Diversification

What is it?

Diversification is the name for extending into a new business. Horizontal diversification involves entering an adjacent, hopefully related, business. Vertical diversification involves extending business activities to encompass a different part of the value chain – For example, a consumer goods company opening its own shops.

Expansion into unrelated businesses is the extreme form of diversification. Modern financial theory (CAPM) holds that this is a poor choice for a listed company, since shareholders can acieve this diversification themselves at much lower transaction cost through buying equities. Unrelated diversification is regarded as an “agency problem” that benefits managers rather than shareholders.

Diversification tends to be a difficult strategy to pull off, since even adjacent businesses are likely to have differenty dynamics to your core business, and are prone to the “grass is greener on the other side of the fence” syndrome.

The resource-based school of strategy believe that entry into a range of businesses is fine providing that they are linked by a “core competence” that provides a common competitive advantage in each business.

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