Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Note: For some background that will improve your understanding of this article, see my summary of Porter's Competitive Strategy, Chapter 16, Entry into New Businesses.
Although there is no consensus on what strategy is, or how to formulate a strategy, there are essentially two levels of strategy for a diversified company:
1. Business unit (or competitive) strategy, i.e., creating a competitive advantage in business units, and
2. Corporate (or companywide) strategy - i.e., determining what businesses the corporation should be in, and how to manage the corporation's various business units to create shareholder value.
Unfortunately, the diversification records of 33 large prestigious U.S. companies, shows that most of their corporate strategies have not created shareholder value. The purpose of this paper is to discuss Porter's research findings on corporate strategy, the premises of a successful corporate strategy, the essential test of a good corporate strategy, the four concepts of corporate strategy, and an action program for choosing a corporate strategy.
A Sober Picture
Most previous studies have measured diversification success by measuring the stock market valuation immediately before and after mergers, but this is not a valid measure of corporate strategy. A more useful measure of diversification success is the percentage of new business units that were retained by the company. The results of Porter's study of 33 companies shows that each company entered an average of 80 new industries and 27 new fields. Over 70% were acquisitions, 22% startups, and 8% joint ventures. On average these corporations divested more than half of their acquisitions in new industries, and more than 60% of their acquisitions in entirely new fields. For unrelated acquisitions (defined below), the average divestment rate was 74%. The findings support Porter's contention that companies need to rethink their concept of corporate strategy.
Premises of Corporate Strategy
There are three underlying premises of a successful corporate strategy.
Competition occurs at the business unit level - Since business units compete (not diversified companies), a successful corporate strategy must reinforce competitive strategy.
Diversification inevitably adds cost and constraints to business units - Relationships with the parent company require time and compliance with company rules and personnel policies.
Shareholders can readily diversify themselves - Shareholders can frequently buy stock more cheaply than a corporation can acquire companies through mergers and acquisitions.
Passing the Essential Test
Diversification will create shareholder value if it passes the following test:
1. The attractiveness test - The industry must be structurally attractive or have the potential to be made attractive.
2. The cost-of-entry test - The cost of entry must not consume all future profits.
3. The better-off test - Either the new unit or the corporation must gain competitive advantage from the connection.
How attractive is the industry?
An industry chosen for diversification must have a structure that will support returns that exceed the cost of capital or that can be restructured into a favorable structure. Many companies ignore this test because they believe the new industry is a good fit with their current business, entry cost is low, or the industry is growing rapidly. See my summary of Porter's Competitive Strategy Chapter 16 for more on identifying target industries for entry.
What is the cost of entry?
Companies can enter new industries by acquisition or start-up. An acquirer can beat the efficient merger market if it pays a price below the price that fully reflects the value of the new unit. However, this is difficult when multiple bidders are commonplace and information flows rapidly through investment bankers and intermediaries. Startups, on the other hand must overcome entry barriers that tend to be high for entry into attractive industries. See my summary of Porter's Competitive Strategy Chapter 1 for a discussion of entry barriers.
Will the business be better off?
The better-off test means that the corporation must gain a one time, or continuous competitive advantage in some way as a result of the diversification, e.g., acquire a first-rate management team, or a well-developed distribution system. However, diversifying simply to spread corporate risk does not pass the better off test. Shareholders can diversify for themselves, so this is not a basis for corporate strategy. Porter also points out that increasing the size of the corporation does not increase shareholder value, and by itself does not pass the better-off test.
Concepts of corporate strategy
There are four concepts of corporate strategy: Portfolio management, restructuring, transferring skills, and sharing activities. Each concept requires that the corporation organize and manage itself in a different way.
The portfolio management strategy involves diversifying through the acquisition of autonomous units. This can create shareholder value if attractive companies can be identified that individual shareholders can not find. The company adds capital, professional management, and coaching. To pass the three test, the corporation must be able to find undervalued units to acquire, and the benefits the corporation provides to the units must yield a significant competitive advantage to the acquired units. Unfortunately, there are a number of reasons portfolio management is no longer a valid model for corporate strategy in advanced economies. For example, the strategies of autonomous units can undermine overall corporate performance, and the complexity of supervising multiple disparate units is more complex than most portfolio managers can handle. For these reasons, the portfolio management approach does not pass the three test required for successful diversification.
Using a restructuring strategy, the corporation diversifies by seeking undeveloped, sick, or threatened organizations, or industries on the verge of significant change. The parent steps in to restructure the acquired company, e.g., by changing the management team, shifting the business unit's strategy, or by adding new technology. Success depends on corporate management's ability to spot attractive companies, to turn them into profitable businesses, and to integrate them to create an entirely new strategic position. To do otherwise is just portfolio management in disguise. This approach requires that the corporation dispose of the business units once they are restructured, or the restructuring company eventually becomes a conglomerate portfolio manager with average returns.
This strategy involves exploiting interrelationships between businesses. Porter uses the value chain to explain the concept of relatedness and synergy. Companies are a collection of discrete activities, These are referred to as value activities and include nine categories: Primary activities (inbound logistics, operations, outbound logistics, marketing and sales, and service), and support activities (company infrastructure, human resource management, technology development, and procurement).
Two types of interrelationships may create value. One type is where skills or expertise is transferred among similar value chains. The other type is the ability to share activities. Opportunities arise when business units have similar value activities, or similar buyers or distribution channels. For this strategy to lead to competitive advantage it must meet three conditions: The activities must be similar enough for sharing to be meaningful, The skills must involve activities that are important for competitive advantage, and the skills transferred must be a source of competitive advantage for the receiving unit.
The industries chosen must past the attractiveness test, and the units should be sold when the opportunities to transfer skills and expertise have been exhausted. The transfer-of-skills strategy can be used in acquisitions or entry through internal develop.
The ability to share activities in the value chains of multiple business units can enhance competitive advantage by lowering cost or increasing differentiation. However, an analysis of the costs and benefits is needed to determine if cost will be lowered through economies of scale, an increase in efficiency, or a learning curve. Sharing can lead to differentiation, e.g., shared order processing may add new features or services, but sharing activities must be coordinated, and must involve activities that enhance the company's competitive advantage. A corporate shared-activities strategy can be initiated through acquisition or startup, but it requires a strong sense of corporate identity and a team oriented incentive system to be successful. Successful coordinated sharing meets the requirements of the cost of entry and better-off tests. However, target industries for sharing must also pass the attractiveness test if the diversification is to succeed.
Choosing a corporate strategy
Although the portfolio management strategy is no longer a valid strategy in advanced economies, the other approaches can be combined. For example, a company can use the restructuring strategy as it transfers skills, or shares activities. Porter's research supports a strategy based on either a transfer of skills or shared activities since most of the successful diversifications did not involve unrelated acquisitions, i.e., those that had no clear opportunity to transfer skills or share activities. The best acquisition records came from companies that emphasized start-ups and joint ventures, but none of the strategies work when the industry structure is unattractive, or the strategy is poorly implemented.
An action program
Successful diversification starts with an objective examination of the corporation's existing businesses and how the corporation adds value. There a seven steps in an action program for choosing a corporate strategy.
1. Identify the interrelationships among existing businesses units for opportunities to share activities and transfer skills.
2. Select the core business to be the foundation for the corporate strategy and dispose of units that are not core businesses.
3. Create horizontal organization mechanisms to facilitate interrelationships among core businesses.
4. Pursue diversification opportunities that allow shared activities, recognizing activities in existing businesses that provide a strong foundation for sharing, e.g., strong distribution channels or technical facilities.
5. Pursue diversification through the transfer of skills if opportunities for sharing activities are no longer available, but the company should avoid a diversification strategy based on skills transfer alone.
6. Pursue a strategy of restructuring if there are no opportunities to pursue corporate interrelationships and management has the necessary skills.
7. If the opportunities listed above do not exist, pay dividends to shareholders. This is better than diversifying when the conditions are not favorable.
Creating a corporate theme
A strong corporate theme unites the efforts of business units, reinforces their connections, places emphasis on how the corporation adds shareholder value, and guides the company's choice of new businesses to enter. A corporation's diversification record can be significantly improved by focusing on the three essential tests and an explicit choice of a corporate strategy.
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