Diversification vs concentrated strategy, which one is more effective to improve firm’s value?

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When the company is stagnating, managers will try to find new sources to maintain growth. In this condition, the company is faced with two choices, concentrating on core areas or trying a new line of business that is different from the company’s initial business when it was founded.

In real business practices, there are many success stories from implementing diversification, including Nokia and Virgin, but many also fail, such as the case of Lego or Columbia Pictures which were purchased by Coca Cola. In Indonesia, many companies are using a diversification strategy which then continues to develop into conglomerate companies such as CT. Corps, Astra International, Djarum Group and many more.

However, the results of diversification did not always match the expectations. Diversification remains an unpredictable high-risk strategy, especially for startup businesses. But both diversification and concentrated strategy can balance each other and increase the benefits of each strategy for the organization. It’s a good idea to think outside the scenario, either choosing one or a combination of both.

Many empirical studies show results doubting the assumption on diversification strategy that it always has a positive impact on performance because various empirical studies actually show different or contradictory results from one another.

These various results suggest that the effectiveness of the company’s diversification strategy in improving performance depends on other factors the company has at the time the strategy is implemented. One of the factors that is strongly suspected to be the determinant is the company’s growth opportunity when implementing a diversification strategy.

The company is pursuing a diversification strategy by opening new business lines, one of which is motivated by low growth, so the company tries to find new sources of growth through a diversification strategy. If the strategy is right, then revenue and growth will increase and the company’s financial performance and market performance will increase.

Recent research conducted on manufacturing companies listed on the Indonesian stock exchange between 2014 and 2018 gives an understanding on Indonesia’s diversification strategy. The study looked at the correlation between diversification strategies, firm’s value, and firm’s potential growth. The results of the study show that the diversification strategy and firm’s value have a non-linear effect, which is shaped like a U curve. It means that in the initial phase of implementing company diversification, the costs and risks that arise are greater than the benefits generated from this strategy. When a company is just entering the early stages of diversification organizational complexity begins to emerge. Companies that initially have fully mastered and fully understood the ins and outs of their initial business bases, with the entry of new business lines, need time to learn and adjust to the ins and outs of the new industry, so costs outweigh the benefits. However, over time, when the company has various types of business lines, the benefits obtained are greater than the costs raised by the company. It explains why in the initial phase of diversification, there is a negative effect and it turns into a positive after passing a certain level.

Furthermore, if we look at how company growth opportunities play a role in mediating the effect of diversification strategies on firm’s value, this study confirms that growth opportunities mediate in full effect.

The findings of this study provide several interesting implications for companies and investors, the existence of empirical evidence that there is a U-shaped relationship between diversification and growth opportunities and the correlation between diversification and firm’s value. Thus, companies that are considering implementing a diversification strategy must look for the optimal level of diversification to obtain a diversification premium. In addition, because of the significant role of growth opportunities in determining the effectiveness of this strategy, managers must observe the best opportunities available to the firm before undertaking a diversification strategy. For potential investors, they need to look at the growth opportunities available before making a decision to invest in a diversified company.

Author: Rahmat Heru

Details of this study can be accessed here: https://www.emerald.com/insight/content/doi/10.1108/JABES-08-2019-0075/full/html

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