Diversified conglomerates were market leaders in the early years of liberalisation. GE was the toast of global markets and every Indian corporation thought it could emulate GE. Indian corporations diversified at will as Licence Raj was being dismantled and tariffs were still high enough to offer protection. Indian companies believed diversified streams of businesses could support each other when fortunes fluctuated. And investors played along. We even loved companies that had completely unconnected businesses within. Most diversification blunders have a common starting point—easy availability of capital and favourable cronyist governments. The availability of easy capital from GDRs and the removal of licensing saw Indian boards go berserk, constantly seeking to enter newer businesses.
Growth-hungry corporations were keen to enter just any industry, merely to diversify. Interestingly, mergers and acquisitions were unknown at that time as promoters never came around to selling businesses, not even the worst among them. So everybody wanting to enter a new area started afresh and ground-up. Some very odd diversifications stand out for how they hurt the capital allocation of the whole company. One of the proverbial blunders was a very promising pharma company entering real estate with GDR money. A textile major committed the same mistake putting too much money into real estate. Worse still, investors had given them money hoping they will grow their core business. More recently, we saw capital allocation blunders happen through diversifications in power, telecom, financial services and infrastructure. Huge sums of capital got mis-allocated simply because money was available cheap and starting up was easy. That everything could be done at a price led companies on.
When businesses mis-allocate capital, it takes long to correct that mistake. Often, the capital becomes sunk and irretrievable. This can happen even while their core business does exceptionally well. As a result, the overall valuation of a company remains muted for long. Markets clearly refuse to show confidence.
The humiliation of diversified companies in recent years has been near total and secular. Boards have been forced to wake up to the market’s indifference and investor insolence. The past decade has seen several unsustainable trends reverse. The largest of conglomerates were forced to separate their businesses. Groups that were famously proud of their diversified nature demerged businesses in the hope of creating better shareholder value. Companies shifted their investment portfolios out of operating businesses into holding companies.
But the lure of diversification has not quite gone away. The difference is groups now diversify through step-down ventures or portfolio companies. A more recent phenomenon is diversification into financial services, lending and real estate. Often, companies chose to do all three together in a conjoined fashion. The availability of cheap debt, access to lards of equity capital and the ease of rolling over debt were the initial decision drivers. That a few early entrants got astronomical valuations made later entrants desperate to establish and grow. So companies glossed over asset-liability mismatches, lack of liquidity and, at times, even poor solvency in their quest for hasty growth.
Over the years, diversifications have mostly failed. Financially strong corporations refuse to take cognizance of failures. They use their conglomerate’s might to gloss over failures and the markets also quickly conclude they are too big to fail. But in the post-IBC (Insolvency and Bankruptcy Code) era, there is no such thing as too big to fail. In fact, the bigger cases of asset-liability mismatches tend to be more vulnerable than ever before. Diversification failures have left large conglomerates with no option but to sell their crown jewels to repay debts as their struggling businesses are simply not saleable. Worse still, businesses with no takers simply die. Recent examples of reputed telecom companies virtually shutting down are probably a sign of things to come in several other overcrowded industries with poor economics. Financials and power seem to be the spaces where promoters are scampering to save their skin and limit collateral damage.
So what is the learning from all this for a serious investor? Investors have seen the benefits of not supporting rampant diversification. They clearly are in no mood to play along. While companies and promoters will always return to diversification in their quest for growth, investors must stick to strong, sustainable, stand-alone businesses to grow their wealth smartly. That is the only safe and sensible option before us.