Portfolio optimization
Linking performance to value
“Wide diversification is only required when investors don’t understand what they are doing”.1 Legendary investor Warren Buffet refers to the fact that, if an investor has conviction in a company’s business model and its ability to create value, then wide diversification of that investor’s portfolio is no longer necessary. Conventionally, investors should not want companies to diversify their own businesses; a company that is a “pure play”3 should be a more attractive asset for an investor to consider. Therefore pure plays should – in theory – trade at a premium in the market relative to more diversified portfolio companies. After all, pure plays give the investor the best opportunity to diversify their own portfolio and get closer to the efficient frontier of capital deployment. This logic lies at the heart of the often-discussed “conglomerate discount”.4 Diversification of investment should be the responsibility of shareholders, not of management teams.
In this re-released paper, first published in Q4 2022, we explore whether the discount investors apply to large collections of business segments is as pervasive as we are led to believe. Is every form of diversification bad for investors, or might there be such a thing as good diversification too? Will investors perhaps even pay a premium for a certain combination of businesses that offer them efficiencies the investors cannot achieve in the market?
1. Steven D. Price. “The Quotable Billionaire: Advice and Reflections From and for the Real, Former, Almost, and Wanna-Be Super-Rich and Others,” Page 164. Skyhorse Publishing Inc., 2009.
2. R. H. Coase. “The Nature of the Firm”, Economica, Volume 4, Issue 16 (1937)
3. Defined as a company that focuses solely on one type of product or service, or has one business segment.
4. Refers to the tendency of markets to value a consolidated company with a diversified group of business segments at less than the sum of its parts.