Business Insider

Peter Crabb: Diversification is good for investors — not for businesses

Too big to fail may now be in too many places.

The crisis of the last two years led to the identification of financial institutions that policymakers saw as being important to the system, in need of support so they wouldn't close. The recession that followed led to a similar identification of systematic institutions in the auto industry.

These events are part of what now is seen as a "comeback" business strategy: Grow really big.

In the 1960s and '70s we had the Nifty Fifty. These were 50 popular and large U.S. companies of the time including Black & Decker, Coca-Cola and Johnson & Johnson. Such names remain popular today, and the companies continue to perform well in the same businesses.

The list also contained many companies pursuing a strategy of conglomeration. A conglomerate is a corporation comprising numerous divisions operating in unrelated industries. However, in the 1980s and '90s, the conglomeration strategy was overrun by corporate raiders and the deregulation of many industries.

Now the conglomeration strategy is back in vogue.

This week, Tony Jackson reported in the Financial Times that current conglomerates like General Electric and Warren Buffett’s Berkshire Hathaway performed much better through the financial crisis than should have been expected. These firms lost much in their financial divisions, but scored higher profits in their more traditional industries like electric utilities. The diversification strategy lessened the damage.

In the upcoming edition of The Economist, the feature article describes two key trends leading to favorable market conditions for large, diversified firms. First, regulation, such as Sarbanes Oxley discourages smaller firms from growing. Large firms can bear the reporting and compliance requirements more easily.

Second, many of the most promising growth areas need large capital investments, such as biotechnology and energy resources. It is expected that only large, geographically diversified firms will raise the needed capital.

These trends encourage managers to pursue growth at all costs and further encourage government policymakers to support their efforts over those of smaller businesses.

In the long run, a conglomerate strategy will serve neither the firm or consumers. The too-big-to-fail problem will only get worse.

Nothing has changed since the '70s that can make this time any better for managers of conglomerates. Diversification is good personal investment strategy but a poor business strategy. It is much easier for shareholders to diversify their investments than for business managers to find good, diversified assets. Managers should seek investments outside their core competencies only if the assets provide cost efficiencies or complement existing assets for more efficiencies or better customer service.

The conglomerate strategy further hurts the consumer as industries become oligopolistic. An oligopoly is a market structure where only a few sellers offer similar or identical products.

Oligopolists maximize profits by forming a cartel and acting like a monopolist. You may say that cartels are illegal and this cannot happen. But firms can implicitly act as a cartel by not undercutting each other’s business, thereby protecting their turf from further competition.

If further crises are to be avoided in the financial industry and throughout our economy, policymakers must direct their efforts to removing barriers to entry in markets currently dominated by large firms, and they must further consider the existing incentives that push medium-sized firms to grow big.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.