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Is diversification in business always “di-Worse-ification”?🧐

This week I explain how investors should think of businesses that diversify into new segments and why all diversifications are not bad, followed by what’s trending in markets and curated good reads.

1. Market snapshot📈

The wheels of fortune in the stock markets are turning again. I mean sector rotation. In the last week, Banks stole the march ahead of NIFTY and other sectors in the last expiry and the impact would stay for some time. Banks are full beneficiaries of interest rate hikes and are likely to do well over the next year or so.

In the last two weeks, Small, micro and midcaps have seen higher selling pressure. Hoping for a bounce back here. 

Time to be selective – we will be sharing the best results from Q4 earnings on Multipie. Join the community and we will figure out together.

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2. Is diversification in business always “di-Worse-ification”? 🧐

                          Big titans- Adani, Tata & Reliance are on a swing!🚀 

Be it Cement (ACC & Ambuja- Adani), Diagnostics (Tata 1 mg & Adani healthcare ventures), Renewable/Green energy, Online grocery (Jiomart & tata Neu) and even Media now (Reliance already had a stake in Network 18 media & recently Adani acquired a significant stake in BloombergQuint) these giants are continuously diversifying by entering all the possible segments.   

Business diversification can happen in 4 ways:

  1. Customer diversification

E.g: L&T Infotech reduced its dependence on its top 10 clients from 52.7% in FY16 to 42% in FY21.

  1. Geographical diversification

E.g: A merger between Kotak Mahindra Bank and ING Vysya bank in FY15 helped Kotak to expand in Southern India from being just concentrated in the Western region earlier. 

  1. Product diversification

E.g: FMCG companies like Emami keep on launching new products.  

  1. Sector diversification (related & unrelated)

Recent E.g: Grasim industries entering into paints industry (unrelated diversification). 

Customer, geographical, and product diversifications are considered good as it reduces the dependence and risk from the same business.

Coming to sector diversifications, a common perception in the market is “Diversifications in new sectors usually fail & managements generally end up misallocating capital” in the name of diversification. 

And of course, this perception is not formed out of thin air because according to the statistical study, unrelated diversifications (diversification in a totally different industry) have had a very low success rate in the past. 

One such case is Exide Industries, which diversified and entered into the insurance business by acquiring a 50% stake in ING Vysya Life Insurance Company Limited in 2005. Since then, the segment has barely generated any operating profits. 

We can clearly make out from the above trend that the insurance business was clearly Diworsification the business. This is the reason, when the company announced to sell off its insurance business to HDFC life in Sept’21, Exide’s share price surged by ~14% on that day itself!😅

But is it always the case? 

No! As we have a few exceptions like Berkshire Hathaway which is also a diversified conglomerate as it operates in different businesses such as investments, insurance, railroad systems, and utilities-energy. 

So, you must be thinking that how should one come to a judgment that whether misallocation of capital is happening in a company which is diversifying? 

Even I had a similar question in my mind, so I read a Thread on diversification and got an opportunity to ask the same & understand in detail from Sanjay Bakshi sir himself in the session organized by Finnacle Academy.  

Key learnings:

  • As investors, we can’t go by the base rates every time, information specific to each situation needs to be analyzed. 
  • It doesn’t matter whether the diversification is related or unrelated, the important thing to consider is:
  1. The “logic” behind the diversification 
  2. Management’s capabilities to build a new business (considering whether they can do better than peers by diversifying; have enough resources, etc.)
  3. Is it making economic sense (ROI of new business should not deteriorate the overall ROI of the company)

Sanjay sir also explained on Berkshire Hathaway that it has a very strong internal discipline on capital allocation. Each manager is responsible for its own segment, every business under Berkshire has to stand on its own, and there are no cross-subsidies. 

So, everything here is very rationale and in this case, all of the three mentioned factors are present which makes it a successfully diversified conglomerate. 

If I were to give one example of any Indian successful diversified conglomerate, it will definitely be the Bajaj group. The way each of its businesses is being operated till now- with a focus & vision of both the brothers in their respective businesses is wonderful. 

Bottom line:
Rather than having a hard-core cemented judgments in the head about diversification as a cause of misallocation of capital, one needs to study each company’s situation from a 360° view and then come to a conclusion. And not denying that successful diversifications rarely happen, but the key to wealth creation remains in finding those rarities itself..!💰

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3. What else is trendin’?🤙🏻

✔️Consumer inflation touched an 8-year high level at 7.79% in April. This inflation has started giving us a hit now! So, to control the inflation, the government is making sure of enough supplies of all the commodities for domestic use (as the scarcity leads to higher prices).

As a result of this, after banning the wheat exports completely, the government has put restrictions on sugar and steel exports as well. Not just steel, higher export duties will also be levied on iron-ore as well. This step will reduce the stress of higher input costs born by the industries such as automotive, construction and heavy equipment. 

✔️ IRDAI might allow life insurance companies to sell health insurance products as well. In 2016, companies were barred to sell any non-life product (mediclaims) to their customers. 

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4. Good reads 📚

4.1 RBI released FY22’s annual report this week. Here’s a thread of key noteworthy pointers from the same. 

4.2 Promoter selling might not always be negative. Read this article to understand the different scenarios of promoter stake diluting which shows that not every promoter selling his share is doing a fraud. 

4.3 An insightful write-up on The three-bears”? Explaining how the asset classes- Stocks, bonds, and cash have seen choppy environment scenarios, simultaneously, only twice in the last 72 years, and this time are we seeing the same situation? 

See you next week. Until then, happy investing!

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