Diversification Law and Legal Definition
In its narrowest meaning, diversification in corporate jargon means participation in multiple industrial activities that do not move in concert as the economy goes up and down. Thus a company that is engaged both in construction and in lumber is not said to be diversified. If construction slumps, so will lumber. But a company with activities in travel destinations and in the publishing of romance novels is thought to be much more diversified. A slump that hurts vacation travel may lift the more dreamy activity of curling up with a cheap novel….
In actuality the history of corporations shows a cycle of fashions in which diversification is viewed positively in one part of the cycle and negatively in the other. Arguments are made for either. An environment that favors diversification emphasizes that "management" is a skill independent of what is managed; management therefore is seen free to select the playing pieces on its boards to reflects its vision of the future. In an environment that favors "focus" (the popular term in the mid-2000s), emphasis is placed on management knowledge of an industry; the "core" business is emphasized; and diverse holdings are viewed as "distractions." The business environment always offers a sufficient large number of both diversified and concentrated companies so that either mode can be proved to be successful using the right sample. In general, times of exuberance, confidence, and high profits favor a diversifying tendency; times of consolidation favor concentration and the shedding of less than stellar businesses. Generally the attitudes and mindsets associated with diversification or concentration are influenced by corporate and stock performance and far less, if at all, by considerations of market needs and employment. Matters of the latter sort are always much more important to the small business which lives and operates at the community level. Diversification, therefore, has a different meaning for the small business.
Corporate structures, based on the content of the business, extend from the polarity of narrow concentration to that of incoherent diversity. There are significant variations at each pole.
Concentration may be quite narrow. An example of such a company may be one that owns a single electric furnace that it operates with purchased scrap. Thus its business is steel-making and nothing else. Its well-being will be governed by such issues as distance of other suppliers, the price of steel globally, the going rate for scrap, for electric power, and the well-being of the companies that purchase its steel. If this company also made steel from iron ore in a Bessemer furnace, it would be more diversified: it would have two sources of raw material. If next it acquired the shipping company that transports its ore on the Great Lakes—and bought a trucking company and several scrap dealers in its next expansion move, it would be more diverse yet. In the event of a softening in steel demand, it might be able to redeploy its transportation lines to carry other products. It might next innovatively transform its Bessemer slag into a gravel product and begin to sell it as road construction fill—supporting this business by its transportation and by adding a wholly-owned plant for making reinforcing bar from its own steel. All of these moves would be considered "diversification," but the company would remain "concentrated" in and around the steel business.
Some of these moves are in the category of vertical integration, which is one type of diversification practiced by concentrated companies. Vertical integration brings under the company's own control activities it once purchased. The company now earns the margin produced by the this business. Integration, however, exposes the company to greater risk if the business as a whole has a turn-down. Therefore vertical integration has its reverse implementation, these days called outsourcing:. outsourcing may or may not be cheaper; it certainly provides greater flexibility.
Concentration is always characterized by close, you might say organic, connections between the elements of a business. The skill-sets of the management are built around understanding these connections deeply enough to exploit them to the optimum.
At the other end of the spectrum may be the hypothetical IJK company which sells Florida time-share condos, operates a printing company that supports investment banking operations, has a banking subsidiary, owns a AAA ball club, a lumber mill, two construction firms, a cruise line, and a textile importer. It also owns IJK Canning, the original company in the diversification of which all these properties were acquired. Over time IJK has become transformed from a manufacturer to a conglomerate. Its many businesses have so little commonality that the company has become, in effect, a holding operation. The management skills involved in running IJK are almost exclusively financial. It operates as a kind of bank and measures its operations by return on investment. If ROI is growing steadily, IJK stock will be valued. But if the company's overall performance begins to slip, stock analysts will begin to question IJK's "coherence." If problems continue, the company may well begin shedding properties based on some formula. In due time, by keeping its condos, ball club, and cruise line, and adding a cluster or well-chosen multiscreen movie centers in well-known up-scale suburbs across the country, it may emerge into coherence again as an entertainment company—thus completing a cycle from extreme diversification to relative diversification, its management now marked by expertise in identifying major trends in recreational activities.
Aside from diversification moves motivated by the likes, dislikes, or predilections of a leading personality or a management team—and moves that are the result of a period of exuberance—diversification is motivated by four structural issues common both to large and small businesses.
- Cyclicality—Publicly traded companies typically aim at steady and predictable earnings. If they are in a highly seasonal business or if their performance is tied to economic cycles (like housing), they will attempt to diversify to remove cyclicality from their performance. A small business in the lawn and garden business may thus diversify into offering snow-removal equipment and use some part of its retail space in winter to sell Christmas decoration as a way of steadying employment.
- Growth or Lack of Growth—A business may be engaged in an industry the nature of which limits growth. As Elizabeth McGowan reports in Waste Age, hazardous waste disposal is a current example. The industry is stable but its character is controlled by federal regulation. The industry, therefore, seeks diversification in order to grow. A small business may similarly find itself in a well-served market unable to expand except by adding some related product line to its business.
- Defense—A business may find itself pressed by the absence of competition in its area for some component that it requires and must virtually sole-source through one vendor. Cost pressures may induce it to enter that business to lower its own costs and also to expand by providing its competitors another source.
- Unusual Opportunity—Due to unplanned circumstances, a business may find itself in possession of an asset the exploitation of which may require diversification for its full exploitation.
DIVERSIFICATION AS ADAPTABILITY
As the foregoing shows, from the small business perspective diversification is a form of adaptability. Significant size was implied before the word took on its more jargonized meaning of acquisitions and divestitures aimed at major transformations of the corporate profile and its image in the market. For the small business diversification moves will emerge as a natural by-product of operations, announcing themselves as problems (the weakening of a product or service line) or as opportunities (new ways of deploying existing resources). A good general rule for the small business is to diversify in relatively small steps from the well known to the lesser known—until the new itself becomes a firm base for the next steps. Any leap into the radically new should be thoroughly studies and the benefits clearly identified in advance.
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