Diversification - various papers

Diversification is where the company invests in other businesses, maybe in other industry, thus holding a portfolio of different investments. Diversification may be used to help a business to reduce its overall risk where unsystematic risk (risk that affects only specific market) can be reduced by investing in other business with negative correlation of current business, ie. one makes profit while the other makes loss.

At a point where one particular industry is thriving, another may be in difficulties. Thus, by operating in more than one industry, it may be possible to achieve less volatility in overall sales and profits. Furthermore, a diversified business may be in a stronger position to survive a downturn in one of the industries in which it has invested.

Diversification, however, may not enhance shareholder value. It can be costly exercise as a premium often has to be paid in order to acquire another business. The key issue is whether diversification by a business will provide any benefits to shareholders that the shareholders themselves cannot achieve. It may well be cheaper and simpler for a shareholder to hold a diversified portfolio of shares than for a business to acquire another. In Ansoff's product/market matrix (growth vector matrix), diversification is the highest risk strategic option because a business is entering into a totally new market and new product is to be sold.

Therefore, a business has to think twice before considering diversification, unless they are confident that through diversification, they can gain much more, probably through synergy effect and are able to cover the cost of acquisition soon in future, they should not diversify and better to return the cash to shareholders so that they can diversify themselves.