Reduction of Risk through Diversification

05/09/2020 0 By indiafreenotes

A strategy used by investors to manage risk. By spreading your money across different assets and sectors, the thinking is that if one area experiences turbulence, the others should balance it out. It’s the opposite of placing all your eggs in one basket.

The term often crops up during periods of economic turbulence, when there’s a lot of uncertainty in financial markets. Rather than leaving themselves exposed to stock market swings, investors might look to spread their money across other assets like bonds and commodities too.

All investments carry some degree of risk and, as a result, you can’t avoid it completely. But the good news is that risk diversification can at least help you to avoid over-exposing yourself to one particular area.

Diversifying your investments doesn’t simply mean spreading your money across different assets. Instead, you can also spread it between companies of varying sizes, different sectors, and a range of geographic regions.

Risk diversification can also be important in the business world. For example, rather than specialising in a single area, a company may choose to expand into new products and sectors.

Diversification is the art of entering product markets different from those in which the firm is currently engaged in. It is helpful to divide diversification into ‘related diversification and ‘unrelated’ diversification.

Diversification is venerable rule of investment which suggests “Don’t put all your eggs in one basket”, spreading risk across a number of securities.

Diversification may take the form of unit, industry, maturity, geography, type of security and management. Through diversification of investments, an investor can reduce investment risks.

Investment of funds, say, Rs. 1 lakh evenly among as many as 20 different securities is more diversified than if the same amount is deployed evenly across 7 securities. This sort of security diversification is naive in the sense that it does not factor in the covariance between security returns.

The portfolio comprising 20 securities could represent stocks of one industry only and have returns which are positively correlated and high portfolio returns variability. On the other hand, the 7-stock portfolio might represent a number of different industries where returns might show low correlation and, hence, low portfolio returns variability.

Meaningful diversification is one which involves holding of stocks of more than one industry so that risks of losses occurring in one industry are counterbalanced by gains from the other industry. Investing in global financial markets can achieve greater diversification than investing in securities from a single country. This is for the fact that the economic cycles of different countries hardly synchronize and as such a weak economy in one country may be offset by a strong economy in another.

Fig. 5.2 portrays meaningful diversification. It may be noted from the figure that the returns overtime for Security X are cyclical in that they move in tandem with the economic fluctuations. In case of Security Y returns are moderately counter cyclical. Thus, the returns for these two securities are negatively correlated.

If equal amounts are invested in both securities, the dispersion of returns, up, on the portfolio of investments will be less because some of each individual security’s variability is offsetting. Thus, the gains of diversification of investment portfolio, in the form of risk minimization, can be derived if the securities are not perfectly and positively correlated.

A related diversification is one in which the two involved businesses have meaningful commonalties, which provide the potential to generate economies of scale or synergies based upon the exchange of skills or resources. In a related diversification the resulting combined business should be able to achieve improved ROI because of increased revenues, decreased costs, or reduced investment, which are attributable to the commonalties.

An important issue in any diversification decision is whether, in fact, there is a real and meaningful area of commonality that will benefit the ultimate ROI. If such a meaningful commonality is lacking, the diversification may still be justifiable, but the rationale will need to be different.

Related diversification

  1. Exchanging skill and resources

Related diversification provides the potential to attain synergies by the exchanged or sharing of skills or resources. One business unit must have skills or resources that are ‘exportable’ to another company or business unit. Thus, a first condition for successful related diversification is to identify skills or resources that are exportable or that are needed and can be ‘imported!

The second condition is to find a partner or business unit that can either provide or use them. The third is to ascertain whether the organizational integration needed to accomplish the exchange is feasible. Skills or resources that can be usefully imported or exported can take a variety of forms.

  1. Brand name

One commonly found resource that is exportable is a strong established brand name like Coca-Cola, Microsoft, Pepsi, Puma, BMW, or Nivea.

  1. Marketing skills

Usually a firm will either possess or lack a strong skill in marketing for a particular market. Thus, a frequent motive to diversify is to export or import a marketing talent. The typical case in this regard is the introduction of Microsoft products into the People’s Republic of China (PRC). PRC was moving from the socialistic pattern of society to market economy.

During the 1990s, urbanization started increasing and a shift was seen from agriculture to the service sector. Agriculture, science and technology, industry and defence were targeted for modernization. Richard Fade, vice-president in charge of Microsoft’s Far-east operations, pondered Microsoft’s planned introduction of products into China.

In the Chinese computer hardware industry of 36 domestic vendors accounted for 82 per cent of the units of domestically manufactured PCs. In the software industry, State Owned Enterprises (SOEs) dominated the market. Since, the SOEs were answerable to the government, all their revenues accrued directly to national government.

The following are the key tasks that need to be done while localizing:

(i) The local character sets need to be supported.

(ii) The interface needs to be translated in a form that is familiar to the local user.

(iii) All documents should be in local language.

(iv) Configure the software so that it can support locally available software and hardware.

(v) Provide local customer service.

Microsoft in 1984 signed its first OEM agreement in Taiwan, home of over 3,000 PC systems and component manufacturers, before opening an office in 1989. Five years later Microsoft opened an office in China. It was estimated that 95 per cent of PCs had the English version of Microsoft DOS installed together with one of the many Chinese shells.

Microsoft had worked with SV earlier on a smaller project and so it agreed to work with them on P-DOS project. Based on their earlier experience, it was understood that it was very difficult to parcel out a particular major software localization task to one SV and hence opted for a ‘consortia’ of SVs and set UP a product development centre. This eventually paid the company a ‘prize reward’ by limiting other competitors in the market.

  1. Service

A small company can often create or enter a market area and do well with an innovative product. As the market matures, however, the necessity for a strong service organization becomes important. The smaller firm might then consider joining forces with a larger firm which has a service organization that can be adapted to the involved product. Typical example is the Bluetooth technology of Blackberry.

  1. R&D and product development

A firm may be highly skilled at R&D and new product development, but it may lack skills in either marketing or production. Godrej is marketing the mosquito repellent Good knight and mango juice Jumpin, which are typical products of small entrepreneurs. Sun silk shampoo of HUL is manufactured in SSI units of Pondicherry.

  1. Exploiting excess capacity

One type of resources that is often easily exchanged is excess capacity. Bottling plants of SDC (Soft Drink Concentrates) are now widely engaged in bottling fresh juices of orange, apple, mango, pineapple, grapes, tender coconut and lemon juice for MNCs Pepsi and Coke in India.

  1. Achieving economies of scale

Related diversification can sometimes provide economies of scale. Two smaller consumer product firms, for example, may not be able to afford an effective sales force, new product development or testing programme, or warehousing and logistics systems. However, the two firms together may be able to operate at an efficient level. Similarly, two firms when combined may be able to justify an expensive piece of automated production equipment.

  1. Risks of related diversification

Even related diversification can be risky. There are three major problems. First, relatedness and potential synergy simply don’t exist. Strategists delude themselves that there is a synergistic justification not on the basis of judgement supported by a thorough external and self-analysis, but by manipulating semantics.

Second, potential synergy may exist but is never realized because of implementation problems. This happens when the diversification move involves integrating two organizations that have fundamental differences and/or because one of the two organizations lacks the ability or motivation to undertake necessary programmes to make the diversification work.

Third, possible violations of antitrust laws in the west and MRTP (Monopolies and Restrictive Trade Practice) law in India create an additional risk when an acquisition or merger is involved. Ironically, as the degree of relatedness and the synergy potential increase so does the possibility of an antitrust or MRTP problem. Jet Airways and Sahara deal is a typical example.

Jet Airways has extended its service to the mass market under Jet Lite. Similarly, Kingfisher acquired Air Deccan and symbolically kept the Kingfisher logo in the wings and POS outlets in the country, which includes all post offices and petrol pumps.

Unrelated Diversification

Unrelated diversification lacks commonality in markets, distribution channels, production technology, and R&D thrust to provide the opportunity for synergy through the exchange or sharing of assets or skills. Reliance entered into retailing by allocating Rs25, 000 crore in a phased manner is a typical example.

  1. Manage and allocate cash flow

Unrelated diversification can balance the cash flows of SBU entities. A firm, which has many SBUs that merit investment might buy or merge with a cash cow to provide a source of cash. The acquisition of the cash cow may reduce the need to raise debt or equity over time, although if the cash cow is acquired, resources will need to be expected.

Typical example is Kingfisher Airlines, where the chairman and CEO Vijay Mallya himself routed the surplus cash from this liquor business to give the ‘Fly the good times’ experience to Indian aviation. So there’s KF Fun TV with seven channels (lifestyle, entertainment, sports, English premium, toon (cartoon), flight guide and view from the top channels, and KF Radio with 10 channels chartbusters and hindi pop, hindi retro (the golden oldies), Hindi Easy Listening, ghazals, english pop, english retro (an earful of vintage), Easy Listening (Honey trenched notes that remind the listener that world is still a wonderful place), Club (dance floor) Jazz and Blues and Lounge (lie back in the lap of lounge with the soothing notes of lounge music) supported with state of the art aircraft and technology for in-flight, catering. The reservation system is a remarkable attempt to reposition the image of the Indian industry.

  1. Entering business areas with high ROI prospects

A basic diversification motivation is to improve ROI by moving into business areas with high ROI prospects. One approach is to enter high growth business areas. According to life style consumption study by Edelweiss Securities, organized retail trade in India is now finding its feet. Its share in the total retail pie is set to increase from the current 2 per cent to about 10 per cent by 2010. This will translate into approximately Rs1, 400 billion of retail trade by 2010 (Figure 8.19).

The study further says retail space is expected to increase from 10 million sq. ft. in 2002 to 80 million sq. ft. in 2010. Retail space development in leading centres will provide high impetus to retail growth as about 38 per cent of India’s high income households live in the top five cities (Mumbai, Delhi, Kolkata, Chennai and Bangalore), and an additional 28 per cent stay in mid-sized cities.

Significant growth in organized retailing during the next three years is expected in the metros and mini-metros through better performance of the existing stores, as well as opening of new stores. From 25 operational malls in 2003, the country is expecting over 600 malls by 2010. Accordingly Videocon Industries spotted organized retailing as the bright spot for future investments to the tune of Rs25, 000 crore by 2010.

  1. Obtaining a ‘bargain’ price for a business

Another way to improve the ROI is to acquire a business at a ‘bargain’ price so the involved investment is low and the associated ROI is therefore high.

  1. The potential to restructure a firm

Allen, Oliver, and Schwallie, three Booz Allen acquisition specialists have suggested another possibility: that an acquisition can provide the basis for a restructuring of the acquired firm, the acquiring firm, or both.

  1. Reducing risk

The reduction of risk can be another motivation for unrelated diversification. The heavy reliance upon a single product line can stimulate a diversification move. Reducing risk can also lead to entering into businesses that will counter or reduce the cyclical nature of the existing earnings.

  1. Risks of unrelated diversification

The very concept of an unrelated business, where by definition there is no possibility to improve that business through synergy, suggests risk and difficulty. Many knowledgeable people have made blanket statements warning against unrelated diversification. Peter Drucker claims that all successful diversification requires a common core or unity represented by common markets, technology, or production processes. He states that without such a unity, diversification can never work; financial ties alone are insufficient.