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Diversification Leading to Billions in Losses
Jul 7, 2016

How often you see big companies diversifying into un-related businesses. Once the company turns big, the growth becomes stagnant on account of a higher base. Then, to spur growth, the company diversifies.

Big companies have enormous cash piles with which to diversify. However, in most cases, the diversification strategy goes wrong and leads to a huge erosion of cash from the balance sheet.

A better use of this cash would be to distribute it to shareholders as dividends.

Let's go through a few of the many examples of diversification leading to 'diworsification'. This term was mentioned by legendary investor Peter Lynch in his book, One up on Wall Street. In that book, Lynch explains the enormous risks of diversifying into unrelated businesses.

Kingfisher Airlines (KFA) is the perfect example. While the liquor business was doing well for the company, the promoter decided to foray into the aviation space...and throw good money after bad.

Reportedly, United Breweries, the holding company of the airlines, ended up lending and giving guarantees of Rs 120 billion to KFA. KFA went bankrupt in 2012, and there was hardly anything that United Breweries could recover.

The market capitalisation of United Breweries has fallen 90% since then, representing massive wealth destruction for minority shareholders.

And now the promoters of VRL logistics have expressed their desire to foray into the aviation business. Now, this is a completely different business for the promoters. When asked by an interviewer regarding the dissent from the minority shareholders, the promoter said, 'I am not bothered about shareholders.' The stock dropped 30% in two days, destroying shareholder wealth.

Another example is Unitech entering the telecom business. Real estate used to be its core business. The massive losses in the telecom space coupled with a huge debt taken for the telecom spectrum, forced the company to sell its core assets (including its headquarters) to repay the debt.

The return on capital employed (ROCE), which was as high as 22% before the telecom acquisition, dropped to a mere 6.6% post the acquisition. And the cash on the balance sheet too dropped from Rs 14 billion to Rs 3.7 billion.

We could keep going with these examples, but the point is one should be very careful while putting their hard earned money in companies looking to diversify into new businesses. The promoters' overambitious dreams coupled with the deployment of excess cash into unrelated business can erode tremendous wealth.

Rohan Pinto

Rohan Pinto (Research Analyst), Managing Editor, ValuePro and Smart Money Secrets, holds a bachelor's in engineering and a master's in finance. He is a practitioner of value investing philosophy inspired by Warren Buffett and Charlie Munger. Being a voracious reader, Rohan believes in the philosophy of mastering the best of what other people have already figured out. In his pursuit of worldly wisdom, he has constructed a multidisciplinary mental models framework, which he believes aids in effective decision making. His search for outstanding stocks is driven by a relentless pursuit of learning from the greatest living investors and the eminent dead.

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1 Responses to "Diversification Leading to Billions in Losses"

ANAND RAMPURE

Jul 8, 2016

This article on diversification by Rohan Pinto was a very relevant information for investors like me. It goes to show that trying to venture into the areas which are not our strong point can have disastrous outcome. Reliance is one more such example. Going long on those companies who perform in limited areas of thier expertise, not trying to experiment too much, giving dividend to shareholders promptly and improvise further in thier own speciality to be competent and to have an edge over other competitors in the same field.

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