managing for value: how the world's top diversified companies

Managing for Value

How the Wor ld ’ s Top D ive rs i f i ed Compan ies Produce Super io rShareho lder Returns

BCG REPORT

Since its founding in 1963, The Boston Consulting Group has focusedon helping clients achieve competitive advantage. Our firm believes thatbest practices or benchmarks are rarely enough to create lasting valueand that positive change requires new insight into economics and mar-kets and the organizational capabilities to chart and deliver on winningstrategies. We consider every assignment to be a unique set of opportu-nities and constraints for which no standard solution will be adequate.BCG has 61 offices in 36 countries and serves companies in all indus-tries and markets. For further information, please visit our Web site atwww.bcg.com.

Managing for Value

How the Wor ld ’ s Top D ive rs i f i ed Compan ies Produce Super io rShareho lder Returns

DIETER HEUSKEL

ACHIM FECHTEL

PHILIP BECKMANN

D E C E M B E R 2 0 0 6

www.bcg.com

© The Boston Consulting Group, Inc. 2006. All rights reserved.

For information or permission to reprint, please contact BCG at:E-mail: [email protected]: +1 617 973 1339, attention BCG/PermissionsMail: BCG/Permissions

The Boston Consulting Group, Inc.Exchange PlaceBoston, MA 02109USA

2 BCG REPORT

3

Table of Contents

About the Contributors 4

For Further Contact 5

Foreword 6

Executive Summary 7

Background to the Study 9

How We Define Diversified and Focused Companies 9

Sample Size and Composition 9

How We Measured Shareholder Returns 9

Dispelling the Myths of Diversification 11

Overview 11

The Popular Arguments Against Diversified Companies 11

The Logical Counterarguments 12

The Empirical Evidence: Focus Versus Diversification 12

The Debate: Swinging in Favor of Diversified Companies—Except in Europe 14

Recognizing When Focus Adds Value 17

Have a Clear Long-Term Strategy to Exploit a New Growth Opportunity 17

Signal Strategic Intent with Decisive Actions 19

Never Buckle to Capital Market Pressure, Unless It Makes Strategic Sense 19

Creating Value from Business Diversity 20

The Key Value-Creation Levers 20

Levers That Are Specific to Diversified Companies 20

Levers That Both Focused and Diversified Companies Can Apply 24

Conclusion 28

Appendix: Definitions and Methodology 29

Managing for Value

About the Contributors

4 BCG REPORT

This report is the product of the Corporate Development practice of The Boston Consulting Group. DieterHeuskel is a senior vice president and director in the firm’s Düsseldorf office. Achim Fechtel is a vice presi-dent and director in BCG’s Munich office. Philip Beckmann is a consultant in the firm’s Stuttgart office andproject leader of BCG’s diversified companies research team.

The authors would like to acknowledge the contributions of:

Daniel Stelter, senior vice president and director in BCG’s Berlin office and global leader of the CorporateDevelopment practice.

Rainer Strack, vice president and director in BCG’s Düsseldorf office and European leader of the Organi-zation practice.

Kees Cools, executive adviser in BCG’s Amsterdam office and global leader of research and marketing forthe Corporate Development practice.

The authors would also like to thank Keith Conlon for his contributions to the writing of this report, MarkusBrummer and Sebastian Markart of BCG’s diversified companies research team for their contributions to theresearch, and Barry Adler, Katherine Andrews, Gary Callahan, Kim Friedman, Pamela Gilfond, and SaraStrassenreiter of the editorial and production teams for their contributions to the editing, design, and pro-duction of the report.

To Contact the AuthorsThe authors welcome your questions and feedback.

Dieter HeuskelThe Boston Consulting Group GmbHStadttor 140219 Düsseldorf GermanyTelephone: +49 211 30 11 30E-mail: [email protected]

Achim FechtelThe Boston Consulting Group GmbHLudwigstraße 2180539 MunichGermanyTelephone: +49 89 23 17 40E-mail: [email protected]

Philip BeckmannThe Boston Consulting Group GmbHKronprinzstraße 2870173 StuttgartGermanyTelephone: +49 711 20 20 70E-mail: [email protected]

5

For Further Contact

The Corporate Development practice of The Boston Consulting Group is a global network of experts help-ing clients design, implement, and maintain superior strategies for long-term value creation. The practiceworks in close cooperation with BCG’s industry experts and employs a variety of state-of-the-art methodolo-gies in portfolio management, value management, mergers and acquisitions, and postmerger integration.

For more information, please contact one of the following leaders of the firm’s Corporate Developmentpractice.

Managing for Value

The Americas

Jeff GellBCG Chicago+1 312 993 [email protected]

Gerry HansellBCG Chicago+1 312 993 [email protected]

Dan JansenBCG Los Angeles+1 213 621 [email protected]

Jeffrey KotzenBCG New York+1 212 446 [email protected]

Walter PiacsekBCG São Paulo+55 11 3046 [email protected]

Peter StangerBCG Toronto+1 416 955 [email protected]

Alan WiseBCG Atlanta+1 404 877 [email protected]

Europe

Jean-Michel CayeBCG Paris+33 1 40 17 10 [email protected]

Kees CoolsBCG Amsterdam+31 35 548 [email protected]

Stefan DabBCG Brussels+32 2 289 02 [email protected]

Peter DamischBCG Zürich+41 44 388 86 [email protected]

Stephan DertnigBCG Moscow+7 495 258 [email protected]

Lars FæsteBCG Copenhagen+45 77 32 34 [email protected]

Juan GonzálezBCG Madrid+34 91 520 61 [email protected]

Jérôme HervéBCG Paris+33 1 40 17 10 [email protected]

Stuart KingBCG London+44 207 753 [email protected]

Tom LewisBCG Milan+39 0 2 65 59 [email protected]

Heino MeerkattBCG Munich+49 89 23 17 [email protected]

Alexander RoosBCG Berlin+49 30 28 87 [email protected]

Peter StrüvenBCG Munich+49 89 23 17 [email protected]

Asia-Pacific

Andrew ClarkBCG Jakarta+62 21 3006 [email protected]

Nicholas GlenningBCG Melbourne+61 3 9656 [email protected]

Hubert HsuBCG Hong Kong+852 2506 [email protected]

Hiroshi KannoBCG Tokyo+81 3 5211 [email protected]

Holger MichaelisBCG Beijing+86 10 6567 [email protected]

David PitmanBCG Sydney+61 2 9323 [email protected]

Byung Nam RheeBCG Seoul+822 399 [email protected]

Harsh VardhanBCG Mumbai+91 22 6749 [email protected]

Foreword

6 BCG REPORT

BCG has been conducting research into diversified companies for several decades. When we published ourprevious report on diversified companies four years ago (Conglomerates Report 2002: Breakups Are Not the OnlySolution), many investment analysts and business commentators were loudly proclaiming that these types ofcompanies would produce higher shareholder returns if they focused on fewer businesses—ideally, on justone. As we showed in the report, this is not true: breakups rarely create value and frequently destroy it. Butis there an optimum degree of diversification? It is a question many of our clients ask us. To find out, we car-ried out a more exhaustive study, and our research, described in detail on the following pages, producedsome surprising results.

First, we discovered that doubts about diversified companies’ ability to produce superior value are not aswidely shared among analysts and investors today as is popularly believed. In fact, the stocks of diversifiedcompanies in the United States and Asia frequently trade at a higher premium than those of focused com-panies. In Europe, however, it is a different story. Most diversified firms in this region have much lower mul-tiples, and many of them are under pressure from analysts to focus. It is worth noting that diversified firmsin Europe also tend to have weaker fundamentals than their peers in the United States and Asia.

The situation, of course, could change. If U.S. diversified companies’ fundamentals deteriorate, they toocould face calls to focus. In Asia, where capital markets are less sophisticated, the relatively low profitabilityof diversified firms has been tolerated; but as the region’s capital markets mature, pressure on diversifiedcompanies could also mount.

Our second and most important finding is that superior value creation is not a function of degree of diver-sification but of how business diversity is managed. More significantly, we have identified the levers that thetop players pull to generate and sustain exceptional value.

These insights—which are based on an analysis of more than 300 of the world’s largest diversified, slightlydiversified, and focused companies—hold valuable lessons for all companies, especially our assessment of thestrategies used by the most successful diversified firms. We hope you enjoy the report and benefit from it.

Daniel StelterGlobal LeaderCorporate Development Practice

7

Executive Summary

The popular assumption that diversified companiessystematically underperform is not supported bythe facts. More than half of the diversified compa-nies that we analyzed beat the stock market average,often by a significant margin, generating share-holder returns that are comparable to many of thetop focused firms.

• Fifty-two percent of the diversified companiesbeat the stock market average, measured by rela-tive total shareholder return (RTSR).

• The average RTSR of these firms (6.1 percent) washigher than the RTSR of 57 percent of the focusedcompanies that beat the stock market average.

• Although the average focused company producedhigher long-term RTSR (2.19 percent) than theaverage diversified business (1.34 percent), thisresult was distorted by a handful of exceptional,outperforming focused firms.

There is no evidence that diversified companieswould necessarily produce higher returns if theyfocused on a smaller number of businesses. In somecases, notably breakups, there is a strong probabilitythat focusing will destroy shareholder value.

• There is no statistical correlation between a com-pany’s degree of focus and its shareholderreturns.

• Only three of the eight European diversifiedcompanies that focused during the period of ourstudy achieved significant value.

• Our 2002 study found that only 30 percent of thediversified companies that took focusing to theextreme and broke up the entire company createdvalue—45 percent destroyed value, and the restexperienced little or no impact on value creation.

Investors in the United States and Asia appear tobelieve that conglomerates have greater value-cre-ation potential as diversified, rather than asfocused, firms. In Europe, however, conglomeratesare under pressure to focus.

• Diversified companies in the United States andAsia have higher expectation premiums—the dif-

ference between their market and fundamentalvalues—than focused firms, on average.

• In Europe, diversified companies not only havemuch lower expectation premiums, on average,than focused firms, their premiums are negative(compared with positive premiums for focusedcompanies). In other words, European diversifiedcompanies are trading below their true marketvalue, indicating that there is a so-called con-glomerate discount in this region.

In certain situations, focusing can add value—but only if it is aligned with a strategic growthopportunity.

• Diversified companies with a clear and well-articu-lated strategic reason for focusing produce higherreturns than those that lack a clear strategy.

• The stock prices of diversified companies withclear strategic imperatives for focusing tend to beless volatile after focusing than those of firms thatlack a clear strategy.

• Any decision to focus—which will usually be toexploit a new long-term growth opportunity—should be decisively signaled to the investmentcommunity through rapid divestments and a well-staged transition path.

The top diversified companies have shown that it ispossible to create superior value by using a combi-nation of up to ten value-creation levers. Five ofthese levers are specific to diversified firms.

• Efficient Capital Allocation. The outperformingand underperforming diversified companiesinvest an almost identical proportion of theirassets in high-growth segments—a surprisinglylow 43 percent and 42 percent, respectively. Butthe top players, on average, invest significantlymore in profitable units than the underperform-ers (64 percent compared with 42 percent)—anasset allocation decision that is a prerequisite forvalue creation. They also more systematically fixor divest unprofitable, value-destroying units andprogressively shift a higher proportion of theirassets toward their value creators over time.

Managing for Value

• A Clear and Consistent Portfolio Strategy. The topdiversified companies also approach acquisitionsand disposals more systematically and decisively,indicating a clearer strategic orientation than theunderperformers. They are either very active, buy-ing and selling units in roughly equal proportionsby value, or they adopt a relatively passive position,content to concentrate on their existing units.

• A Lean Organization Structure with Clear Responsi-bilities. Successful diversified companies are morelikely to have a lean, two-tiered structure than theunderperformers, which overwhelmingly favor athree-tiered approach. The leading players alsotailor the role of the corporate center to theirdegree of diversity.

• CEO-Driven Management Initiatives. Top diversifiedfirms often single-mindedly pursue one manage-ment initiative at a time and ensure it has top-level support. Each initiative is repeatedly com-municated throughout the organization and ischampioned by one unit supported by a cross-functional implementation team.

• Management Development and Skills Transfer. Thetop players often rotate senior executives andtechnicians—supported by financial incentives—among units, functions, and geographies in orderto transfer skills and best practices. Several havealso established corporate universities.

The other five levers are general value-creationlevers that can be applied by both focused anddiversified firms.

• These levers are: strict corporate governance, mir-roring the approach used by many private equityfirms; transparent reporting (notably reporting bysegment); optimization of tax and financial advan-tages; a rigorous value-management system; and capi-tal market guidance, not subservience.

• Although these levers can be applied by bothfocused and diversified companies, they have par-ticular value-creation potential for diversifiedcompanies.

It is not the degree of diversification that deter-mines a company’s shareholder returns; it is how afirm manages its business diversity that matters.

• As BCG has consistently demonstrated in previ-ous reports, superior long-term value creation isultimately determined by a firm’s fundamentalperformance. And this holds true for diversifiedcompanies.

• Provided diversified companies pull the rightlevers at the right time, they not only can gener-ate higher shareholder returns than many of theworld’s top focused firms, they also can avoid thedistracting and often unwarranted calls to focuson fewer businesses.

8 BCG REPORT

9

Background to the Study

This report explores how the world’s top diversifiedcompanies produce superior shareholder returns.We analyze the differences in performance amongdiversified, slightly diversified, and focused compa-nies around the world—and what caused those dif-ferences. We assess the pressures to focus and whenfocusing makes sense. And we identify the criticallevers that can drive value and deliver shareholderreturns for diversified companies—and others.

How We Define Diversified and Focused Companies

We categorized the universe of companies that we analyzed as diversified, slightly diversified, and focused.

• Diversified Companies (also Known as Conglomerates).Diversified companies have three or more unre-lated businesses, each accounting for at least 10percent of total revenues. To qualify as an unre-lated business, a unit must have fundamentallydifferent products and customers from the otherunits and require different management capabil-ities and know-how. To determine whether a unitis unrelated, some element of qualitative businessjudgment is needed because Standard IndustryClassification (SIC) codes alone are not suffi-cient. BMW, for example, judging by its SICcodes, appears to have a large number of stand-alone businesses, but few would call it a trulydiversified company.

• Slightly Diversified Companies. To provide a morenuanced view, we also analyzed slightly diversified

companies. These are defined as firms that eitherhave two unrelated businesses or operate in twoor more segments of a vertically integrated valuechain, such as oil exploration, refining, and mar-keting.

• Focused Companies. Focused companies generateat least 90 percent of their revenues from onemain business. This business can consist of sev-eral closely related segments, such as mobile andfixed-line telecommunications.

Sample Size and Composition

BCG analyzed 300 of the largest industrial compa-nies (measured by revenues in 2004), drawn inequal numbers from the United States (100 compa-nies), Europe (100 companies), and Asia (100 com-panies). Of these, 30 were diversified, 142 wereslightly diversified, and 128 were focused compa-nies, based on the classification criteria describedabove. (See Exhibit 1, page 10.)

How We Measured Shareholder Returns

We compared the value creation of our three cate-gories of companies—diversified, slightly diversified,and focused—using RTSR. This is the annual per-centage change in a company’s share price plus divi-dends relative to the average return of its regionalmarket index. So a firm with an RTSR of 9 percenthas an annual average total shareholder return(TSR) that is 9 percent above its index’s average.

Managing for Value

10 BCG REPORT

Two unrelated businesses or two or more segments of a vertically integrated value chain

Europe: 11 diversified companies

Alstom

MAN

PhilipsSaint-Gobain

SiemensSuez

ThyssenKrupp

Bouygues

VeoliaEnvironnement

Bayer

Asia: 10 diversified companies

Hitachi

Itochu

MatsushitaElectric Works

Sanyo Electric

Toshiba

Toyota Tsusho

Hanwha

Sojitz

Hutchison Whampoa

Mitsubishi Heavy Industries

Overall sampleSlightly diversified

companiesFocused

companies Index

Definitions

GEUnited Technologies

Tyco1

3M

Emerson

Motorola

Honeywell

Cendant1

Sara Lee

United States: 9 diversified companies

128 companies142 companies30 companies300 companies

A.P. Moller-Maersk

Diversifiedcompanies (conglomerates)

The 100 largest companies, by revenues, in: the United States, Europe, and Asia

Three or more unrelated businesses, each accounting for at

One main business generating at

Regional market indexes2 for the United States, Europe, and Asia were used to

E X H I B I T 1

THE ANALYSIS FOCUSED ON 30 DIVERSIFIED COMPANIES IN THE UNITED STATES, EUROPE, AND ASIA

SOURCE: BCG analysis.

1These companies announced breakups by 2006.

2The following regional market indexes were used to calculate RTSRs: United States, S&P 500; Europe, DJ STOXX 600; Asia, FTSE All World Asia-Pacific.

Many investment analysts and business commenta-tors make blanket assumptions about diversifiedcompanies, most notably that they are inherentlyinefficient and squander shareholder value.However, a detailed analysis of these firms’ per-formance—especially at the regional level—revealsnot only that a more nuanced view is required butthat diversified companies are more than able toproduce superior returns.

Overview

Diversified companies are rarely held up asparagons of value creation. When they create supe-rior returns, they are usually viewed simply as suc-cessful companies. And when they fail to deliver theresults that the capital markets expect, they becomethe standard-bearers for all the evils that are popu-larly associated with diversified companies, spark-ing demands from investment analysts and otherkey opinion makers for diversified companies tofocus on fewer businesses or, even better, to dis-band. But how fair and representative is this view ofdiversified companies?

To find out, we systematically analyzed how diversi-fied companies are perceived by the outsideworld—including analysts, the media, and academ-ics—and compared these perceptions with theiractual performance relative to that of focusedfirms. The results were surprising:

• First, we discovered that, despite the high-profilecriticisms of diversified companies, these types offirms are by no means universally viewed as theenemies of shareholder value. In the UnitedStates and Asia, for example, there is very limitedpressure on these types of companies to focus onfewer businesses. In fact, their shares frequentlytrade at higher multiples than those of focusedcompanies. Only in Europe are conglomeratesunder pressure to focus. Interestingly, their fun-damental performance is also significantlyweaker than that of their peers in the UnitedStates and Asia, indicating that the core issue isnot their degree of diversification but how theymanage their business diversity.

11

Dispelling the Myths of Diversification

• Second, we found that the diversified firms thatoutperform the market often produce substan-tially higher shareholder returns than focusedcompanies that beat the market, reinforcing ourprevious hypothesis that it is how diversified firmsmanage business diversity, not their degree ofdiversification, that holds the key to success.

The Popular Arguments Against Diversified Companies

Diversified companies are regularly attacked byboth the financial media and investment analysts.As a Financial Times journalist once wrote,“Shareholders would benefit if [these] corporatemonsters were broken up.” Investment analystshave tended to be equally skeptical, reflected in thefact that many apply a discount to their valuationsof these types of companies—the so-called conglom-erate discount (typically around 15 percent)—on theassumption that the price of their stock would behigher if they focused on a smaller number ofbusinesses.

Three key criticisms of conglomerates lie behindthis discount logic and the general antipathy todiversified companies.

• Misallocation of Internal Capital. Many diversifiedfirms are often alleged to have an ingrained ten-dency to allocate capital inefficiently among busi-ness units. In particular, it is claimed that theyeither invest in units on the basis of their size orhistoric performance, as opposed to their long-term value-creation potential, or knowingly cross-subsidize weaker units. The most efficient solu-tion, say the critics of these companies, is todisband them and allow the external capital mar-kets to allocate resources, free of internal emo-tional or political considerations.

• Lack of Transparency. Diversified companies tendto report only the minimum statutory financialresults and rarely detail the performance of busi-ness segments—increasing investor uncertaintyand risk. This also makes it difficult for the out-side world to establish how effectively the busi-ness is allocating internal capital, fueling thebelief that diversified companies invest unwisely.

Managing for Value

• Overly Complex Organization Structures. The multi-layered nature of many diversified companies,coupled with the complexities of juggling somany disparate businesses, makes it very difficultto manage them efficiently, claim their critics.

The Logical Counterarguments

There is, of course, an answer to each of the pre-vailing criticisms of diversified companies. What isperceived as a problem to some may be an advan-tage to others. And these criticisms are not neces-sarily endemic to diversified companies. Further,many of these issues can be, and have been, dealtwith successfully.

• Privileged access to information gives diversified com-panies the edge in internal capital allocation. In aworld of perfect information, the capital marketswill be able to identify companies with thestrongest long-term value-creation potential andallocate capital accordingly. The reality is thatdiversified companies will always have the upperhand: they will have privileged access to informa-tion and consequently, at least in theory, be ableto make superior investment decisions.

• Lack of transparency is not “genetic”—it can be easilycorrected. Lack of transparency is not an inherentfeature of diversified companies. It is a question ofwill and can be overcome, as companies such asBayer have shown. Nor is this problem confined todiversified firms. It is not possible, for example, toassess information on many focused multination-als’ performance in individual countries.

• Complex organization structures can be simplified. Aswe discuss later, several diversified companieshave rationalized their structures with significantresults. When restructuring is done, however, it isimportant that it be tailored to the business mixand that it be built on a clear and specific value-creating role for the diversified company’s center.

The Empirical Evidence: Focus Versus Diversification

Theoretical arguments have a tendency to goround in circles. The acid test is whether these the-ories stand up to empirical evidence. And, as weshow below, there is compelling evidence thatdiversification can produce superior returns andthat focusing can often destroy value.

On average, most diversified companies outper-form both the market and a high proportion of theworld’s top focused firms. On the surface, itappears that the criticisms of conglomerates are jus-tified. Since we published our last report on diver-sified companies in 2002, their average returnshave fallen below those of focused firms, suggestingthat focused companies have greater long-termvalue-creation potential. In our latest study, cover-ing 1996 through 2005, we found that focused firmshad an average RTSR of 2.19 percent, comparedwith 1.34 percent for diversified companies—downfrom around 2.8 percent for diversified companiesfrom 1996 through 2000. (See Exhibit 2.)

However, these results are based on the relativeaverage performance of all the diversified andfocused companies in our sample. And, as is wellknown, averages can be highly misleading, oftenconcealing significant variations in performance.Not surprisingly, this turns out to be the case withdiversified companies. When you compare theirindividual performance, it is clear that they differdramatically in their ability to generate shareholdervalue, highlighting the dangers of making blanketassumptions about diversified companies.

Although a significant proportion of diversifiedcompanies (48 percent) underperformed from

12 BCG REPORT

0

1

2

3

RTSR comparison, 1996–20051

RTSR(%)

Diversifiedcompanies

Slightly diversifiedcompanies

Focusedcompanies

Overall sampleaverage1.34

0.97

2.19

E X H I B I T 2

ON AVERAGE, FOCUSED COMPANIES CREATED MORE VALUE THAN DIVERSIFIED COMPANIES

SOURCES: Thomson Financial Datastream; BCG analysis.

1RTSRs were not available for 14 percent of the analyzed companies during this

period.

Conglomerates text 11/29/06 2:30 PM Page 12

1996 through 2005, measured by negative RTSR,more than half (52 percent) outperformed thestock market average. In Asia, several producedsubstantial above-average returns for theirinvestors, including Hanwha (with a positive RTSRof 13.6 percent) and Toyota Tsusho (with a positiveRTSR of 13.4 percent). In Europe, where the pres-sure to focus is highest, several diversified compa-nies also generated impressive shareholder value,notably Bouygues and A.P. Moller-Maersk, with anRTSR of 11.7 percent and 9.2 percent, respectively.(See Exhibit 3.)

The key question is how do the returns of the diver-sified companies that beat the market compare withthose of focused companies? And, once again, ourresearch produced some intriguing results. Theaverage RTSR of these diversified companies (6.1percent) was higher than that of 57 percent of thefocused companies that beat the stock market aver-age. Moreover, conglomerates’ returns are less vari-able, as we show later.

The obvious counterargument is that the top-per-forming diversified firms did not produce the high-est returns, which should be the goal of every busi-ness. Moreover, in a perfect market, they never will.This is both logically and empirically true. Afocused company that succeeds in the world’s mostbuoyant growth market will always produce higherreturns than a diversified company with units oper-ating in the same market, because the conglomer-ate’s results will be diluted by other units in less fer-tile markets. In fact, none of the top ten players inour study, measured by RTSR, were diversified com-panies. However, none of the bottom ten werediversified either. This is the dilemma of focusing:putting all your chips on one number has thepotential to generate higher rewards than spread-ing your bets, as conglomerates do, but the poten-tial losses are also greater if your number doesn’tcome up.

Critics of diversified companies will claim thatinvestors do not need firms to diversify their risksfor them. They can do this more efficiently them-selves. But it could also be argued that managers ofdiversified companies are likely to have a fuller,more detailed view of the businesses they are invest-ing in than outsiders.

If the critics are right, then focusing should pay off.But is this the case? There are two ways diversifiedcompanies can focus. They can either concentrateon particular markets, divesting unrelated busi-nesses, or they can take the most extreme measureand disband the entire company. However, asBCG’s research has found, neither of these avenuesnecessarily produces higher returns.

For example, eight of the European conglomeratesthat we analyzed in our 2002 report have focusedsince then, but only three have created significantadditional shareholder value, as we discuss in thenext chapter. Moreover, as we demonstrated in our

13Managing for Value

Underperformers versus outperformers1

48% 52%

Top ten value creators among diversified companies

Saint-Gobain

General Electric

Tyco

Philips

Hutchison Whampoa

United Technologies

Bouygues

Toyota Tsusho

Hanwha

0 5

13.6

13.4

11.7

9.2

8.7

5.3

4.8

4.8

4.1

2.5

10 15 20

Underperformers(RTSR <0)

Outperformers(RTSR >0)

A.P. Moller-Maersk

RTSR, 1996–2005 (%)

E X H I B I T 3

MORE THAN HALF OF THE DIVERSIFIED COMPANIESOUTPERFORMED THE STOCK MARKET AVERAGE,1996–2005


1Three diversified companies were excluded due to insufficient data.

2002 report, companies that go to the extreme ofdisbanding their entire business rarely benefit: 45percent of breakups destroyed value and only 30percent created it. The rest (25 percent) had littleor no impact.

One of the main reasons why breakups have suchlow success is that they are predicated on subjec-tive—and often overly optimistic—forecasts of busi-ness units’ performance, including sales, after theyare sold off. Moreover, the calculations are basedon a short-term, single-point-in-time breakup valuefor each business unit, ignoring its ability to sustainvalue creation in the long run. In addition, noaccount is taken of the value that the diversifiedcompany’s center adds to the business. A moredetailed discussion of these issues can be found inthe 2002 report.

There is no statistical correlation between focusand shareholder value. A statistical analysis of the

relationship between a company’s RTSR and itsnumber of nonrelated businesses reveals that thereis no correlation. Diversified companies with two ormore standalone businesses are just as likely to out-perform or underperform as focused companies.In fact, as expected, their RTSR performance islikely to be more stable—lowering investors’ risk,which is reflected in the declining variation in per-formance as the number of business unitsincreases. (See Exhibit 4.) This is logical: the morebusinesses that a company has, the greater the flex-ibility it has to reinvent itself and sustain growth.

The Debate: Swinging in Favor of DiversifiedCompanies—Except in Europe

Despite the high-profile criticisms of diversifiedcompanies over the years, there is evidence that thetide is turning and that investors and analysts aregaining confidence in these types of companies.

14 BCG REPORT

0

0 1 2 3 4 5

Focusedcompanies

Slightly diversifiedcompanies


Median

RTSR, 1996–20051

(%)

Distribution tends to decrease withincreasing number of businesses

No correlation between number of businesses

and value creation

R2 = 0.1%

Number of unrelated businesses2

40

30

20

10

–10

–20

–30

E X H I B I T 4

THERE IS NO CLEAR CORRELATION BETWEEN DIVERSIFICATION AND PERFORMANCE


NOTE: RTSRs were not available for 14 percent of the analyzed companies during this period.

1Based on the relevant regional index.

2Unrelated businesses with a 10 percent share in total revenues.

Since the 1980s, academic estimates of the con-glomerate discount have progressively declined,from a high of around 28 percent to around 10 per-cent today. (See Exhibit 5.)

These figures, however, are exclusively based onstudies of companies in the United States. To estab-lish how strong and geographically widespread thisrenewed confidence in diversified companies is, wecarried out two analyses. First, we looked at the rel-ative expectation premiums of diversified and focusedfirms. Expectation premiums measure the differ-ence between market and fundamental values andcan be used as a good proxy for investor confi-dence.1 Second, we investigated analysts’ reports tosee how often they mentioned the conglomeratediscount. (See the sidebar “To What Extent DoDiversified Companies’ Shares Trade at a Dis-count?” page 16.)

Our findings show strong support for diversifiedcompanies, not only in the United States but alsoin Asia. But in Europe, there is significant pres-sure on diversified firms to focus on fewer busi-nesses.


1970 1980 1990 2000

–10

–20

–30

Percentagediscount

Denis/Denis/Yost (2002)

Period coveredby study

Heavily cited academic studies of the conglomerate discount in the United States

Billet/Mauer (2003)Denis/Denis/Sarin (1997)

Berger/Ofek(1995)

Best/Hodges/Lin (2004)

Lang/Stulz (1994)

Servaes (1996)

E X H I B I T 5

EMPIRICAL STUDIES SHOW A DECLINE IN CONGLOMERATE DISCOUNTS IN THE UNITED STATES


NOTE: The years next to the authors’ names refer to the publication dates of their studies.

1. For a detailed analysis of expectation premiums see Spotlight on Growth:The Role of Growth in Achieving Superior Value Creation, the 2006 ValueCreators report, September 2006.

• Investors in the United States and Asia place a higherpremium on the stocks of diversified companies thanon those of focused companies, on average. In theUnited States, diversified companies have a sub-stantially higher expectation premium thanfocused firms. (See Exhibit 6, page 16.) In Asia,too, where the market as a whole is underval-ued, diversified companies are valued morehighly than focused companies. Although diver-sified firms trade at an expectation discount totheir fundamental value, this discount is lowerthan the discount for focused companies.

• Investment analysts rarely apply the conglomerate dis-count to their valuations of diversified companies inthe United States and Asia. A survey of the majoranalysts’ reports in the past five years on diversi-fied firms in the United States, Asia, and Europefound that analysts never mentioned theconglomerate discount when discussing U.S.companies, and they only referred to it whentalking about three of the Asian diversified com-panies in our sample. But analysts referred to a conglomerate discount in discussing almost all European diversified firms in the sample.

The question that needs to be asked is “why arediversified companies viewed so much more posi-

tively in the United States and Asia than inEurope?” In the United States, this mindset haslargely been driven by strong fundamental per-formance: it is the results companies deliver, nothow they produce them—whether through diversi-fication or focus—that appear to matter. Iconicconglomerates such as General Electric have alsoprobably fostered a more receptive attitude towarddiversified companies. In Asia, diversified compa-nies have produced less sparkling results, particu-larly in terms of profitability, but they have tendedto escape criticism largely owing to their pivotal his-toric role in their countries’ socioeconomic devel-opment and also because Asia’s capital markets areless sophisticated.

Our findings do not mean that all diversified com-panies should remain diversified. Sometimes theycan create additional long-term value by focusing.But the opportunities to do this are limited, as wediscuss in the next chapter.

16 BCG REPORT

1

6

In Europe, diversified companies have lower (and negative) expectation premiums

than focused companies

In the United States, diversified companies enjoy higher expectation premiums

than focused companies

In Asia, diversified companies are valued less negatively than

focused companies

Average expectation premiums in Europe, 2000–2004

Average expectation premiums in the United States, 2000–2004

Average expectation premiums in Asia, 2000–2004

Relative expectation premium(%)

36

31

26

21

16

11

–4

–9

–14

1

6

36

31

26

21

16

11

–4

–9

–14


Focusedcompanies

1

6

36

31

26

21

16

11

–4

–9

–14

–19



Focusedcompanies

–19 –19



Focusedcompanies

–3.3

9.5

28.9

20.3

–4.8

–13.0

E X H I B I T 6

DIVERSIFIED COMPANIES IN EUROPE ARE RELATIVELY UNDERVALUED


NOTE: For information on the methodology used, see the Appendix.

Many studies have shown that diversified compa-nies’ shares trade at a discount—the so-called con-glomerate discount. The conglomerate discount isthe difference between a conglomerate’s marketvalue and its sum-of-parts value or hypotheticalbreakup value. But the figures that these studiesarrive at are averages and conceal the fact, oftenhidden in the appendixes of these studies, that manydiversified companies actually do trade at a pre-mium. Not all diversified companies are viewedunfavorably.

In our research, we measure the conglomerate dis-count using expectation premiums—the differencebetween a firm’s market and fundamental values.For a more detailed explanation of how we calculatethese premiums, see the Appendix.

T O W H A T E X T E N T D O D I V E R S I F I E D C O M -P A N I E S ’ S H A R E S T R A D E A T A D I S C O U N T ?

17

Recognizing When Focus Adds Value

Greater focus can add value, but only if it is driven bystrategic considerations, not merely by external pres-sure. And only if it is executed clearly and decisively.

Although the pressure on diversified companies tofocus has generally eased over the past ten years, itremains intense in Europe. In the past five years,for example, eight of the largest European diversi-fied companies in our sample disposed of unrelatedbusinesses. (See Exhibit 7.)

In several cases, the pressure was self-inflicted. Threeof the firms, for example, ran into financial difficul-ties and had no choice but to dispose of businessesas key measures of overall turnaround programs inorder to survive. This can help companies escapetheir short-term difficulties, but it rarely leads to

superior long-term value creation. (See the sidebar“Focusing to Escape a Crisis,” page 18.)

But what about the companies that can choose whenthey focus? Why do only some of these create value?

There are three preconditions for success in focus-ing: having a clear and well-articulated strategy forpursuing a new growth opportunity, decisively sig-naling the strategy to the investment community,and choosing the right time to act.

Have a Clear Long-Term Strategy to Exploit a NewGrowth Opportunity

Companies that have a clear and well-articulatedstrategic imperative for focusing not only outper-

Managing for Value

Norsk Hydro(2004)

A French company(2003)



A Swiss company(2004)

TUI/Preussag(2003)

RWE(2004)

E.ON(2002)

E X H I B I T 7

EIGHT OF THE LARGEST DIVERSIFIED COMPANIES IN EUROPE FOCUSED IN THE PAST FIVE YEARS


NOTE: The years in parentheses indicate when each company focused.

form firms with unclear strategies but also find thattheir stock prices are less volatile. (See Exhibit 8.)Typically, the reason will be a major strategicgrowth opportunity that has arisen through marketliberalization or the advent of a new technology inone of the core businesses—an opportunity thatcan only be pursued by redirecting resources tofewer business units.

E.ON’s decision to focus on the energy sector is acase in point. Toward the end of the 1990s, thecompany was a classic conglomerate with success-ful businesses in several industries ranging fromelectricity and chemicals to real estate andtelecommunications. However, around this time,there were a number of pivotal developments thatmade the energy market—especially gas and elec-tricity—an increasingly attractive sector. Theseincluded the liberalization of Europe’s energymarkets, enabling companies like E.ON to expandinternationally, and the privatization of variousEastern European markets, dramatically expand-ing the accessible customer base for suppliers thathad the necessary scale to service these newmarkets.

To develop the requisite scale to capitalize onthese developments, E.ON exited all its segmentsapart from electricity and used the cash to enterthe gas market and to grow its electricity businessthrough mergers and acquisitions (M&A), withoutjeopardizing its credit rating through additionaldebt. In just five years, the company became apure-play energy business, with electricity account-ing for 70 percent of its revenues and gas account-ing for 30 percent. By streamlining its business,the company was also able to reduce its complex-

ity and overheads, as well as enable its manage-ment team to pay closer attention to the sensitiveregulatory demands of Europe’s fast-paced energymarket.

It is a strategy that has clearly paid off. Since 2003,E.ON’s share price has risen steadily, and its newapproach is widely applauded by analysts.

18 BCG REPORT

Three large diversified companies in our sample wereforced to focus over the past five years owing to finan-cial difficulties. Although they all created significantvalue—measured by RTSR—by streamlining theirportfolios, it is worth noting that all were originallyvalue destroyers, with negative RTSR. The only waywas up. Moreover, their stock prices have not returnedto their historic highs, indicating that many turn-arounds are unlikely to lead to the same level of valuecreation as a well-run diversified business.

F O C U S I N G T O E S C A P E A C R I S I S

Strategic focusing strategy

–60

–40

–20

0

20

40

60

80

0 89 178 267 356 445 534 623 712 801 890 979

Indexvalue1

Unclear focusing strategy

–60

–40

–20

0

20

40

60

80

0 52 104 156 208 260 312 364 416 468 520 572 624 676 728

TUI/Preussag

Indexvalue1

Trading days from date of focusing

Trading days from date of focusing

Upward trendRelatively low volatility

RWE E.ON Norsk Hydro

French company

Sideways movementRelatively high volatility

E X H I B I T 8

THE SHARE PRICES OF FOCUSING COMPANIES WITH CLEAR STRATEGIES FOR GROWTH SHOW A POSITIVE TREND


NOTE: Winners in this example also benefited from rising oil and gas prices.

1Relative change over DJ STOXX 600.

Signal Strategic Intent with Decisive Actions

The capital markets need credible signs that acompany is committed to focusing. This can bedone by swiftly disposing of units, restructuringthe organization, and adjusting the executiveteam—all clearly in line with the company’s newstrategic direction. Although this should be donerelatively rapidly to demonstrate commitment, itshould be executed in a structured, phased man-ner. E.ON, for example, completed its transitioninto a pure-play energy business within just 18months through a series of calculated, well-com-municated disposals and acquisitions. Investorsknew what to expect, and E.ON was able to securefirst-mover advantage.

Never Buckle to Capital Market Pressure, Unless ItMakes Strategic Sense

Given their access to privileged information that isnot available to investment analysts and other exter-

nal observers, diversified companies should be in amuch stronger position than outsiders to judgewhen is the right time to focus. Norsk Hydrodemonstrated not only this strength but also thevalue of resisting external calls to focus.

During the late 1990s, Norsk Hydro was underpressure from analysts and other members of theinvestment community to divest its underperform-ing fertilizer business. The company resisted andinstead concentrated on turning around the busi-ness before selling it at a significant premium viaan initial public offering (IPO), under the nameYara. Since the divestiture, the stock prices of bothNorsk Hydro and Yara have improved substan-tially.

The evidence suggests that in many cases it is bet-ter to concentrate on how to become a premiumdiversified company than to get distracted or loseconfidence and take the short-term route ofbreaking up the firm.


employed these levers more often and more suc-cessfully than the underperformers. As a result, weconsider these to be just as important as the otherlevers. Out of the six empirically tested levers, fivewere found to have a potentially significant impacton the value creation of diversified companies. Theonly one that did not have an immediately apparentinfluence was transparent reporting, which showedno statistical correlation with shareholder value.Nevertheless, it is important to take this lever intoaccount for reasons described later.

Levers That Are Specific to Diversified Companies

Diversified companies have successfully employedfive value-creating levers that are specific to them.

1. Efficient Capital Allocation. The top playersinvest much more heavily in profitable units—aprerequisite for value creation. Sixty-four percentof the top diversified firms’ investments went intoprofitable units, compared with just 42 percent forthe underperformers. This gives the top companiestwo major advantages. First, it enables them to gen-erate the additional cash needed to invest in high-growth units. And second, it provides a solid plat-form for long-term value creation, for whichprofitable growth is one of the necessary conditions.

All diversified companies, however, invest a similarproportion in high-growth segments, on average.The ability to spot and invest in high-growth mar-kets does not appear to be a distinguishing factorbetween the winners and the losers. Both the topplayers and the underperforming diversified firmsallocated around 42 percent of their investments inhigh-growth segments, on average—a surprisinglylow percentage.

Although the winners and losers invested very similaramounts in high-growth segments, the fact that themost successful firms invested more heavily in prof-itable business units means that they tended to investmore heavily in value-creating units. (See Exhibit 9.)On average, these types of units accounted for 28 per-cent of their investments, against 19 percent for theunderperformers. Moreover, they invested far lessfrequently in value destroyers (21 percent of total

Creating Value from Business Diversity

20 BCG REPORT

As we have demonstrated, external pressure tofocus should be challenged. Nearly all diversifiedcompanies can generate superior returns providedthey pull the right value-creation levers. Here wedescribe the ten key levers that the top players useto stay ahead of the market—providing lessons thatall companies can fruitfully apply.

The Key Value-Creation Levers

Through a combination of quantitative and qualita-tive analyses, we tested hypotheses on ten possiblevalue-creation levers that the top diversified com-panies might use to turn their diversity to theiradvantage.

The five levers that are specific to diversified com-panies are as follows:

• Efficient capital allocation

• A clear and consistent portfolio strategy

• A lean organization structure with clear responsi-bilities

• CEO-driven management initiatives

• Management development and skills transfer

There are five other levers that can also be used.Although these can be applied by both focused anddiversified companies, they have particular value-creation potential for diversified companies:

• Strict corporate governance

• Transparent reporting

• Optimization of tax and financial advantages

• A rigorous value-management system

• Capital market guidance, not subservience

It was not possible to analyze the impact of four ofthese levers—CEO-driven management initiatives,management development and skills transfer, opti-mization of tax and financial advantages, and a rig-orous value-management system—in a strict empir-ical sense, but we did find that the outperformers

investments) than did the underperformers (35 per-cent of total investments).

The outperformers also progressively channeled ahigher proportion of their assets into profitablebusiness units. Based on an analysis of the changein allocation of assets over time, we found that thetop diversified firms systematically shifted a muchhigher proportion of their assets to value-creatingunits than the underperformers—refuting the pop-ular assumption that all conglomerates misallocateresources. On average, 75 percent of the top com-panies increased their investments in value-creatingunits, compared with just 45 percent of the under-

performers. (See Exhibit 10.) Nevertheless, nearlyall diversified firms, including some top players,continued to support their value-destroying busi-nesses to varying degrees.

There are three ways to win at internal capital alloca-tion: assign a strong role to the diversified company’scenter, establish clear rules and processes for capitalallocation, and closely monitor business units andencourage them to avoid capital allocation pitfalls.

• Assign a strong role to the center. At Emerson, theCEO and senior leadership team rigorously cross-examine each division about its investment plansat an annual planning meeting. Three criteria areused to determine whether to support a plan: thedivision’s ability to earn a return above the cost ofcapital; the feasibility of its plan to improve salesand hit its new targets; and its long-term prof-itable growth potential, based on analysis of itshistoric and forecast profits and losses spanning aten-year period—five back and five forward.Every detail is challenged, and the CEO has thefinal say.

• Set clear capital allocation rules and processes. One ofthe European diversified companies in our sample


Outperformers—share of investments

Underperformers—share of investments

Above average

Segment growth

Below average

Above average

Segment growth

Below average

Below average Above average

Segment return on assets



15%28%

21%36%

23% 19%

35%23%

E X H I B I T 9

OUTPERFORMERS ALLOCATE MORE OF THEIR INVESTMENTS IN PROFITABLE BUSINESS UNITS THAN UNDERPERFORMERS


NOTE: This analysis covers the period 2000–2005. For information on the

methodology used, see the Appendix.

75

45

55

25

0

20

40

60

80

100

Outperformers Underperformers

Value-creating change Value-destroying change

Companies with specific asset-change strategies(%)

E X H I B I T 1 0

OUTPERFORMERS INCREASE THEIR INVESTMENTS IN VALUE-CREATING BUSINESS UNITS MORE THANUNDERPERFORMERS


NOTE: This analysis covers the period 2000–2005. For information on the

methodology used, see the Appendix.

uses a simple but effective classification matrix todetermine its investment priorities. This involvestwo main steps. First, the performance of each unitis evaluated to establish what type of business it is,based on its relative market share, financial results,and other criteria. Is it a basic cash-generating busi-ness, a growth business, or a business that is still indevelopment? Second, the long-term strategicvalue and fit of each of these business units need tobe assessed. By combining these performance-ori-ented and strategic insights, each business is classi-fied into one of four categories, each with differentyet very clear investment policies. Strategically impor-tant units—those with the strongest growth poten-tial—are the top investment priority; the goal is toeither attain or defend market leadership. Coreunits are second-priority investments; the goal is todefend and exploit these units’ existing marketposition. Noncore units will receive short-term invest-ments only to maximize the business’s cash poten-tial; these units will be the first to be disposed of tofinance the growth of more promising businesses.Unverified units, whose strategic value is still unclear,will not receive significant investments.

• Closely monitor business units and encourage them toavoid capital allocation pitfalls. There is a risk thatunits will either put forward unnecessarily pes-simistic plans or overstate their investmentrequirements—the classic “empire building” sce-nario. To avoid these problems, the center shouldrigorously challenge all plans, pushing for realisti-cally high returns, and link the compensation ofeach unit’s management team to its success inachieving the agreed-upon plan. To strengthenthis performance-reward relationship, the man-agers responsible for the plan should also beresponsible for its execution.

2. A Clear and Consistent Portfolio Strategy. Oneof the surprising findings was that the top 25 per-cent of outperformers had a passive approach toportfolio management: they did not actively buy orsell business units, suggesting that they have a clearstrategic vision and have established the units thatthey need to achieve this vision—notably businessesthat are growing profitably, above the cost of capi-tal. However, they are not always passive. When thesituation changes along a core business’s life cycleand units are unable to continue to grow profitably,these outperformers actively manage the portfolio.In short, their portfolio management has active and

passive phases following an overall corporate-levelbuild/consolidate life cycle.

The underperformers had a less settled approach,with only a few content to assume a passive posi-tion. Nearly half expanded or reduced the numberof businesses in their portfolios. This could reflecteither a lack of a clear strategy or a failure to graspthe different approaches required for managing aportfolio actively and passively.

During phases of active portfolio management, wefound that the outperfomers centrally steer theirM&A activities and apply consistent M&A and dis-posal criteria to all units. In phases of passive port-folio management, these companies systematicallymonitor their units and apply equally systematicprocedures for dealing with underperformingunits—in a process similar to that for internal capi-tal allocation.

There are three ways to win at portfolio manage-ment: centralize M&A and portfolio managementexpertise, establish clear acquisition and divest-ment criteria, and regularly monitor portfolio per-formance and composition.

• Centralize M&A and portfolio management expertise.At Saint-Gobain, all portfolio decisions, evenminor ones, are made centrally, with relevantexpertise concentrated in the strategy depart-ment and the CEO’s office. The CEO has thefinal say in all cases. This approach is under-pinned by a clear M&A and divestment strategy.This strategy includes acquiring the leadingnational players in fragmented industries andgradually buying out the others, as well as dispos-ing of businesses that do not have the potential tobecome market leaders.

• Establish clear acquisition and divestment criteria.Similar to establishing clear capital-allocationrules, outperfomers set clear acquisition anddivestment criteria and follow them, as Jack Welchdid when cleaning up GE’s portfolio in the 1980s.

• Regularly monitor portfolio performance and composi-tion. Toyota Tsusho reviews its portfolio annuallyand expects each division to explain its plans forunderperforming businesses, taking into accountthe company’s overall strategic vision. If a turn-around is attempted, the unit is constantlytracked and controlled by the strategy and plan-

22 BCG REPORT

ning departments. Moreover, all portfolio recom-mendations for all units, irrespective of their rel-ative performance, are incorporated in the units’business plans. Key success factors include sim-ple, common criteria for evaluating each unit’sperformance, alignment of the review processwith the annual strategic-planning process, andregular restructuring of the portfolio in order todevelop the necessary competencies.

3. A Lean Organization Structure with ClearResponsibilities. Lean is likely to be mean.Underperformers tend to have a more layered andcomplex structure than outperformers. Eighty per-cent of the underperformers had a three-layerstructure—headquarters, intermediary administra-tion (for example, subholdings), and the businessunits themselves—compared with 55 percent of thetop players. Only 20 percent of the underperform-ers had a two-layer structure, compared with 45 per-cent of the outperformers. Although this is notdecisive evidence, it is worth noting that many ofthe long-term outperformers, including GE andToyota Tsusho, have leaner structures. They alsoassign a clear role to the center.

Typically, the more diversified the business, thegreater the relevance and value of a lean, two-tieredstructure. Nevertheless, there will be situationswhen it is appropriate to have more than two lay-ers—notably when a company has a large numberof businesses that can be clustered into relatedgroups. The appropriate role of the center, ofcourse, varies—depending on the degree of busi-ness diversity. There are no hard and fast organiza-tional rules: each case has to be appraised on itsindividual merits.

There are two ways to develop a winning organiza-tion structure: keep it lean and clearly define theroles and responsibilities of the center and the busi-ness units.

• Establish a lean structure. Bouygues has a clear andsimple two-layer structure, which eliminatesduplication of functions at the divisional level.The center, for example, provides shared servicesto the divisions—including IT, legal, and humanresources—and takes responsibility for strategyand capital allocation. Although Bouyguesappears to have a third, intermediate layer—for

example, Bouygues Construction and BouyguesTelecom—that layer is only a reporting line; ithas no operational role.

• Clearly define the roles and responsibilities of the centerand units. Among top diversified companies, thegreater the business diversity, the lower the oper-ational involvement of the center.2 (See Exhibit11, page 24.) At Toyota Tsusho, which has a rela-tively low degree of diversity, the center’s mainfunction is to develop the collective potential ofits portfolio of businesses. This includes identify-ing common growth opportunities, fostering col-laborative platforms, and helping to shape thebusinesses’ strategies in order to exploit theircommonalities. Berkshire Hathaway, by contrast,is highly diverse and limits its center’s role tomanaging the company’s financials and buyingand selling units; the center does not get involvedin the operations of the businesses.

4. CEO-Driven Management Initiatives. It is essen-tial to have a focused and structured approach todeciding, communicating, and implementing spe-cific management initiatives. For many of the topdiversified companies, this involves the following:

• Ensuring the Initiative Has Top-Level Support. Typi-cally, just one priority initiative will be pursued ata time, often under the guidance of the CEO,who regularly monitors its progress.

• Communicating the Initiative Throughout the Organi-zation. The CEO briefs top management on theinitiative and then cascades the plans down to allstaff through a series of road shows or workshops.

• Establishing Clear Roles and Responsibilities for ItsImplementation. In many cases, one business unitor segment will take the lead on the initiative andpilot and champion it to the other units.

At Saint-Gobain, for example, the CEO identifiesand pushes the priority target and communicates itto the top 200 senior executives from all divisions.One division is selected to lead and initially imple-ment the initiative, building up a cross-functionalteam that will later coach and pass on its experi-ences to the other divisions as they enter the imple-mentation phase. At every stage, the process isclosely tracked by the CEO.


2. Further insights into the role of the center can be found in our forthcoming report, The New Role of the Center.

Another large diversified European company,which has a long history of successful managementinitiatives, takes a slightly different yet equallymethodical approach. It identifies hot issues withinthe company and creates a comprehensive packageof initiatives to address them. Moreover, each pack-age shares a common approach to the issues athand—including common terms and definitions—ensuring that members of the staff are able toquickly grasp what is required of them and build ontheir learning from previous initiatives.

5. Management Development and Skills Transfer.The top players often rotate senior executives andtechnicians—supported by financial incentives—among units, functions, and geographies in orderto transfer skills and best practices. Saint-Gobaindoes this in four ways:

• All job openings, across all segments and coun-tries, are advertised via a central database that isaccessible to all

• Each sector and country has an internationalmobility specialist

• Annual staff-performance evaluations enable thehuman resources department to match skills withjob offers

• To aid succession, the most likely candidates tofill senior posts are identified well in advance ofincumbents’ departures

Numerous diversified companies have also set upcorporate universities to share and enhance theknowledge and expertise of their staffs, includingSuez and MAN—but this also holds true for focusedcompanies. What makes these universities particu-larly beneficial to diversified companies is theopportunity to leverage the diversity of their man-agement expertise.

Key success factors include the following:

• Ensuring top management commitment to teach-ing at the university

• Making attendance mandatory at senior-leveltraining sessions

• Ensuring that “students” in classes represent a crosssection of international and functional experience

Levers That Both Focused and Diversified CompaniesCan Apply

In addition to the five value-creating levers specificto diversified companies, there are five value-creat-

24 BCG REPORT

Example

Diversified company

Degree of diversification

Degree of intervention

Slightly diversified company

Center’s main contribution tobusiness units

Synergy-driving center

• Drives synergies

• Pushes best-practice exchange and cooperation

• Develops common tools for business units

Portfolio-developing center

• Identifies collective growth potential/opportunities

• Fosters platforms for collaboration

• Helps shape business units’ strategies

Performance-managing center

• Manages by financial objectives

• Selects/provides incentives for top management

• Challenges business units’ strategies and sets targets

• Allocates resources

Financial investment center

• Exclusively manages by financial objectives

• Manages portfolio of businesses

• Allocates financial resources

Berkshire Hathaway1 Lafarge Toyota Tsusho General Electric

E X H I B I T 1 1

THE ROLE OF THE CENTER SHOULD BE DETERMINED BY THE DEGREE OF BUSINESS DIVERSIFICATION


1Berkshire Hathaway is not included in our diversified-companies sample, but it is a well-known example of a financial investment center.

ing levers that can be applied by both focused anddiversified firms.

1. Strict Corporate Governance. The top diversifiedcompanies tend to have major shareholders—thatis, investors who hold a disproportionately largenumber of shares. (See Exhibit 12.) For example,60 percent of the shares of A.P. Moller-Maersk, aleading diversified company that has generated anRTSR of 9.2 percent over the past five years, areowned (directly and indirectly) by Mærsk Mc-Kinney Møller.

We found that there are several reasons why a majorshareholder is likely to have a positive impact onvalue creation:

• The owners’ and managers’ interests are moreclosely aligned, enabling more decisive strategicdecisions.

• There is likely to be less pressure to increasereturns in each quarter, allowing a longer-termstrategic perspective to be taken and imple-mented.

• The larger the investor’s shareholding, thegreater its influence and the more likely therewill be direction from the shareholder to man-agement—creating an ownership culture and amore entrepreneurial environment.

• In some cases, the owner’s personality canbecome an integral part of the company’s equity,instilling trust and confidence in customers. SirRichard Branson’s involvement in Virgin (a com-pany not included in our sample) is a case inpoint.

By the same token, however, a major shareholdercan create problems—especially if the investortakes an overly active interest in the day-to-day run-ning of the business. An equitable balance needs tobe struck.

The governance model that many of the most suc-cessful private-equity firms apply to the companiesthat they invest in holds two important lessons fordiversified companies with major shareholders:

• Establish a strategic dialogue with the dominantinvestor. Such a dialogue should not be left to theinvestor relations team. Senior managementshould stay in close and regular contact with the

dominant investor and incorporate the investor’sobjectives in the company’s strategy. However, itis important to bear in mind that in most coun-tries, any information revealed to a dominantinvestor must also be disclosed to all other share-holders at the same time.

• Build an effective and engaged board. Recruit exter-nal board members with the breadth and depthof functional and industry expertise required tooptimize the potential of all business units in theportfolio. The board should be encouraged toplay an active role in the running of the business,not simply a supervisory function. Board mem-bers’ compensation should be linked to value cre-ation, and board members should be required tohold shares in the company.

2. Transparent Reporting. As GE and many othercompanies have discovered, lack of transparencycan become a lightning rod for external demandsto focus—especially when a firm fails to live up tothe market’s expectations. When GE’s fourth-quar-ter profits in 2005 disappointed analysts, for exam-ple, the German edition of the Financial Times pro-claimed that the company was “extremely difficult


Median

0

100

200

300

400

500

600

515

349

Outperformers Underperformers

Average shareholder concentration index1

E X H I B I T 1 2

OUTPERFORMERS TEND TO HAVE A HIGHER CONCENTRATION OF MAJOR SHAREHOLDERS THAN UNDERPERFORMERS

SOURCES: Bloomberg; BCG analysis.

NOTE: This analysis covers the period 1996–2005.

1The average shareholder concentration was measured using the Herfindahl

Hirschman Index.

to understand” and “deserves a hefty discount.”3

However, we found no correlation between trans-parency and a diversified company’s ability to cre-ate value. Most firms—67 percent of the outperform-ers and 69 percent of the underperformers—adhered to the minimum international reportingstandards and offered little more. (See Exhibit 13.)

Nevertheless, reporting and operating in a moreopen manner could shield many diversified firmsfrom unnecessary criticism.

There are two ways to improve transparency: intro-duce detailed segment reporting (for example, bybusiness unit or geographic region) and communi-cate openly and transparently with investors andother stakeholders.

• Introduce detailed segment reporting. A significantstep up in transparency can be achieved byreporting the financial performance of each seg-ment as if it were an individual company, adher-ing to (or even exceeding) international report-ing standards. Bayer has excelled at this,progressively increasing its transparency over thepast ten years. It now provides a comprehensiveexplanation and assessment of each segment and

voluntarily discloses additional informationabout value-based indicators and each segment’srisks and cost of capital.

• Communicate openly and transparently with stakehold-ers. United Technologies’ award-winning investor-relations team has established a strong reputationfor candor, transparency, and responsiveness toanalysts’ and portfolio managers’ needs. Thisincludes ensuring that individual members of theteam offer analysts and other stakeholders thedepth of industry-specific information they expect.

3. Optimization of Tax and Financial Advantages.Companies operating in different geographicregions can often leverage the tax differencesbetween these locations to offset the losses of busi-ness units. General Electric, for example, used thebook losses from GE Capital’s leasing assets toreduce the tax on its other units’ profits.

As studies have shown, a company’s size and diver-sity can also lower its credit risk, leading to higherratings and, consequently, a lower cost of capital—enabling it to enjoy more profitable growth.

Although neither of these advantages was testedempirically in our research, separate studies haveindicated that these benefits can be significant.

4. A Rigorous Value-Management System. It is impor-tant that every unit understand the performance itmust deliver—for example, in terms of return oninvestment, sales, growth, and profitability—in orderfor the corporation as a whole to achieve its share-holder value target. To achieve this, it is important tohave an integrated value-management system thatoptimizes the corporation’s performance acrossthree critical dimensions: fundamental value, valua-tion multiples, and distributions of free cash flow.This usually involves six steps.4

• Understand the sources of value creation. Using a com-bination of quantitative and qualitative analyses,identify the historic drivers of underlying funda-mentals, investor expectations, and free cash flow.To gauge how value is likely to evolve in the future,

26 BCG REPORT

“Obscurers”

“Minimalists”

“Dazzlers”

“Stars”Fulfilled

Not fulfilled

Mandatorydisclosure

Low (scoring < 4)

1367

20

69 15

16

Percentage share of outperformers Percentage share of underperformers

Voluntarydisclosure

High (scoring ≥ 4)

E X H I B I T 1 3

MOST DIVERSIFIED COMPANIES—BOTH OUTPERFORMERS AND UNDERPERFORMERS—FULFILL REPORTING OBLIGATIONS

SOURCES: 2004 annual reports; BCG analysis.

NOTE: For information on the methodology used, see the Appendix.

3. See “General Electric aus drei Perspektiven,” Financial Times Deutschland,April 18, 2006.

4. Further insights into integrated value-management systems can be foundin Spotlight on Growth: The Role of Growth in Achieving Superior Value Creation,the 2006 Value Creators report, September 2006.

it is also necessary to consider current plans,industry trends, and the dynamics of the capitalmarkets, as well as the investor mix. What are dom-inant investors’ priorities and views of the com-pany’s plans?

• Set realistic long-term value-creation goals. One effec-tive way to do this is to assess two or three com-peting TSR scenarios and thoroughly debatethem among the senior management team. Forexample, contrast a low-risk strategy that willdeliver modest, above-average TSR in the longrun with a more aggressive strategy designed toachieve top quartile returns in the near term.Debating options like these will reveal not onlystrategic tradeoffs but also senior managers’ pri-orities and beliefs in the organization’s ability tohit stretch targets.

• Translate value creation goals into internal targets foreach business unit. All high-level TSR targets haveto be translated into specific objectives and grass-roots-level metrics that managers throughout acompany can influence. Are existing metrics,such as operating income or return on investedcapital, sufficient? Or will new ones, such as cashvalue-added, have to be introduced? When formu-lating the metrics, it is essential to ensure that theycan be practically applied to the individual units;they should relate to how the unit operates. Which-ever metrics are chosen, it is equally important toensure that they are incorporated in supportprocesses, such as planning and budgeting, in-vestor communications, and other relevant fields.

• Align internal plans and market expectations.Companies must ensure that their business planswill deliver the fundamental performanceneeded to produce their target shareholderreturns. What are the market expectationsembedded in a firm’s stock price? Is there a gapbetween what it plans to deliver and whatinvestors expect? Quantify the gap and identifyways to close it.

• Institute rigorous value-based planning and reporting.Each aspect of the firm’s business plan needs tobe meticulously plotted, with clear, measurableobjectives and timelines, as well as reporting sys-tems, to regularly monitor progress. As circum-stances change, the plan and strategy need to beupdated and amended where appropriate.

• Align management incentives with internal and exter-nal value-creation goals. A significant portion ofexecutives’ compensation should be linkeddirectly to their contribution to the overall TSRgoal, measured by the value creation metrics thathave been selected to influence shareholder value.

5. Capital Market Guidance, Not Subservience. Aswe showed earlier, companies that simply give in tocapital market pressures to focus, without havingclear and well-articulated strategies for exploitingnew opportunities, do not create significant addi-tional value. Firms should be open to strategicopportunities with the potential to deliver long-term improvements in their fundamentals, notguided by external pressures.


fied in this report; in other instances, serendipitymight have played a role. All of these companiescan produce even higher returns by following thesecore principles of value creation more consistently.

Diversified companies in Asia also need to takethese lessons on board, especially given their cur-rent levels of profitability. Although cultural con-siderations and the less sophisticated capital mar-kets in the region have insulated them fromsignificant pressure to focus, the situation is likelyto change, in line with so many other developmentsin this economically critical and responsive part ofthe globe. In Europe, of course, the pressure tofocus is already very evident, and diversified com-panies need to take action immediately to relieve it.In a handful of cases, focusing will be the answerprovided it makes strategic sense. For most diversi-fied companies, though, the solution lies in focus-ing on the ten value-creation levers.

Conclusion

28 BCG REPORT

As BCG has shown in its previous reports, superiorlong-term value creation is ultimately determinedby a firm’s fundamental performance. And thisholds true for diversified companies: it is not thedegree of diversification that matters; it is howfirms manage their business diversity that counts.Provided diversified companies pull the right leversat the right time, they can generate higher share-holder returns than many of the world’s topfocused firms—and also avoid the distracting andoften unwarranted calls to focus on fewer busi-nesses.

In the United States, many diversified companieshave pulled the right levers, reflected in their rela-tively high fundamental performance and expecta-tion premiums—not to mention the almost totalabsence of any pressure put on them to focus as anend in itself. In some cases, they succeeded by con-sciously pulling the ten value-creation levers identi-

29

Appendix: Definitions and Methodology

Managing for Value

TSR =Dividends + share price increaseShare price at point of investment

Total shareholder return(TSR)

Absolute value creation from the investor’s perspective

Relative total shareholder return(RTSR)

1 + TSR

1 + TSR Index– 1RTSR =

Value creation relative to capitalmarket (benchmark index)

DEFINITION: TSR/RTSR


Marketvalue

III

II

I

Result

Fundamental value

Current operative

value

Value of current growth

Expectationpremium

Current performance

Market value(including debt)

NPV1 of additionalcash flows

generated by growth and profitability

(BCG fade model)

Method/source

DEFINITION: EXPECTATION PREMIUM


1NPV is the net present value.

Focused companies Slightly diversified companies

300 largest industrial companies

128 companies 142 companies 30 companies

• At least 90 percent of revenues from one main business

• The main business may consist of several closely related businesses

• Two unrelated businesses

OR

• Two or more businesses in a vertically integrated value chain (for example, oil exploration, refining, and marketing)

• Three or more unrelated businesses

• Each business accounts for at least 10 percent of revenues

Diversified companies (conglomerates)

DEFINITION: REPORT SAMPLE


30 BCG REPORT

Similar Different

Similar Different

Similar Different

A business qualifies as unrelated if it has...

Different products …

… for different customers

… requiring different management capabilities and know-how

All three criteriamust be fulfilled

DEFINITION: UNRELATED BUSINESSES


Classification of Growth Segments Profitability Classification

1. Selected approximately 40 representative industries

2. Identified appropriate Datastream indexes

3. Calculated revenues of the respective index participants

4. Determined average growth rates for each industry and region (2000–2004)

5. Assigned segments to growth classes

1. Determined return on assets for each segment and year (operating income/total assets)

2. Determined average return on assets for all conglomerates by region

The top 50 percent were classified as above average; the rest were classified as below average.

Segments with return on assets greater than the regional average were classified as above average; the rest were classified as below average.

Above average

Segment growth

Below average



15%28%

21%36%

METHODOLOGY: INVESTMENT ALLOCATION ANALYSIS



Determined asset change (2000–2004) for each investment class

Calculated relative asset change by dividing asset change of investment class by total asset change

Evaluated pattern of asset change

+

–

+– Return on assets

Return on assets

Return on assets

Return on assets

Return on assets

Return on assets

Return on assets

Return on assets

Growth

Shift to low-growthsegments

1.

2.

3.

4.

+

–

+–

Growth

+

–

+–

Growth

+

–

+–

Growth

+

–

+–

Growth

+

–

+–

Growth

+

–

+–

Growth

+

–

+–

Growth

Assigned business segments to investment classes (for example, high/low return on assets and high/low growth)

Value-creating asset change

Value-destroying asset change

Disinvestment fromvalue destroyers

Investment invalue destroyers

Shift togrowth segments

Shift to high-returnsegments

Shift to value creators

Shift to low-returnsegments

Disinvestment fromvalue creators

METHODOLOGY: RELATIVE ASSET CHANGES


Assessment: reporting obligatory information

1. All segments correctly reported?

2. All necessary information included? •Result (operating income)

•Depreciation/amortization•Assets•Investments•Debt•Income/revenues, external•Income/revenues, internal

3. Information correct and adequately allocated? •Share of unallocated operating result

•Share of unallocated revenues•Share of unallocated assets•Reconciliation provided

4. Segments reported separately?

Scoring: voluntary information

!

Obligations considered fulfilled if not morethan one question is answered negatively Additional P&L figures (for example, EBITDA) 0–2 pts.

Value-based management figures (ROCE, etc.) 0–4 pts.

Segment risk review and/or capital cost per segment 0–4 pts.

Scores greater than 4 points are considered high

!

“Obscurers”

“Minimalists”

“Dazzlers”

“Stars”Fulfilled

Not fulfilled

Mandatory disclosure

Low (scoring < 4)

13%67%

20%

69% 15%

16%

Voluntarydisclosure

High (scoring ≥ 4)

METHODOLOGY: REPORTING TRANSPARENCY


32 BCG REPORT

For a complete list of BCG publications and information about how to obtain

copies, please visit our Web site at www.bcg.com.

To receive future publications in electronic form about this topic or others,

please visit our subscription Web site at www.bcg.com/subscribe.

The Boston Consulting Group has published many reports and articles on corporate development that may be of interest

to senior executives. Recent examples include:

Spotlight on Growth: The Role of Growth in Achieving Superior Value Creation

The 2006 Value Creators report, September 2006

Innovation 2006

A Senior Management Survey by the Boston Consulting Group, July 2006

“The Strategic Logic of Alliances”

Opportunities for Action in Corporate Finance and Strategy, July 2006

“What Public Companies Can Learn from Private Equity”

Opportunities for Action in Corporate Finance and Strategy, June 2006

China’s Global Challengers: The Strategic Implications

of Chinese Outbound M&A

A report by The Boston Consulting Group, May 2006

How the World’s Top Performers Managed Profitable Growth:

Creating Value in Banking 2006

A report by The Boston Consulting Group, May 2006

“Return on Identity”

Opportunities for Action in Corporate Finance and Strategy, March 2006

“Razors and Blades: New Models for Durables”

Opportunities for Action in Consumer Markets, January 2006

www.bcg.com

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