Is Diversification Good or Bad?

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The trend towards building companies up and ripping them back down seems to go in waves. Indeed, some decades conglomerates rule, other decades they are seen as overly complicated and the market doesn't fully value their parts. Some companies clearly do corporate diversification better than others, though, and there's money to be made if you pick the right ones.

Eggs and Baskets

The old saying of not putting all of your eggs in one basket rings true when investing. However, you get the most bang for your buck if you take the biggest risks. So, as an investor, you have to make a choice between buying a basket of stocks from different industries or just one stock that you are willing to bet the house on. Luckily, most investors choose the basket.

On the corporate level, there's much the same decision to make. Should a company focus all of its efforts on getting one thing right or branch out and try to go multiple things well? It's the difference between a Yum! Brands and McDonald's. Yum! has successfully managed multiple food concepts for years, while most of McDonald's attempts to diversify haven't worked out.

Then there are the situations where companies go the diversified route and get too enamored of one business, letting it take over such a large portion of the business that it becomes a problem. General Electric (NYSE: GE) is the perfect example of this. GE was in a golden period under CEO Jack Welch. The company's performance was impeccable, hitting virtually every target management set out. The image of a company that could do no wrong had pretty strong supporting evidence.

What Went Wrong at GE

Welch cut waste and focused on efficiency, creating a culture of success. For these things it is hard to fault him. However, under his watch there was an unseen cancer growing in the industrial giant—GE's finance arm. The original point of the finance division was to help support the company big-ticket item sales, a similar strategy is employed by many other industrial companies. However, it started to stray into areas that weren't core General Electric's other businesses.

Welch retired and his hand picked successor, Jeffery Immelt, took the helm in 2000. He didn't stop the cancer when he had the chance and cracks were beginning to show. The transition was smooth enough, but within a few years, management was missing some self imposed targets. Even Welch was publicly critical. The wheels finally came off when the financially led recession hit and the financial division nearly took the entire company down with it.

GE even stooped so low as to take a government handout to help ensure its solvency. It was almost sad to watch these events transpire. And, the biggest betrayal came when the company cut the dividend in 2009. That is the kind of betrayal from which it is hard to recover, though Immelt has been working hard on the seemingly successful turnaround.

Breaking it Down

Some companies don't go through the near death experience that brought GE low, however. They simply decide that the whole doesn't equal the sum of the parts. So, to enhance shareholder value, they start to split up. There can be any number of reasons for this.

For example Altria (NYSE: MO) was once known as Philip Morris, owning a beer company, food company, and its namesake tobacco company. Having successfully fought off tobacco liabilities for years, it didn't seem like there were too many risks in keeping all of the parts together. However, once the risk on the tobacco side started to weigh down the stock price, management jettisoned both the beer and the food businesses. This allowed investors to benefit from the value of these companies and protected them for the liabilities that were increasing on the tobacco side of the business.

Pfizer (NYSE: PFE), meanwhile, has decided that it had too many moving parts for management to focus on its core pharmaceuticals business. To that end, it has been revamping around the core by selling or spinning off other businesses, including the recently IPO'd animal unit and the sale of its nutrition business. There are risks in this, however, since those two businesses were dependable cash cows with notable, though perhaps slow, growth prospects. If the pared down Pfizer doesn't execute well in the drug space, getting rid of the money makers that could have covered up the mistakes will turn out to be an error in judgment.

That's Some Good Diversification

There are a few companies that appear to be, or have historically, made wonderful use of diversification. Johnson & Johnson (NYSE: JNJ) is probably one of the best examples. The company is a serial acquirer and has been for most of its very long life. It goes after large and small companies alike. For example, the company is now a major player in the pharmaceutical space, but that wasn't the case two decades ago. Management, however, saw the writing on the wall, and the profits to be made, and built itself a business. JNJ did the same thing with its medical device business. It didn't, however, get rid of its consumer business in the process. Management knows that this business is a cash cow that can help it fund growth in other areas.

DuPont (NYSE: DD) is also remaking itself today. This chemicals giant is moving aggressively into the agricultural space via internal projects and acquisitions. While it is trimming off some underperforming businesses, it isn't making a wholesale shift. There is value in moving into agriculture, where a growing population of middle income consumers will demand higher quality foods (which generally means more need for grain to feed animals), however, that's no reason to get out of core businesses throwing off the cash that has allowed the shift into seeds. While the transition isn't going as smoothly as management, or shareholders, might like, the long-term implications are positive.

So, is Diversification Good or Bad?

There is no easy way to decide if diversification is good or bad except to look at each company on an individual basis. In GE's case, diversification was a great thing until one business was allowed to get too big. While it might have felt good to take the ride up, the evidence that the finance arm was overtaking the business was pretty clear. For Altria, paring down proved to be the right move in the end, as it protected shareholders from potentially larger legal issues facing just the one division.

The real issue is to avoid the market-wide emotion of “it's good” or “it's bad.” Understand the benefits, like providing cash to support growth at JNJ, and negatives, like Pfizer's belief that too many products are a distraction. Then, after looking at the situation, make the call yourself.

Yours,

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Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson and McDonald's. The Motley Fool owns shares of General Electric Company, Johnson & Johnson, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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