Are You Too Focused

As successful companies mature, they must diversify to survive-and they can dramatically improve their shareholder returns as they do. The only questions are when and how. Of all the levers that a CEO can pull to achieve superior performance, managing a corporation's scope may offer the greatest potential to generate strong shareholder returns. Economic cycles and other factors that contribute to a company's fortunes or misfortunes may be beyond even the boss's control, but among the activities that he or she can influence, adjusting the breadth of a corporate business portfolio represents a significant portion of the company-specific drivers of shareholder returns. (1) It is therefore odd that so little consensus exists on the topic. True, long-standing conventional wisdom maintains that "focus is the answer' Volumes of finance theory argue, correctly, that investors allocate capital among diverse businesses more efficiently than corporations do and that good projects can typically attract funding in public or private capital markets. Conversely, markets are quicker than ever to discount the valuations of diversified companies as a result of their perceived shortcomings, including the cross-subsidization of financially unattractive projects and difficulties in aligning the management incentives of diverse business units with the fortunes of the corporation at large. And yet.every CEO knows that no matter how focused his or her business is, at some point diversification is necessary to regenerate growth and create value over the long term. Companies must branch out into new businesses to compensate for the declining prospect of creating value in older ones. What is more, many CEOs of successful businesses assert, in a kind of street-smart amendment to the findings of academics, that investors implicitly fund strategies and management teams, not individual projects. Our research has uncovered a particularly fertile middle ground between focus and diversification. While focused companies generally do trump more diversified ones, companies we categorize as moderately diversified perform at least as well as, and often better than, their focused counterparts. Focus, in short, isn't always the best answer. Moreover, these moderately diversified companies share a common approach to managing scope-an approach that, applied at the right time in the life cycle of a business, generates superior returns through higher growth that is both realized and anticipated by capital markets. Finding the sweet spot In our research, moderate diversification emerged as a strategic sweet spot between pure business focus and broader diversification. This trick isn't easy to pull off: the optimal balance can vary widely from company to company and from point to point in the stages of a business's life cycle. Furthermore, managers of scope shouldn't think of moderate diversification as a steady state; they must direct a process of continuous balancing between tightening a company's focus and branching out through business building, acquisitions, and other forms of related diversification. We believe that the goal should be a portfolio with an appropriate balance of current performance and growth potential and that an intense management focus can meet the markets' expectations through the dynamic reshaping of assets. Moderate diversification can be positive indeed. We began our analysis by using publicly reported revenues to classify 412 S&P 500 companies as focused (that is, deriving at least 67 percent of revenues from one business segment), moderately diversified (with at least 67 percent of revenues from two segments), or diversified (with less than 67 percent of revenues from two segments). (2) Then we validated our results by testing them against two other common measures of focus. (3) Even a broad analysis based on publicly reported revenues by a Financial Accounting Standards Board (FASB)- defined segmentation scheme confirmed the idea that in total returns to shareholders (TRS), focused companies outperformed diversified ones (Exhibit 1). …