Diversification Motive

A business owner should diversify when the market no longer responds profitably enough to justify reinvestment –and there is still entrepreneurial appetite, capacity, and talent remaining. The default should be reinvestment in one’s primary endeavor, where the insights and probabilities are strongest.

If a firm begins to lose value, then the owner should make changes to rectify operating procedures, reduce expenses or liquidate assets to a size where they can once again obtain adequate profits from their resources.

A conventional mindset highlights the vulnerability associated with concentration. Entrepreneurs are non-conventional. They are rare by definition. They see outside of the normal procedural playing field and tend to recognize the miss-priced risk that others have not encountered or did not act upon. They move to possess the favorable payback probabilities, effectively saying, “I’ll take that risk.” The rest of the time they spend looking, exploring, preparing for the exploit-mode situation. Depending on the strength (and accuracy) of their judgment, they should allocate with intensity. It’s normally pretty obvious to them and does not require (nor should not require) very many other people to understand… at the beginning.

However, growth should be throttled by managerial capacity and the rate of training and integrating new employees. In extremely fast-growing companies, this becomes very hard. However, it is solvable by higher quality entrepreneurial talent. If you don’t know how, well, you’re stuck.

So, when the markets for existing products and services do not grow fast enough to fill the entrepreneur’s appetite (and profitability), she ought to diversify into new products or services with nearly-as-good returns on invested capital. If she can find better returns, then moving, over time, in that direction will naturally begin and perhaps even accelerate. If inadequate, then it can slow. But over what time frame should it be evaluated? What criteria should be used? What ratios are proper? If you don’t know then, well, you’re stuck.

From my vantage point, the diversification motive begins with having options. I think every business owner should have two or three good alternatives to move between mentally regularly. If you go all-in on just one business, this is the way to massive wealth. It’s also a path to ruin. In most cases, it tends to become a supermajority (>67%) and very often more like 80% of your net worth. A high-functioning business is rare, and it just outperforms everything else you are associated with. However, if you spend some time finding a second thing, then you can have maneuverability. I often liken this to fire and motion, or direct and indirect. Many business owners find real estate appealing for this purpose. They can rotate between labor-intensive and capital-intensive. It’s not a bad idea and also provides some strong tax advantages, along with societal benefits. It’s also quite conventional and difficult for the extremely energetic to bring to full utility. Why? In my experience, they run out of geographic density.

Geographic diversification as a strategy is very rarely the main motive. What tends to happen is a grouping of activities or a process that works in one area and is assumed, by the entrepreneur, to work in another area. So they leap into a new location and hire a manager to install the procedures in the new location. Sometimes they do it themselves. Sometimes it works. Sometimes it does not. By this manner, I believe diversification was a by-product of the entrepreneurial appetite and a scaling up of the initial insight. Some huge firms have grown this way. There is some diversification “value” in this manner, but most of that is still correlated to the process, industry, and customer profile served. Competitive forces may differ in various regions and through time.

However, like before, the profit motive should inquire of one’s entrepreneurial spirits, “Is this the best my mind can do?” “Could I not see something else, more obvious? more easy?”

New products to the same relationships often come to my mind. Is that good, or does it muddy the relationship too much? Is that diversification or not? Can existing management oversee that or not? Can it justify another manager yet or not? This is hard to justify within surge capacity from the entrepreneur. It is doable, but it is also not clear and obvious.

Some firms maintain a very high entrepreneurial appetite but strong patience. This enterprising spirit is tough to tame. Frankly, it can only be self-moderating. This is a temperament issue. Can the person wait long enough to execute the obvious when presented? What about all the social pressure that has built up around them during the waiting? Can they break free, or will they be like the elephant, tamed by the shackle on the stake from its youth?

Good diversification often happens very fast. It does not go broadly. It goes big. What is usually not seen is all the research and development effort built up before the more public maneuver. Whether this is launching a new product or buying a company. The “next” profit engine happens slowly and then very fast. It’s a risk-adjusted, entrepreneurial leap.

We have not always practiced it this way. Sometimes we get excited, and our brains go too mush. But we are working on that. Our ambitions are sometimes ruined by being in too much of a hurry. We avoid ruin like the plague (or should I say pandemic now?)

“An acquisition is often a peculiarly suitable means of becoming acquainted with the techniques and problems of a new field.” – Edith Penrose.

My personal preference is to own minority shares of publicly traded companies… and one of which I would be comfortable –or would like to become comfortable with–owning a controlling interest therein. This is a clean way of thinking. If I don’t know enough, I work on knowing enough. If I still don’t know enough, I work harder. If I still don’t know enough… I give up.

We, as entrepreneurs, ought to do what is easy for us and hard for everyone else. This is where the profit lies. If it’s too dang hard for me, I just move on… or, at least I try to.

What I thought Edison’s “it’s 99% perspiration, and 1% inspiration” was the work ethic way of life. It is. I’m not saying I stop working. I chose to allocate my time to something that produces more. And, frankly, I personally like to hide all my blunders… they are numerous. Privately, however, I rub my nose in them.

This is hard for most. Easy for me.

Result? Rapid learning of new, loosely correlated ideas. Value? TBD.

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