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Portfolio Management
Learning Objectives covered in this Teaching Note:
1. Define vertical integration and explain situations in which it is advantageous/disadvantageous.
2. Describe "portfolio" management and its relationship to core competencies.
3. Illustrate "related" and "unrelated" strategies and impact on value creation.
Since the 1950's the dominate corporate strategy has been diversification, providing multiple products to diverse customers. Therefore, a diversified firm operates multiple businesses in diverse markets. The businesses constitute a "portfolio". The term is, in fact, an investment term. A stockholder holding multiple stocks of diverse businesses is said to manage a "portfolio". Similarly, a corporation manages a portfolio of business investments. This observation has led some to argue that the modern corporation has replaced the role of the traditional investor. A traditional investor, the argument is made, ought to invest in businesses representing a single product market. Investor-owners ought to be able to pick "winners" and losers" in the competition for capital and decide where economic resources will be committed based on market performance of firms. The modern corporation, however, chooses which businesses will receive capital funds through its diversification strategies. Diversification permits a corporation to siphon off profits from one of its businesses to invest in other businesses, without regard to these businesses market performance. If true, diversification would permit a corporation to subsidize a poor performing business, that under market forces would not survive. Portfolio management techniques address this argument by formalizing rules by which corporations invest in business.
Before we investigate portfolio techniques, it is useful to point out that corporations so not pursue the same kinds of diversification strategies. To be able to make generalizeable statements about diversification strategies it is useful to classify the different variations of the strategy. As is the case in much of the business literature, there is no single "typology", or classification scheme.
A typology that seems to prevail in textbooks classifies diversification into the following types:
Concentric
diversification- Businesses cluster in related marketsYour professor prefers a more intuitive typology that is consistent with major authorities (e.g., Hax and Majuf) and with common business practices:
The value of following the practice that I propose is that it facilitates analysis of mixed portfolios using the mapping of lines of businesses in a mixed corporate portfolio to an identified core business.
The notion that there is a core business for a cooperation is not always intuitively evident in analyzing diversification strategies. But, the analysis of diversification assumes that there is a core from which the company is expanding into other products and markets. The very concept of synergy suggests that there is some fundamental business that is complemented or supported through diversification -- value is added, created, enhanced by adding businesses to this core. Often the tendency is to label the "historical" or traditional business of a corporation as its "core", but as evidenced in the following example of Armtek which started as Armstrong Tire, companies redefine themselves over time to lose its anchor to an historical core business. In much of the academic research on diversification the problem of identifying a core business is resolved by characterizing the business unit with the largest revenues (or profit generation) as the "core" business. The preferred characterization of business core in theory is identical to the resource dependency view of "core competency".
An example of a mixed corporate portfolio: Armtek - (formerly Armstrong Tires) in 1980's facing declining profits and sales
Related diversification strategies have been demonstrated to achieve higher value creation (profitability and stock value) than unrelated diversification strategies (conglomerates). The interpretation of this finding is that there must be a kind of economy of scope, attained through shared resources, experience, competencies, technologies, or other value-creating factors. This is the synergy effect of diversification -- the whole is greater than the sum of its parts. While it is difficult to predict what is a "synergistic" match of a business to an existing corporate portfolio, the test must be that the business creates new value when it is added to a corporation's line of existing businesses. The example of Sears and Allstate demonstrate that diversification strategies can be "wrong". While Sears has lost market share in the past few decades in its traditional retailing base, Sears's decision to let go of its Allstate insurance business has benefited Allstate. The value of Allstate as an independent business (not part of the Sears portfolio) has increased.
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Sears and Allstate In 1925 Sears and Roebuck, at that time America's largest retailer, introduced Allstate tires and in 1931 expanded Allstate into auto insurance. During the 1980's merger mania Sears undertook an ambitious diversification strategy into real estate (Caldwell Banker), stock brokerage (Dean Witter), consumer finance (Discovery Card), auto parts (Western Auto), and other consumer services (Prodigy, Eye Care Centers). But its traditional base of retailing by the late 1980's was under attack by Wal-Mart, surpassing Sears in 1991 as America's largest retailer. Sears has attempted to refocus by divesting it's non-retail businesses, letting go of nearly all of its earlier acquisitions, including Allstate. While Sears has continued to suffer a loss of its retailing market, evidenced in its stock performance, Allstate has clearly benefited from its independence. |
How the FTC Classifies Mergers and AcquisitionsThe Federal Trade Commission monitors and reports on significant mergers, acquisitions and combinations of businesses. In this activity, the FTC has developed the following classification scheme:
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