0:39
This would be the idea of a company and the conglomerate model using their profits
to find another profitable opportunity that they can invest in,
another business [INAUDIBLE].
The critique here, and this one's a pretty strong one, is that really at the end
of the day that's not the role of the organization or the company.
At the end of the day shareholders, the investors, can choose where to invest for
themselves.
It's not the role of the company to decide where to invest those monies.
So at the end of the day, the argument would be, you should return
those profits to the investors, the shareholders, in the form of a dividend,
and then allow them to decide where they want to invest their money.
There's no reason to believe that the firm itself would be better at reinvesting
those retained earnings than a shareholder would be.
Well, let's go to a second reason then.
Well, maybe it's that you can capitalize opportunities in related markets.
So the argument here is to say well perhaps firms do have privileged
information about profitable opportunities.
In those markets that day are operating.
And in fact, have better insight than even the capital markets themselves could have.
This would be, again, a company saying, we know our markets well.
Therefore, we're able to invest our earnings in
other businesses that are related, because we know better.
1:58
Again, this argument has fallen somewhat into disfavor, because there's really
little empirical evidence that what we might call an internal capital market,
this internal investing in opportunities, is any more efficient
than a public capital net markets that are available to the general public.
So again, this is an argument for
diversification that I would say has really fallen in disfavor in recent years.
And this reflects, I think, the changing attitudes towards conglomerates as well.
These were some of the same exact arguments given for
why having this diverse, unrelated portfolio of businesses made sense, again,
from a financial standpoint.
These arguments aren't as strong as they might have been 30 years or so ago.
How about we hold this diversified portfolio to reduce
the volatility of the businesses that we hold.
In other words, one could imagine that some businesses and
some industries are highly volatile.
Think of the movie industry.
So movie companies have hit blockbusters and then they have failures as well.
And as a result, their earnings can fluctuate wildly year in, year out.
By diversifying into other lines of business,
as the argument goes, that allows them to reduce that volatility that's inherent in
one of their industries.
Smooth them out, spread them out, and therefore reduce the risk of bankruptcy or
other negative financial outcomes.
Now, again, the critique here is, yes, you could do that,
that type of smoothing of risk.
But at the end of the day, shareholders can do that for themselves.
They can understand the inherent risk of investing in a movie business.
And therefore, they can decide how they wanna diversify their risks themselves.
It's not clear, it's really the firm's responsibility to do this.
[BLANK AUDIO] Last but not least, we can overall reduce the risk
by diversifying by reducing some of our costs.
Let's say employment cost, or financial cost.
By reducing this risk of bankruptcy.
So this is a nuance on our last argument, which said
this will help smooth our earnings, maybe reduce some of the risk of bankruptcy.
This is saying, that there's actually a cost to those risks.
Again, think about employees who'll demand higher payment if they believe this is
a business that is very volatile and risky.
Therefore, we can lower employment costs and
become more attractive if we diversify our assets in this way.
4:17
The critique here is that empirically there is limited evidence that
by diversifying your assets, you risk in diversifying your businesses,
you reduce this type of risk here.
In fact, there's some evidence that by combining units you can actually compound
risk across units.
So think again about of a large, diversified media company like Disney.
If Disney has one of its units have an issue that might end up leading to
problems for other units as well.
There've been a number of times where Disney might produce a movie that causes
some type of controversy, and
the end result is people then boycott their theme parks.
So you can imagine between these two businesses,
there is now risk compounding across them, rather than if they were just two separate
units, operating as separate businesses, independently from one another there.
So again, with all of these financial reasons to diversify,
while there are some arguments for these, there are also very
powerful critiques to say these really aren't the best reasons to diversify.
So I share them with you to say, you should be thinking about these.
But these will not be necessarily the strongest ones I would endorse for
reasons to diversify.
Michael LenoxSenior Associate Dean and Chief Strategy Officer
Jared HarrisSamuel L. Slover Research Chair in Business Administration
