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While analyzing a diversified company

Jul 6, 2004

...it is important to understand that your risk is not diversified! If you are planning to invest in such a company, what factors should you bear in mind? Here is an attempt to simplify your decision making process. The cases 'for' a diversification by any company generally are...

  1. When there is limited growth potential in the core business, diversify!

  2. When a company is flush with funds and does know what to do with the same. So, diversify!

  3. When you see a competitor performing well after a diversification, you are also lured into the same. Diversify!

  4. When some areas are 'hot' (like information technology and biotech). Diversify to increase market capitalisation!

  5. When a company has an expertise in the manufacturing of cement (a commodity), why not enter into making steel! After all, steel is also a commodity. Forget about the fact that the similarity ends there and then!

  6. When a company is a part of the large business group, the holding company plans to venture into a new area. So, the holding company 'requests' this company to fund a part of the new venture. The management of the company finds this as 'opportunity to grow' in the long-term. So, diversify!

  7. When a company is protected by government regulations in the sector where it operates and eventually it is opened up for competition, the management has nowhere to look. It diversifies to 'grow'.

  8. Build-Operate-Sell (BOS): This is like a company buying a telecom license when the sector is opened up, build a base and then, sell it to an incumbent player for a big profit! Plough back the money to the existing business. Forget the fact that during this BOS period, the core business was losing money. Some times, it clicks big time and on most other days, it results in the management selling its existing business!

Before 'You' (the retail investor) is awed by this new growth opportunity being explored by a company, think again? There is a difference between diversification and backward or forward integration. If Reliance ventured into manufacturing of petrochemicals to refining, there was a strong synergistic aspect to the same (the feedstock and key components used in manufacturing petrochemicals are refined from crude). This is backward integration. Forward integration is when a pure refining company like Kochi Refineries ventures into setting up of retail petrol pumps. But when Larsen and Toubro (an engineering company) ventured into providing online share trading services (believe it or not!), it is diversification in every sense of the word.

So, if it is a diversified company, what are the factors investors should keep in mind before taking any investment decision?

  1. The rationale study: If a company says that it is acquiring a BPO company owing to its strong growth prospects, one must ascertain whether the management has the technical skills to manage such a business. A textile company venturing into BPO should raise apprehension among investors! Apart from the 'growth story', there could a disaster story, which could be unwinding in the future.

  2. Cash flow is king! Until the new business venture achieves a critical mass, one has to remember that the core business, though growing slowly, generates bulk of the cash flow. The large cash flow from this core business is diverted towards the new venture. So, one has to watch what is the likelihood that the core business could suffer?

  3. Segmental margins: Corporate disclosure levels have improved dramatically in the last five years. The Securities and Exchange Board of India (SEBI) regulations state that a company should disclose performance of each segment. Since this information is publicly available, track the segmental margins (i.e. segmental profit divided by segmental revenues). This would enable an investor to understand which is the most profitable business of the company. There are very few companies, which have justified the diversification decision.

  4. Valuations: It has always been observed that a diversified company trades at a discounted valuation. Though growth prospects may be promising, the stock market may not assign valuations similar to the best player in the industry. If L&T has an Infotech division, L&T may not trade at similar valuations like Infosys. At the end of the day, the management is acclaimed for its engineering skills. Of course, value-unlocking possibilities exist.

To conclude, we are not trying to say that all companies that have diversified are at fault. But from a retail investor's perspective, one should be clear as to why one is buying the stock?

  1. Is one buying into L&T for its engineering execution skills or for its subsidiaries growth prospects?

  2. Is Indian Rayon good at selling ready-made garments or is it good at selling insurance and BPO services?

  3. Is Tisco good at being the cost efficient manufacturer of steel in the world or is it good at funding telecom projects?

  4. How will Nirma, the detergent maker, fare if it ventures into cement manufacturing (reportedly)?

There are numerous cases like these. Before one gets excited about M&M's ability to sell time-share units (Mahindra Resorts), judge whether the company would be able to survive in its core business of manufacturing UVs and tractors! At the end of the day, it is important not to miss the woods for the trees.

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