen and laundryroom products.

The figure below gives an outlineof Parbury’s level of acquisitions,divestures and write-offs since 1988. Itpaints a picture of a company focusedon removing unnecessary operations.

$- $5,000 $10,000 $15,000 $20,000 $25,000 $30,000

Acquisitions

Disposals

Write-Offs

Ass

et

Amount (in ,000)

1988

1989

1990

1991

1992

1993

What were the implications of thesechanges? The graph below shows theperformance of Parbury Ltd equity ascompared to the ASX buildingmaterials company index. Beginningin early 1993, along with Parbury’scampaign to focus its operations anddump its unrelated businesses, there isa rapid response on the part ofinvestors. In the period January 1993through August 1994, Parbury

achieved significant increases in valuedespite the fact that the company wasshowing operating losses and payingno dividend while selling businessesduring a recession.

* Source: This discussion is based oninformation contained in Parbury Ltd’s AnnualReports plus G. Stickels, Business ReviewWeekly, 11 April 1994.


Parbury Performance (1991-1994)

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1.00

1.50

2.00

2.50

3.00

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x of

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form

ance

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0)

Parbury

Bldg Materials

Phil Cave Appointed

MD

$5.35MLoss

PNG GoldmineDisposal

Disposals: Sawmills & Hardware

Stores

$2.83MLoss

Disposals: MT&MM, Neela, Nolex, Padina,

Engineering, REI, Sandovers, Wood Wizards

$1.64MLoss

Profit Forecast= $1.6M

What is Related Diversification?We still need a definition of what ‘related’ means. For our purposes, related

diversification is the application of the company’s asset base to new products,operations or markets that:

• Increase the efficiency of the utilisation of the asset base. This can occur eitherthrough the increased efficiency in the production and selling of existingproducts in existing markets and/or because the operations associated with newproducts and markets are more efficient than would be the case without theexisting asset base.

• Increase the build up of new assets. In other words, a company, havingexpanded its product lines or moved into new markets, has increased its assetbase over and above what would have occurred if the activities remainedseparate.

How might this translate into the activities of the firm? Stated simply, the abovetwo conditions ensure that the total from joint operations or diversification is greaterthan the sum of the independent parts. In the case of VI, we showed that integrationup and down the value chain has value only when both joint production economies(JPEs) and trade in intermediate products (TIPs) demand it. With HI anddiversification expansion of the same logic holds. The first question that needs to beasked is: do the activities add more value together than they would separately?Financially, we are asking if value additivity holds. Value additivity implies that thetotal net present value (NPV) of a set of projects is equal to the sum of the individualproject NPVs.

Value Additivity: NPV(A + B + C) = NPV(A) + NPV(B) + NPV(C)


Therefore, the first condition for rational diversification or HI is the existence of somejoint value from the linkage of markets or products. We will call this super additivity(SA).

Super Additivity: NPV(A + B + C) > NPV(A) + NPV(B) + NPV(C)

Note that joint production economies (JPEs) are simply a subset of the idea of SA.However, just as we found that JPEs were not sufficient to ensure that VI wasnecessary, there is no indication that SA implies that HI or diversification shouldoccur. The second condition for rational diversification or HI is that the joint valuecannot be contracted without internal control, that is, we have market failure. In otherwords, if we know that NPV(A+B) = NPV(A) + NPV(B) + NPV(AB), then thequestion becomes: can firms A and B somehow write a contract that allows them toshare NPV(AB) fairly and with stability? If the answer is yes, then some sort of jointmarketing or production agreement is sufficient. If the answer is no, then some formof internal diversification or merger is necessary. Just as in the case of JPEs and VI,SA is a necessary condition for HI but market failure is both necessary and sufficient.

There are three areas where more efficient asset utilisation and development areimportant to the horizontal diversification of the firm: supply or production; customerdemand; and business or managerial skills.

SA in Production. From the supply perspective, we are talking once again aboutjoint production economies and economies of scope. These arise from the ability toshare overhead, production, distribution, marketing and other resources in a way thatincreases the gains to new and existing operations. There are fairly obvious examplesof multi-market and multi-product JPEs. Ideally, the merger of Goodman Fielder withUncle Toby’s should have proven to have been a classic example of distribution andmarketing synergy. Unfortunately, the relatively well-run Uncle Toby’s operation wassubject to the bureaucratic and inefficient Goodman Fielder management structure.Another example is seen in Komatsu’s expansion from an equipment manufacturerinto the development and production of machine tools. This expansion arose from thejoint proprietary know-how developed by Komatsu through the engineering of largescale precision machines – its competitive advantage in its battle with Caterpillar.

SA in Customer Demand. From the demand perspective synergies arise due tocustomer rigidities or switching costs. For example, Korean electronicsmanufacturers have focused on supplying products for the private label and OEMmarkets. In customer surveys, the product quality and satisfaction of the Koreanmanufacturers are normally perceived to be equal to those of the Japanese electronicscompanies, as long as the brand’s identity is hidden. Once the product is revealed tobe Korean, say a Goldstar product, evaluations drop. The implication is that longestablished intangible assets, such as brand names, can have dramatic effects.

In the United States, Sears, Roebuck & Company built a reputation based on itshistory as a mail order company that would sell customers in any location just aboutanything they wanted – it actually sold prefabricated houses at one time – and wouldcompletely guarantee quality and satisfaction, no mean feat in the late 1800s. Overthe years this positioning was developed into an established reputation for qualityassurance. Sears began leveraging this reputation by putting its name on a host ofproducts, from tools and paints to white goods and clothing. Up until the 1970s, Sears


competitive advantage was this long established perception of guaranteed quality andits reward was the premium it could charge for its private label products. Thisadvantage ultimately fell in the face of fierce competition from production-drivendiscounters – first K Mart and then Wal Mart and the warehouse discounters – whofound that such quality guarantees could be mimicked, especially in a world whereproduct quality had become less variable and quality guarantees came directly fromthe manufacturer.

SA and Managerial Skills. The number one area of synergistic gains is in the realmof managerial skills. Unfortunately, unlike the two prior areas of product and marketinter-relationship, this is the most difficult to codify. The benefit of managerial skillsas a source of SA is that, like other intangibles, their value is generally jointlyproduced and utilised and, therefore, a source of fundamental strategic advantage.

A nice example of synergies arising out of the development of specific butunidentifiable skills is seen in the major American defence companies. The majorproduct groups of four of these companies is shown in table 9.2. It should be clearthat many of these product groups are separable from one another; that is, there are noapparent JPEs that imply they should be together. This fact is supported by GeneralDynamic’s recent sale of its missile operations (to Hughes Aircraft), its electronicsbusiness (to the Carlyle Group), and its tactical military aircraft group (to Lockheed).Defence contractors reaction to the American military build down has not been awholesale move to commercial applications, but rather a refocusing of the companiesaround the critical skills associated with meeting specific defence needs.

Table 9.2: Major Products of American Defence Contractors

General Dynamics Lockheed Grumman Northrop

Nuclear Submarines F-16/F-117A/F-22 Radar Systems B-2 BomberM1 Tank C-130 Computer System

DesignElectronic Counter-measure Systems

Armoured Vehicles Space ShuttleProcessing

AircraftComponents

Missiles

Launch Systems Missile Systems Special PurposeVehicles

BAT AntiarmourSubmunitions

Two factors are driving this restructuring. Firstly, the skills necessary for thedevelopment of high technology weapons systems reside in the know-how possessedby the companies through their historic development, the human capital of theirengineers and managers, and patents and designs they have developed. Given that aminimum level of scale is necessary to be successful in the defence industry in thelong term, it pays to focus when demand declines. Secondly, and more importantly,there are unique skills required when dealing with the Pentagon procurement system.New weapons systems are not developed independent of existing weapons, nor is onesystem under development independent of the other systems under development. Thisrequires the companies to have built up tangible and intangible assets associated withworking the Pentagon system. More interestingly, linkages with other defencecontractors become critical as well, given that the know-how necessary for thedevelopment of a modern weapons system is unlikely to reside in one company. The


end result is that what makes defence contractors unique, and unlikely to successfullyintegrate their operations into more commercial endeavours, is that their keycompetency is the ability to work within the procurement system of their keycustomers.

Accounting for Market Failure in HI and DiversificationGiven that SA alone is not sufficient to justify HI and diversification, we need to

concentrate on the factors that lead to internal HI dominating external contracting. Todo so, it is best to go back to the value chain and extend it to account for morecomplex organisational structures. The best method for doing so is to build on theidea of a value constellation as described by Norman and Ramirez9 . We can describea value constellation as a set of independent and related value activities. According toNorman and Ramirez, the modern corporation is not the linear value creatorenvisioned by Michael Porter10 but a more complex, non-linear, value creator wheredifferent customers formulate their own ‘products’ by picking and choosing thecombinations of value activities that most satisfy their needs.

The example in figure 9.2 outlines a stylised non-linear value chain for a bankand will serve as the basis of our discussion of when HI and diversification arenecessary.11 Three characteristics of this system are important to understand. Firstly,there are fundamental skills which represent the basis of the value activities. Theseskills encompass the tangible and intangible assets and know-how that represent thecore of what defines the firm. In our simple example, three clusters of skills areimportant, retail selling skills, computer/telecommunications skills and portfoliomanagement skills. These clusters of skills represent non-tradable or imperfectlycontractible components of the firm (otherwise we would have broken them downfurther). However, trading may be possible across the skill clusters. Secondly, thereare value activities that arise from the application of these skills. For example,computer and telecommunication skills are necessary for clearing operations, ATMs,trading activities and phone banking systems. Finally, there are the linkages betweenthe skills and activities and the between the activities themselves. The criticalquestion that will need to be addressed is whether these linkages are best facilitated bymarket mechanisms or the firm’s internal organisation structure?

9 R. Norman and R. Ramirez, From Value Chain to Value Constellation: Designing InteractiveStrategy, Harvard Business Review, 71, July/August, 1993, 65–77.10 A linear system is one where activities follow in a line. In all fairness to Porter, we should note thathe does talk about more complex configurations of value chains. However, the logic of Norman andRamirez is different in both substance and style from more traditional value chains as described in theliterature.11 This example is highly stylised to make a complex argument simpler. Banks do considerably morethan outlined here and the arguments herein are not meant to be a perfect reflection of true bankoperations.


Retail Selling SkillsPortfolio Management

Skills

PhoneBanking

MortgageLending

DepositTaking

ATMAccess

HomeLoan

Centres

SAVINGS - CustomerSegment 1

SavingsAccount

FULL RETAIL -Customer Segment 3

ClearingOperations T

ransfer

Transfer

Financial Management

Services

Trading

SuperannuationServices

Transfer

Transfer

FULL DEPOSIT -Customer Segment 1/2

FULL SERVICE -Customer Segment 3/4

INVESTOR - CustomerSegment 4

Value Activities

Skills Underlying Activities

Value Activities Done Out-of- House

Transfer Indicates a Market Transaction

CHEQUE - CustomerSegment 2

ChequeAccount

Computer/TelecommunicationSkills

Figure 9.2: A Hypothetical Value Constellation of a Bank

The bank system provides a host of value activities that different customersegments select amongst. CHEQUE customers require only ATM and cheque accountaccess while FULL RETAIL customers demand checking and savings accounts,deposit taking, ATM access and mortgage financing. INVESTORS require financialmanagement and superannuation activities and access to phone banking. What isimportant from the firm’s perspective is not so much what the customers demand butwhich skills and assets are necessary to deliver the value activities. In the case ofcustomer segments 1, 2, 3 and 3/4, the relevant skills are retail selling andcomputer/telecommunications. The question for the bank is whether it needs toprovide all the value activities associated with serving these segments or whether itcould contract out some of them? For these customer segments, it is extremelyunlikely that the different activities could be provided by completely different firms.Firstly, it is probably economically inefficient to break up the retail selling skills sincethere are likely to be strong JPEs between the different value activities. Secondly, it isunlikely that the bank would even know which of the retail selling skills are critical towhich type of activity (they may all be necessary for all of the activities). The SA isso heavily intertwined in the underlying assets that having different firms do thedifferent activities for these customer segments would be difficult if not impossible.For example, how would the bank know where to attribute success and failure whencustomers are buying bundles of services for which the selling activities cannot beseparated?

However, once we step across skill boundaries the likelihood of outsourcingincreases. It is quite likely that the skills associated with computers /telecommunication are sufficiently different from retail selling that unbundling thetwo skill groups and the value activities on which they are dependent makes sense.


There is no fundamental logic to argue that the ATMs and clearing operations couldnot be operated separately. Going further, it is possible that the portfolio managementskills are also sufficiently independent that the activities derived from them would becontracted out.

Using the above logic, we are left with five firms supplying different bundles ofservices. The core bank provides cheques, mortgages, savings and deposit taking.The investment house provides superannuation and financial management activities.The clearinghouse does clearing services for the core bank while the trading househandles the financial market transactions of the investment house. Finally, thecomputer services company services all of the prior companies. It handles ATM andphone bank services along with miscellaneous services surrounding trading andclearing activities.

But what of the customers? Would they not be confused by all this? If thecustomers truly value one-stop banking, then there is no reason to believe that theyneed to know that the main services provided to them are provided by someone otherthan their bank. In the United States, almost all the ATMs are operated by RossPerot’s company EDS. The fact that Bank of America does not operate its own ATMsystem is unknown to most customers. Also, most smaller banks do none of their ownclearing operations, leaving this to larger banks with sufficient economies of scale tojustify doing it in-house. There is also no indication that the bank even needs to be asource of funds. With large scale securitisation of things like mortgages, auto loansand credit cards, the bank becomes less of a financier and more of an originator andservicer. The bank builds on its skills associated with access to the customer, leavingthe actual funding to large investment banks who can achieve the minimum scalenecessary to fund the smaller banks activities at a better cost of funds and lower risk.

So where does this leave us? The HI and diversification story is similar to theVI story. Integration is necessary when the assets and skills required to deliver thevalue customers demand cannot be handled through market transactions eitherbecause such transactions are inefficient, due to the inability to write a contract, oruneconomic due to large SA. It is this logic that is the driving force behind theoutsourcing revolution sweeping business today. It also forces management toconfront a very fundamental issue, what is role of the corporate headquarters?

What is the Role of the Corporate Centre?At the heart of the rationally diversified firm is the role played by the corporate

centre. The corporate centre works as a central coordination, leadership and policingmechanism for the rest of the corporation. Like all structures we must ask, is thisnecessary? Today many companies are downsizing and reducing their corporateheadquarters staff significantly. If we examine the evidence in Europe, we find thatmost companies have responded to the Single European Market initiative not byremoving authority from their country operations but rather by reducing the need forEuropean headquarters staff. This seeming contradiction is supported by the fact thatrationalisation of production and marketing has increased the demand for coordinationbetween country operations that were previously independent. The result has beenthat the coordination function has drifted away from the headquarters and to the morecritical local operations since these are perceived to be closer to the market.12

12 T. Devinney and W. Hightower, European Markets After 1992, Lexington MA: Lexington Books,1991.


So what is the role of the corporate centre? At its very heart, the corporatecentre is an information node in the corporate network. Corporate headquarters do notproduce any product and, therefore, cannot be seen as creating tangible value forcustomers. However, by efficiently facilitating the transfer of information, thecorporate centre serves as a substantive intangible value creator for the customer.This information function can show up in a number of ways, all of which follow fromthe simple oft-repeated dictum:

Centralise strategy, decentralise operations.

Strategic Mission – The HQ as LeaderAt one level, the corporate headquarters provides the leadership and guiding

mission of the corporation, ensuring that goals are clear and criteria for performanceare spelled out in a way that ensures transparency. The leadership function of theheadquarters serves to ensure, not that functions are performed, but that functions areused to steer the ship the in the appropriate direction. The CEO or Managing Directorserves as a personification of the direction of the company. As an example of this,consider a comparison between the mission statements of Pacific Dunlop andAdvance Bank.

Pacific Dunlop’s mission as revealed by its 1992 Annual Report is given below:

Today our business are market leaders in fields as diverse as clothing,footwear, food, medical and health care products, automotive, building,communication and industrial products...... And, despite their diversity, allshare one common attribute – they add to the quality of our life...... Brands arefundamental to our business and they will provide the springboard to furthergrowth ......13

This statement reveals little except that the company doesn’t have a core propositionthat links its disparate operations. Compare Pacific Dunlop’s mission to the statementby Advance Bank from its 1994 Annual Report:

The Bank is committed to developing long-term relationships with itscustomers, supported by the highest level of service. Our staff are supported bystate-of-the-art technology and are dedicated to the efficient delivery of modernbanking services to our customers...... [The Bank’s aims are to] increaseresidential lending ...., develop products and services for business customers ....,to continue our expansion interstate ...., [and] extend our range of electronicbanking services.....14

The statement is clear and to the point, non-grandiose, and provides guidance for thedifferent bank operations.

Performance Criteria – The HQ as ControllerConditional on the mission of the corporation, the corporate centre is

responsible for ensuring that the value of the whole is maximised. As we noted

13 Pacific Dunlop, 1992 Annual Report, 1.14 Advance Bank, 1994 Annual Report, 2–3.


earlier, the rationally diversified firm exists in a world where investment, productionand marketing activities have spillovers onto the other operations. Without a multi-dimensional criteria for measuring performance, the whole system will be sub-optimised. The role of the corporate centre as controller arises because, since thecorporate headquarters can (ideally) react more quickly to changing circumstances, itis better able to continuously discipline the various parts of the enterprise than wouldbe possible from external financial markets or institutions. To use an analogy,financial markets and institutions serve more like periodic doctor’s check-ups, whilethe financial discipline imposed internally is like a constant heart monitor.

Too much can be made of the part that HQ management play in controllingconglomerate operations. This has been recently brought home to General Electric(GE) and their troubles at Kidder Peabody. GE Capital grew out from the financingarm of the old General Electric Company, a purveyor of turbines, engines andelectrical products. Seeing gold in the finance business, GE moved more and moreinto pure financial activities without a real feel for the nature of the business. There islittle doubt that a lack of an understanding of the business it was pursuing is a majordeterminant of the company’s recent troubles. As noted in Case 9.2, Kidder Peabodynever really fit into GE. Jack Welch learned the hard way that to be a controller onemust understand every facet of the business being controlled.

CASE 9.2: GE’s Nightmare on Wall Street*

General Electric’s nightmare onWall Street began when the electricalgoods and engine manufacturerdecided it should diversify into thefinancial sector. GE already had somepresence in the finance industrythrough GE Capital Services Inc. GECapital was a large financing companyinvolved in car leasing, mortgageinsurance and equipment financing andwas very profitable.

In 1986, GE sought tosubstantially increase this presencewith the acquisition of the securitiesfirm Kidder, Peabody and Co by GECapital. The aim was to build synergywith GE Capital to produce a ‘force inthe world’s financial marketplacessecond to none.’

Unfortunately, GE failed torealise that there is a vast differencebetween the worlds of finance in whichGE Capital and Kidder operate.Whereas GE Capital was focussed onMain Street, Kidder’s world was WallStreet. No one at GE really understood

the industry in which Kidder wasoperating. This was exemplified byCEO Michael Carpenter, who had nosecurities industry experience and whohad joined GE from a career inmanagement consulting. Carpenter andother senior Kidder executives did noteven obtain the necessary securitiesdealer’s licences from the Securitiesand Exchange Commission that werearguably required of them by law tooperate in the industry.

Carpenter embarked on a riskystrategy to gain a dominant position inthe fixed-income market, especiallymortgage-backed securities. To thatend, he allowed Kidder’s bondinventory to grow dramatically to graba larger number of underwritings. Hethought that Kidder could hedge part ofthe inventory and that, in the hands ofhis best traders, the inventory couldbecome a source of enormous tradingprofits. Such risk taking wasencouraged by the implied financialbacking of GE, creating a moral hazard


problem. When interest rates rose in1994, Kidder was left exposed andvulnerable. Kidder’s profits were veryvolatile, but the firm increasingly ranup big losses.

Carpenter never got along withGE Capital head Gary Wendt, anengineer turned finance expert. Hereported to Jack Welch, head of GE,not to Wendt who ran the companyKidder was notionally a part of.Kidder’s top personnel were farremoved from the GE Capital mouldand never really fitted into thecompany. The animosity betweenCarpenter and Wendt underminedmuch of the potential synergiesbetween the two operations. Clientswho wanted GE Capital to put upmoney for a deal would avoid usingKidder as their investment banker.Kidder, despite being a powerful playerin mortgage securities, didn’t evenmake it into the ranks of the top threeunderwriters of the mortgage securitiesthat GE Capital had issued in 1994.The opportunities for synergy fell awayas Kidder evolved into more of atrading house, a business that has verylittle to do with the operations of GECapital.

GE erred in thinking thatmanagement success in one businesswould automatically transfer toanother. It thought that controlling thepeople who make up Wall Street’sfreewheeling trading culture was assimple as controlling manufacturingprocesses such as those in which GEhad long specialised. Most firms on

Wall Street, however, lack the kind oftight management structure that ischaracteristic of companies such asGE. Kidder was no exception. It waspoorly run and a lacklustre producer ofprofits.

It was this environment thatallowed Kidder trader Joseph Jett tonotch up huge amounts of fictitioustrading profits in government securitiesand that forced GE to report a $US350million pre-tax loss in early 1994. Thescandal was a fiasco, not only from thepoint of view of Kidder. It was adamning indictment of themanagement of GE, previously upheldas the model of a well run organisation.

GE commissioned a report bythe former head of enforcement at theSecurities and Exchange Commission,which concluded that Kidder sufferedfrom ‘lax oversight’ and ‘poorjudgement.’ Virtually all of theKidders executives, including CEOMichael Carpenter, were forced outand replaced by GE executives.Despite having a much-vaunted andmuch-studied management system, theKidder fiasco demonstrated that GEwas just as capable as any other majorcompany of making major errors ofjudgement when operating in anindustry that it did not fundamentallyunderstand.

*Sources: T. Smart, Wall Street’s BitterLessons for GE, Business Week, 22 August1994; T, Paré, Jack Welch’s Nightmare onWall Street, Fortune, 5 September 1994.

Management of Cash Flows – The HQ as BankerAs noted in chapter 4, much of the activity of the corporate centre is the

management of cash flows; that is, the headquarters serves as corporate banker. Atthis level, there are two roles played by the headquarters. Firstly, the internalcorporate financial market may be cheaper for many smaller types of financialtransactions. For example, it may be more efficient for a corporation to financeactivities internally because it reduces the expense of having to continuously go to the


capital markets for new projects. Secondly, the internal corporate financial marketmay be more efficient than external capital markets. This would arise because of themoral hazard problems that normally exist with arm’s length financial instruments,such as bonds, equity or bank loans. With internal monitoring associated with internalfinancing the corporation is better able to control its different operations (this is theHQ as controller) while not having to release information into the marketplace.

Our discussion in chapter 4 pointed out that caution must be exercised whenusing the HQ-as-bank as a rationale for a firm’s diversification strategy. Efficientfinancial markets, whether they be formally organised or not, are quite powerful atproviding financing as well as policing management. Hence, the tendency to findmore unrelated operations under one holding company in countries with relativelyinefficient or overly regulated financial markets. For example, in the United States,the massive venture capital market represents a formal though unorganisedmechanism for funnelling capital to small companies. In more regulated countries,like Australia and those of the European Union, this channel is unavailable to mostsmall firms, forcing them to rely on banks and government programs or by linkingthemselves with larger holding companies. In addition, the relative profitability ofcompanies like Email and Pacific Dunlop, is not prima facie evidence thatdiversification pays but may be a reflection of the nature of the Australian governancestructure and shareholding laws.15 Finally, even if there was a financial marketsefficiency justification for the role of the corporate HQ, there is no reason to believethat such a role requires that the businesses financed internally be unrelated.

Management of Interrelationships – The HQ as CoordinatorSince the firm gets its distinctive value from joint asset utilisation it should be

clear that this imposes on management the need to coordinate the joint utilisation ofassets directly. For example, if a bank allowed branches to operate completelyindependently, it would find that much of each branch’s activity would be directedagainst other branches of its own company. In the United States, General Motorsfound that its Oldsmobile and Chevrolet divisions were more direct competitors thanthey were competitors of the Japanese motor car manufacturers. When Oldsmobilebegan a campaign of rebates to reduce its burgeoning inventory most of the sales camefrom GM’s Chevrolet division.

Management of Intangibles – The HQ as ProtectorA majority of the value of the firm is in its intangible assets and, as events like

Marlboro Friday have shown, it is the most nebulous and sensitive area of a firm’svalue. As such, the firms intangible assets must be managed from the centre to ensurethat such assets are not needlessly depreciated and that sufficient ownership exists sothat there is an incentive to build them further. Intangible assets show up in two 15 Australia, unlike the United States, permits banks to hold equity positions in corporations. Thiscreates a curious difference between the incentives facing directors of American versus directors ofAustralian companies. Banks, unlike ordinary shareholders, hold both debt and equity positions incompanies. This leads to a demand on the part of the banks for more stable cash flow patterns whichthe banks can enforce because of their shareholding position. In the United States, banks also wantstable cash flows but have no voting rights. Equity holders do not care about stability of cash flows aslong as the price reflects risk. The end result is that countries permitting banks to hold equity will findtheir corporations putting more emphasis on cash flow stability rather than equity return generation.See T. Devinney and H. Milde, Managerial Contracting and Bank Lending with Private Information, inW-R Heilmann (ed.), Geld, Banken und Versicherungen, Karlsruhe Germany: VVW, 1992.


primary areas: brand names and other demand-based intangible assets and know-howor other managerial or production-based intangible assets. Since we gaveconsiderable emphasis to the latter types of assets in the last chapter, let us concentrateon a short discussion of the role of demand-based intangible assets.

Coca Cola Corporation and Pepsico are two examples of companies withenormous investments in amorphous assets, their brand names Coke and Pepsi.Simon and Sullivan16 estimated that the value of the Coke brand name was 55 percentof the total value of Coca Cola Corporation while the comparable figure for Pepsi wasaround 37 percent of the market value of Pepsico.

Coca Cola found out exactly how sensitive its intangible brand assets wherewhen it made its dramatic formula change in 1985. The New Coke debacle wasdriven by the fact that Coke was losing market share to Pepsi in the critical under-30year old age group. Blind taste tests confirmed that Pepsi’s formulation was preferredto Coke’s. However, Coca Cola management failed to realise that the Coke namecreated sufficient customer rigidity to ensure that, when the taste tests were not blind,Coke was the preferred product. Figure 9.3 (the right hand side) shows whathappened to the value of the Coke and Pepsi brand names when Coca Cola broughtout its new formulation. From January 1985, when news leaked of the possiblechange in product formulation, through to July 1985, when the original formulationwas re-introduced, Coca Cola lost approximately 14 percent of the value of the Cokebrand name (or approximately 4.5 percent of the total company’s value).Interestingly, during the same period, the value of the Pepsi brand name soared bymore than 40 percent (a 15 percent increase in the value of Pepsico).

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

Feb-

82

Apr

-82

Jun-

82

Jul-

82

Sep-

82

Nov

-84

Dec

-84

Mar

-85

Apr

-85

Jun-

85

Aug

-85

Oct

-85

Inde

x of

Int

angi

ble

Ass

et V

alue

Coca Cola

Pepsi

July 1982Diet CokeIntroduced

April 1985New CokeIntroduced

Source: Simon and Sullivan (1993)

Figure 9.3: A Comparison of the Relative Intangible AssetsValues of Pepsi and Coca Cola

16 C. Simon and M. Sullivan, The Measurements and Determinants of Brand Equity: A FinancialApproach, Marketing Science, 12, Winter 1993, 28–52.


Although quite sensitive to bad news, the public goods nature of intangibleassets creates interesting opportunities for strategists. The Coke name has realtangible value (although for intangible reasons). This is seen by the increase in thevalue of the Coke brand name when Diet Coke was introduced in 1982 (the left handside of figure 9.3). For years, Coca Cola’s main diet soft drink was Tab, a saccharin-based cola. With the introduction of aspartame in 1983, Coca Cola executivesdecided that the quality of a new diet formulation warranted the use of the Coke brandname. Previously, Coca Cola executives refused to allow Tab to use the Diet Cokemoniker because it was felt that Tab was an inferior product that would depreciate theCoke name. The introduction of Diet Coke had no real impact on value of the Pepsibrand name but was responsible for increasing the value of the Coke brand name bymore than 50% in less than a year.

These examples indicate the double-edged nature of the management ofintangible assets. By definition these assets are transferable but are generally quitesensitive to good and bad news. In the case of production or managerial intangiblesthis is due to the fact that their value is linked with workers’ and managers’ humancapital. In the case of demand-based intangibles this is primarily because their valueresides in their ability to affect customer behaviour, a poorly forecastable and quiteunstable commodity. Because of these facts, intangible assets are slow to develop,subject to expropriation and quick destruction, either within the firm or bycompetitors, and lack natural incentives for future development. Only through tightownership of the asset by the core of the corporation is the viability of these assetssustainable.

SummaryIn the rationally diversified firm the corporate centre adds value through its

monitoring and protecting, coordination, and guidance roles. However, these roles arenot independent. The schematic in figure 9.4 attempts to capture some of the flavourof the interaction between the key components of the HQ’s value creating activities.

Leader

Controller

ProtectorBanker

Coordinator

Figure 9.4: The Role of the Corporate Centre

The role of the HQ as controller is tightly linked with its personification asbanker and coordinator since the same fundamental factors are in play, the job of thecorporation as a manager of joint assets. The centre’s roles of coordinator andprotector are also tightly linked for the same reason, plus the added incentive thatintangible assets require, not only coordination, but protection from depreciation.


Finally, the overarching purpose of the HQ is to provide guidance. This characteristicshould pervade all the facets of the centre’s operations.

The Product / Market PortfolioOver the years, a number of approaches have been developed with the aim of

simplifying the product / market investment decision. Financial NPV models werefound by many to be too complex or too narrow to address general strategic questions,as opposed to decisions like the choice of which specific project to adopt. Product /market portfolio approaches exist primarily as simplifying tools and need to berecognised as not providing the end solution to product and market investmentdecisions. We will summarise three of these models and provide a fourth model thatis more logically rigorous.

The Growth Share MatrixThe growth share matrix (GSM) approach was developed by BCG as a means of

determining cash flow allocations across products and, to a degree, markets. Thesimplest form of the GSM is shown in figure 9.5. This approach looks at the relevantdimensions of corporate effort allocation as the level of market growth and the relativestrength of the company’s products. Market growth could include sales growth of aproduct category (if all the products on the matrix were in the same product category),GDP growth of an economy (if the relevant comparison was between markets), orsome relative growth measure (if the products were from different categories andmarkets). Market share would be measured as either raw market share or somerelative measure against a base competitor.

Market Growth

Mar

ket S

hare

Low High

Low

Hig

h

Dog

Cash Cow

Star

Proble

m Chil

d

Dividing LineSome Median; e.g.,

GDP Growth

Dividing LineTwo or Three Largest

in High Category

Figure 9.5: The BCG Growth Share Matrix

The GSM breaks the world into four alternatives, cash cows, stars, dogs andproblem children. Cash cows are products in mature or declining markets with netpositive cash flows. Dogs are products in mature or declining markets with low or


negative net cash flows. Stars are products in developing markets where thecompany’s position is strong. Problem children are products in developing marketswhere the company has a weak position. The net cash flows of stars and problemchildren could be positive or negative. Table 9.3 outlines some of the empiricalregularities found regarding these classifications.17

Table 9.3: Performance Difference Across the GSM Categories

Cash Cow Star Problem Child Dogs

Return on Investment 30.00% 29.58% 20.55% 18.48%Advertising/Sales 0.71 0.85 1.02 0.81R&D/Sales 1.68 2.76 2.63 1.76Cash Flow FromInvestment 10.01% 0.74% -2.67% 3.41%Market Share Growth 0.38 0.72 0.39 0.14

Source: Hambrick, MacMillan and Day

The options are fairly clear (see figure 9.6). Dogs require one of two decisionsto be made, divest the operation or invest to build market share. Problem childrenwill, over time, become dogs without investment to build market share. If investmentis not viable, the problem child should be divested. Over time, stars will develop intoeither cash cows or dogs and corporate effort needs to be directed toward making thelatter possibility remote. The original premise of the GSM was grounded in the beliefin an experience curve effect. If cost declined with experience, market sharetranslated into lower costs. Ergo, stars could be built into cash cows as long as aleadership position could be maintained. The alternative is that entry and competitionwill erode market share and move the product more into the realm of a strong dog or aweak cash cow. In the GSM approach, the position of the cash cow is sacred andcorporate effort is to be directed at maintaining the cash flow and protecting theposition.

17 See D. Hambrick, I. MacMillan and D. Day, Strategic Attributes and Performance in the BCG Matrix– A PIMS-Based Analysis of Industrial Product Businesses, Academy of Management Journal, 25,September 1982, 510–531.


Mar

ket Gro

wth

Low High

Dog

Cash Cow Star

Problem Child

Mark

et Share

Low

High

DivestBuild Market Share

Loss Making OperationsMature or Declining Market

Low Cost of OperationCapital DepreciatedMature or Declining Market

Divest

Positive or Negative ProfitsCapital ExpenditureNew or Growing Market

Loss Making OperationsCapital ExpenditureNew or Growing Market

Hold &

Defend

Figure 9.6: Performance and Strategy Implications of the BCGGrowth Share Matrix

The general prescription following from this approach is that the company needsa balanced portfolio of opportunities and sources of funds. Dogs are to be avoidedand problem children either invested in or removed. Cash cows are to be protected soas to fund investments elsewhere in the corporation. Stars are to be nurtured. Case9.3 gives an example by applying the GSM to Texas Instruments.

CASE 9.3: The GSM and Texas Instruments

Texas Instruments (TI) is based in thefast growing electronics industry. Thefigure below portrays TI’s portfoliosome years ago. There are a number ofstriking aspects of TI’s product mix.The centre of gravity of the portfolio,that is, the weighted average of thevarious businesses, is a relative marketshare of 1.5 times its competition. Thefirm is the market leader in most of itsbusinesses and, in many, it has a verystrong position. The overall growthrate of the portfolio, at 12 percent, isalso high. That is, of course, notsurprising given the nature of thebusinesses the firm operates in.

It is very interesting to note thatthere are no real dogs in the TI stable.The closest thing to a real dog is therelatively small investment in ‘OtherCalculators’. In that case, the firm hasabout a 30 percent relative marketshare in a market growing at 10percent. Although a growth rate of thatlevel still allows some opportunity forrealignment of market share, we mightsuspect that the prospects are notauspicious for a firm with only 30percent of the market share of its maincompetitors. Beyond that case, thefirm has either been extremely lucky orvery ruthless in avoiding dogs. We


might suspect that it has disposed ofanything that it could not build into a

star and eventual cash cow.

Market Growth10% 25%2%

1.5X

.1X

30XM

arke

t Sh

are

(Rel

ativ

e to

Com

peti

tion

)

DigitalBipolar

Gov’tElectronics

Metals/Controls

Watches

Minis/Terminals

Linear

ConsumerCalculators Power

Discretes

CASH COWS STARS

DOGSOtherCalculators

GeoServices

SpecialisedApplications

X indicates relative market shareThe size of the circle indicates importance (assets)

PROBLEMCHILDREN

Centre ofGravity

The history of TI is that relativelyfew products have ever entered theportfolio as stars. The firm has notbeen the innovator in thesemiconductor business in thepost-war period. Most of theinnovation has come from Fairchild,Intel, Mostek and others, but not TI.However, TI has made its reputation bycoming in after the pioneer and thenbeing very forceful in its assault on themarket.

Texas Instruments has had aconsistent corporate philosophy, ‘[we]would like to dominate [any businesswe enter], and we have a view thatdominance in these technologiesrequires adding capacity at anextraordinary rate to meet market

demand, and pricing aggressively wellahead of the experience curve’. It hasnot always won and has had a coupleof spectacular losses (the most aweinspiring being in personal computers).But, by and large, it has managed topersuade most of its competitors thatwhen it latches onto what will becomea large scale commodity product, theonly way to compete with TI is on ahigh-volume, low-price basis, or elseyou will be driven into a segment inthe corner. So the above figurerepresents the portfolio of the lateentrant price cutter, using its cash baseto fund new entries. It is a very strongportfolio with almost no dividend.That naturally increases the cash TI hasavailable to fund its new entry strategy.

The Competitive Strength MatrixThe second of the popular matrix approaches is the competitive strength matrix

(CSM) popularised by Shell, General Electric and McKinsey. This approach is verymuch a ‘fit’ methodology – develop products or markets where you are strong andwhere growth opportunities are good. A rudimentary CSM is shown in figure 9.7.


The dimensions are industry attractiveness, a more general concept than simplemarket growth, and competitive strength, an expansion of the concept of market share.

Low

Hig

hM

oder

ate

Com

peti

tive

Str

engt

h

Industry AttractivenessLow Medium High

Up or Out

Up or Out

Up or Out

InvestSelective Growth

DivestHarvest

Figure 9.7: The Strategic Implications of the CompetitiveStrength Matrix

The CSM imposes five decisions on the firm. The most obvious decisions are to‘invest’ in areas where markets are attractive and the company’s strengths are utilisedand to divest oneself of operations where strength and attractiveness are low. Theother decisions are of varying degrees of fuzziness. ‘Harvesting’ entails takingadvantage of the company’s strengths or the growth of the market to make moneywhile the getting is good. The company is effectively exiting but in not as quick amanner as would occur with pure divestiture. In the ‘selective growth’ scenario,investment occurs, however, the company reserves the right to wind down operations.The ‘up or out’ option essentially means that the company should harvest orselectively invest.

The Life Cycle MatrixThe third approach to market and product investment was developed by Arthur

D. Little and posits investment strategy based on life cycle location and competitivestrength (see figure 9.8). Competitive strength is defined as in the CSM while theoperative measure of the attractiveness of the industry is the life cycle stage of theproduct category. The implication that follows from using the life cycle matrix(LCM) approach is that companies need to generationally diversify their portfolio ofproducts. However, caution is expressed about engaging in such diversificationwithout linking it to the fundamental strengths of the company.


Low

Hig

hM

oder

ate

Com

peti

tive

Str

engt

h

GrowthIntroduction Maturity Decline

Life Cycle Stage

PUSH:

Invest A

ggressiv

ely

Danger:

Harvest

Caution:

Invest Select

ively

Figure 9.8: The Strategic Implications of the Life Cycle Matrix

Dissecting the Matrix ApproachesAlthough each of the matrix approaches was argued to be a unique addition to

management thinking, there is little real difference between the three models. Figure9.9 super-imposes the three matrix approaches on one graph and points out thesimilarities. Effectively, all the approaches break the world into two dimensions. Thefirst dimension is some measure of company or product strength, as measuredsubjectively (CSM & LCM) or more objectively (GSM). The other dimension is theattractiveness of the market, again either measured objectively and narrowly (GSM) ormore subjectively and broadly (CSM & LCM). Each approach tends to tell a differentstory about what is the appropriate role of the product / market portfolio. The GSMtells managers that the product / market portfolio should be balanced around sourcesand uses of cash. The CSM highlights the importance of fitting the market with thecompany’ sources of strength. The LCM talks about the importance of having aconstant balance of products / markets so that younger products / markets are in aposition to take over from declining products / markets.


Industry AttractivenessLow Medium High

Market Growth

Mar

ket

Shar

e

LowHigh

Low

Hig

h

Low

Hig

hM

oder

ate

Com

peti

tive

Str

engt

h

GrowthIntroduction Maturity DeclineLife Cycle Stage

ExternalOpportunity

InternalStrength

Figure 9.9: A Comparison of Matrix Approaches

What are we to make of these approaches? Are they useful or grossoversimplifications of complex problems facing managers? The beauty of theseapproaches is their simplicity and the fact that they force managers to confrontcomplex problems by simplifying them and thinking about them on comparabledimensions. By doing so, they take what might appear to be unresolvable problemsand boil them down to something manageable. However, in doing so they substituteone type of error for another. By not simplifying a problem, managers make errorsdriven by their inability to see the forest for the trees. That is, they view problems asintrinsically unique when they are nothing of the sort. By using the matrixapproaches, managers error in the opposite direction – they force problems intoinappropriate and naively simplistic boxes.

There are a host of shortcomings associated with these approaches and table 9.4outlines the most typical weaknesses discussed in the literature of the two mostpopular models, the growth-share matrix and the competitive strength matrix. 18

From the perspective of the discussion here, there are two fundamental issues thatneed to be addressed without which an understanding of the shortcomings of theseapproaches cannot be gleaned, the issue of risk and the measurement of thedimensions of internal and external strength.

18 A. Hax and N. Majluf, The Use of the Growth-Share Matrix in Strategic Planning, Interfaces, 13, 1,1983, 46-60; A Hax and N Majluf, The Use of the Industry Attractiveness-Business Strength Matrix inStrategic Planning, Interfaces, 13, 2, 1983, 54-71.


Table 9.4: Weaknesses of Portfolio Approaches

Growth-Share Matrix Competitive Strength Matrix

Business units portrayed as autonomousignoring sources of joint value

Assessing internal factors heavilydependent on subjective judgement –

Tendency to simplify to generic factors

Market share measured at consumer end –Ignores resources shared at functional level

Assessing external factors heavilydependent on subjective judgement –

Tendency to simplify to generic factors

Market definition very subtle issue – market may be defined too narrowly or broadly

Market share not necessarily a major factorin determining profitability

Business strength not necessarily a majorfactor in determining profitability

Industry growth not the only variable thatexplains growth opportunities

Multidimensional indicators can add toomuch complexity while unidimensional

measures are too simplistic

Wider set of critical factors needed forreliable positioning of business units

Industry attractiveness somewhatambiguous

Growth and profitability are not necessarilylinked - maybe a trade off

Attractiveness and profitability notnecessarily linked

Ideal business portfolios not necessarilybalanced in terms of internal cash flow

Focuses on resource allocation, not cashflow balance

Attempts at quantification can disguise real issues

More useful for competitive analysis thanstrategic guidance for the firm

More useful for strategic guidance of ownfirm than for competitive analysis

Source: Adapted from Hax and Majluf

First and foremost is the fact that these models say little if nothing about risk.Where there is a discussion of risk, risk is defined either as the likelihood of making amistake, for example, investing in a dog, or the variance of some accounting returnmeasure, such as ROA or ROE. To have a model of investment that says nothingabout risk from a financial perspective is a serious shortcoming and one we willaddress in the next section.

The second area where these models come up short is in their definition ofmarket attractiveness and company strength. There is no reason to suspect that onecan easily come up with a uni-dimensional measure of either concept. For example,Coca Cola’s competitive strength is its brand image. This is also its competitiveweakness since it cannot risk doing anything to damage an asset that accounts for 55percent of its value. Also, how is it possible to have one measure of attractiveness,short of some financial measure like profitability. Consider the market for cataract


remedies. Two dimensions are important, ability to pay for a remedy and thelikelihood of getting cataracts. The first is measurable by income and the second byincome. However, they are almost perfectly negatively correlated! What, then, definesan attractive market for cataract remedies?

Matrix approaches are useful when their limitations are recognised and they areapplied as tools used in conjunction with other techniques for making complexdecisions and not as stand-alone guidelines for product and market investments.

Understanding Risk and Diversification19

We previously spoke about how the traditional matrix approaches ignore thesources of synergy associated with business activities along with the concomitantfinancial risks. The approach that we will discuss now provides a simple overview ofthe concerns associated with accounting for the risk-return relationship within thefirm. It should be recognised that the reason the firm exists is to provide an internalmechanism through which JPEs and SA are capitalised. Given that the existence ofthese synergies implies that value additivity doesn’t hold in the rationally structuredfirm, we are left with the quandary that simple NPV rules for investment don’t holdperfectly. What is more interesting is that the failure of value additivity hasimplications for both the return associated with a specific diversification structure aswell as the risk of that structure. We should note before proceeding that, when wespeak of risk, we are talking about financial risk as measured by the firm’s beta or costof capital and not the variance of cash flows or profits.

If I know that a new model motor car shares production, marketing anddistribution with my existing models, how do I appropriately account for the fact thatthe profits associated with the new model will be affected by decisions associated withthe old models and vice versa? In addition, how do I account for the fact that when Iinvest in this new model, I alter the risk characteristics of my existing businesses?Figure 9.10 allows us to understand the risk-return characteristics of specificconfigurations based on the degree of synergy on the demand side or on the supply(production) side of the business equation. We begin by defining the nature of theinter-relationships that can exist.

• Complements. Demand complements exist when the demand for one productis related positively to the demand for another product, e.g., hardware andsoftware. Supply complements exist because of economies of scope or otherJPEs.

• Substitutes. Demand substitutes exist when the demand for one product isnegatively related to the demand for another, e.g., two brands of soft drink.Marketers refer to the existence of demand substitutes as cannibalisation.Supply substitutes exist when the cost of joint operation is greater than the costof two separate operations. Normally this arises because the complexity costsoverwhelm any cost-based gains.

• Neuters. Demand and supply are not correlated.

19 See T. Devinney and D. Stewart, Rethinking the Product Portfolio: A Generalized Investment Model,Management Science, 34, September 1988, 1080–1095.


Return Rises

Risk Rises

Return ???

Risk ???

Return ???

Risk ???

Return Falls

Risk Falls

Return Rises

Risk Rises

Return Falls

Risk Falls

Return Rises

Risk Rises

Return Falls

Risk Falls

No Effect

No Effect

Demand

Supply

Complements

Complements

Substitutes

Substitutes

Neuters

Neuters

Source: Devinney and Stewart (1988)

Figure 9.10: The Relationship Between Risk and Return andSupply and Demand Relations

The key to understanding the risk-return relation shown above is to note that riskand return always move in the same direction. In other words, whenever there is aprofit gain from synergy, the positive relationship between the cash flows that drivethis gain also serves to force the company to bear the additional cost of higherfinancial risk. This arises because (1) the nature of the economics implies that theproducts should be provided by a single company rather than a multiplicity ofcompanies, and (2) because the cash flows are positively correlated and this positivecorrelation cannot be diversified away. Because the profit gain can only be realisedwhen one firm is selling both products, financial risk will rise.

For example, if I choose to bring out a new model motor car that, on average,has positive synergies with my other models, my cash flows will be positivelycorrelated and my stock market beta and cost of capital will rise. If I happen to bringout a model that cannibalises my existing models, then my cash flows would benegatively correlated and my cost of capital and beta would fall. Note that this is notpure financial diversification. In the first example, the return associated with havingthe two models together is greater than would be the case had they been soldseparately. In the second example, the level of cannibalisation would be lower than ifthe two products were sold by separate companies. That is, I am better offcannibalising my own products than allowing the sales to be stolen by a competitor.

So what are the implications? Firstly, the simple result is that prescriptionscoming from the CSM, which imply that one expands into areas that fit with thecompany’s strengths, will generally force the company to link its cash flows moretightly and will, therefore, increase financial risk. In fact, this is what is seen inreality. Focused companies have higher stock market betas than less focused firms inthe same industry.20 Secondly, as firms develop and change over time, not only do weexpect their profitability to change but their risk should change as well. This is alsoseen in reality. Firms with the greatest turnover in product lines have the least stableequity betas. Thirdly, returns and hurdle rates, as measures of investment approval, 20 See T. Nguyen, A. Séror and T. Devinney, Diversification Strategy and Performance in CanadianManufacturing Firms, Strategic Management Journal, 11, September 1990, 411–418.


fail to account for the fact that inter-relationships exist with internal firm investments.Therefore, firms will tend to approve too many high return investments since theyhaven’t adequately accounted for the increase in risk and will reject too many lowreturn investments because they haven’t taken account of the decrease in risk.21

Perhaps what is most important about understanding the firm’s internal risk-return relations is the fact that there is no ‘free lunch’ when it comes to diversification.Suppose a firm engages in unrelated or pure financial diversification. The firm isdoing nothing more than buying, at the market price, a larger or smaller return withmore or less associated risk. According to the approach discussed here, the firm thatchooses to rationally invest in products and markets that build on company strengthswill also pay a similar price but that price is considerably more difficult to assess.

Summary – What Should go with What?This chapter concentrated on four areas related to diversification: the

determinants of related diversification, the characteristics of rational HI, the role of thecorporate centre, and product / market portfolio models. The main lesson that comesfrom all this discussion is the importance of fundamentals as the drivers ofdiversification strategy. The onus should be on those desiring to diversify theircorporation to prove that the structure they propose is the only one that truly addsvalue to the company. Just as we saw with VI, HI does not necessarily arise becauseof synergies but because those synergies cannot be capitalised without the firmoperating all the related activities, in this case multiple products / markets.

The importance of information as the lifeblood of the modern corporation cameto the fore in our discussion of the corporate centre. Ignoring possible failures in thefinancial markets, companies like Email, Pacific Dunlop, Hutchinson Whampoa,TATA, and Hanson Trust do not really need a corporate centre as we have defined it.Being true conglomerates, there is nothing crossing the company division barriers thatcould truly be considered strategic. There is no doubt that the managers of thesecompanies will attempt to rationalise the importance of the mix of operations they arepursuing but from a strategic standpoint, they possess little value. Indeed, externalpressures are beginning to change many of these companies as the recentreorganisations of both Pacific Dunlop and Hanson Trust attest.

Product / market portfolio models were attempts by consultants to simplifyfinancial investment analysis while attempting to develop techniques for strategicinvestment decisions. Most of the models tend to be logically flawed but serve as niceadditions to the more rigorous financial analysis of alternative strategic directions.The three major problems with these techniques are: their lack of good definitions oftheir underlying constructs, market attractiveness and business strength; their failure toaccount for the synergistic relationships between the strategic decisions; and theirfailure to account for the financial risk associated with strategic decisions.

Ultimately, the issue of product and market diversification becomes one ofmanagerially and logically which products and markets allow the firm to mosteffectively match its resources and business processes to the current and potentialfuture value of the customers. Campbell, et al22 develops the idea of the ‘parentalcore’ of a corporation as a way of encompassing the internal aspects of this idea. 21 See T. Devinney, New Products and Financial Risk Changes, Journal of Product InnovationManagement, 9, September 1992, 222–231.22 A. Campbell, M. Goold, and M. Alexander, Corporate Strategy: The Quest for Parenting Advantage,Harvard Business Review, 95, March/April,1995, 120-132.


Figure 9.11 provides a summary of how we might capture this idea simply. Thehorizontal axis relates the degree to which the opportunities presented by the businessmatch the competences of the corporate core. On the vertical axis we have the degreeto which the key success factors necessary to be successful in the business match withthe competences of the corporate core. An initial reaction to this approach is that it isthe same as the matrix approaches that we earlier viewed so critically. However, thereare some key differences which we can address by posing the questions a managershould be asking about what businesses belong in the company:

• What is at the heart of the corporation? Note that this does not ask what does thefirm do but what lies at the heart of business in which it should be operating; i.e. itis a philosophical rather than purely descriptive idea.

• What is required to be successful in a particular business?• Do the opportunities the corporation is facing match well with what the

corporation is at its most fundamental?• Is what is necessary to be successful in a particular business match with what the

firm would see as its capabilities and competences?

Two examples of this idea are presented in figure 9.11. The top figure, presentsthe case of the Australian conglomerate, Pacific Dunlop. This company faces twoproblems: (1) what is the parental core that defines the company (there appears to benone) and (2) how do the parts of the company relate to this core (since there is nocore this is a moot point!)? Note that because this company has no fundamentalproposition other than making money, which company we put in the heartland doesnot really matter. The lower figure in figure 9.11 presents the pre-breakup ICI, theBritish company.23 ICI’s core was defined around applied chemical technologies.However, over time the required competencies in many fields of endeavour taken onby the company moved away from chemical processes and required more detailedknowledge of genetic engineering and biology (notably agrichemicals, seeds andpharmaceuticals). ICI’s reaction to this pressure was to create a new company,Zeneca, that allowed these divisions to focus their efforts without a concern for thelost synergies with the chemical-based divisions.

23 This example is developed from G. Owen and T. Harrison, Why ICI Chose to Demerge, HarvardBusiness Review, 95, March/April, 1995, 132-142.


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ICI

Figure 9.11: Examples of Rational Portfolio Determination

We are left with the final question of how do we define what is at the core ofthe corporation? What embodies what the corporation does at its most fundamental?This is a dynamic process whereby management is asking itself a few fundamentalquestions about what it does and which customers it is attempting to satisfy. Figure9.12 provides a simple schematic. Before asking the question of what is at the heart of


the corporation, management needs to assess the linkages between products andprocesses and how these add joint value. If the answer is that they don’t or that somedon’t while others do, then management needs to address the issue of how toconfigure the firm’s portfolio of processes and products such that a consistentdefinition arises as to what the firm’s parental core or heart really is. This can beaddressed at a number of levels. One alternative is for the firm to reconfigure anddivest itself of unrelated businesses. This was the ICI solution and is definitely areactive strategy. A second alternative would be to ask the question, what can be donewith the products and processes that the company currently possesses to make themmore related? This option is proactive and puts management as the key determinantof what relatedness means.

What is at the "heart" of our corporation?

Do the current products fit with our "parental" core?

Do our current management processess match with the

"parental" core?

NO

Rethink

Do our current products add value jointly?

Do our current management processess

add value jointly?

YES YES

NO

Rethink

NO

Rethink

Figure 9.12: What is at the Corporate Core?

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