Diversification is a good business strategy, but not all diversifications come equal. If you are looking for unrelated diversification examples, you are in the right place. In this brief article, we will explain what diversification is, what is unrelated diversification, and what are some examples of it.
Unrelated diversification may sound like a complex business concept, but it is not. As we will discuss in a moment, it is simple to understand, but never easy to implement in practice. We will also support this guide with clear unrelated diversification examples, so that anyone can benefit from this post.
What is Diversification?
Before we can dive into unrelated diversification examples, let’s spend a few words on diversification in itself. Diversification is an approach to business suggesting to have different products or services that are unrelated with one another, so that if one is performing poorly the others will compensate.
This idea derives from the fact that each company lives in an industry, and it is subject to the ups and down of that industry. For example, if your company is an airline, you may have the best customer services, the best planes, the lowest fares, and outcompete by a big leap all your competitors. Yet, if nobody wants to fly because there is a global pandemic – not only with you, but with any of your competitors – your company will suffer. Not because your company is badly run, just because it is in an industry (airlines in this case) that, at this point in time, is in distress.
What if your favourite airline, on top of flying planes, start to do other things: run an oil refinery, sell lemonades, and maybe even sell a subscription to a videoconferencing tool like Zoom or Teams do. It is less likely that all these different activities will go bust at the same time. In fact, some may even perform better precisely because others are performing poorly (e.g., Zoom does particularly well while if not because airline is doing bad).
So, in short, diversification is adding different lines of businesses to make your company less vulnerable.
What is Unrelated Diversification?
Now that we know the definition of diversification, we can expand to understand when diversification is unrelated. First, by the simple fact we are diversifying, it means we have at least two lines of business (that’s the whole point of diversification). If this diversification is unrelated or not, it has to do with the relationship between these two (or more) lines of business.
Considering two lines of business as a pair, that pair will have a correlation coefficient. This ranges from +1 to -1, and can assume any value between those two, extremes included.
If two lines of business are positively correlated, when one is performing good the other is performing good as well, and by the exact same amount. This can be clearly seen with stocks. If you own shares of company A and they go up 10%, and you also own shares in company B and they go up 10% at the exact same time, then they are positively correlated and with a coefficient of 1. Of course, we can have a positive correlation with a lower coefficient, for example 0.5, in that case if a stock goes up 10% the other will go up 5% (10% * 0.5 = 5%).
The opposite of that is negative correlation. In that case, when a stock goes up (or a line of business), the other goes down. If this is the same amount, then we have a correlation coefficient of -1. But, of course, we can have a different coefficient as well. For example, a stock correlated at -0.5 with another will go down by 5% when the other goes up by 10% (10% * -0.5 = -5%).
Finally, we can say that two stocks are uncorrelated or unrelated if their correlation coefficient is zero, or close to that. In that case, there is no pattern. When one goes up, the other may go up, down, or stay the same. In other words, there is no relationship whatsoever, the fact that one is moving in one direction or another have no bearing on the other.
We can identify correlation and unrelated diversification between two stocks, two lines of business, or a stock/line of business and the entire stock market as a whole. This is done by measuring their returns over time, for example taking weekly returns over the last year is a common approach to identify correlation.
Unrelated Diversification Examples
Unrelated diversification means there is no correlation between two lines of business. Hence, any random-looking example can be a good example of this concept. However, we will try to give you some unrelated diversification examples so you can gain a better understanding for yourself.
Soft Drinks and Sport Tournaments
This is something that Red Bull does. You have two lines of business here: producing and selling soft drinks on one side, and running sport tournaments and competitions on the other side (and cashing in from sponsors and TV rights).
Those two lines of business are so vaguely correlated that we can say they become part of our unrelated diversification examples. The fact that the soft drink industry is booming has nothing to do on how well people are interested in sport tournaments, and vice versa.
However, a word of caution is needed here. It is extremely likely that Red Bull consumption is actually influenced by or at least correlated with the sport tournaments that Red Bull runs, which tend to be extreme sports. Since all those events are extremely branded, the more they get popular the more the Red Bull brand itself becomes popular, and this it is likely to increase sales of their energy drink.
Washing Machines and Jet Engines
Companies like GE manufacture all kind of things, including washing machines and jet engines. Even if doing so implies always a manufacturing process, those products are radically different and totally unrelated. How many washing machines are sold has nothing to do with how many jet engines you can place to Airbus or Boeing.
This is a great example of unrelated diversification, because you can leverage your core competences (manufacturing, engineering) to produce different products used in vastly different markets that have unrelated sales performance. It is great because the company does not have to develop any new skill, they can just leverage the skills they have to diversify. This is the kind of unrelated diversification you should target.
Enterprise Software and Online Gaming
Microsoft is strong on enterprise software sold to large businesses, and at the same time is aggressively pursuing the gaming sector with Xbox. This is another great example of unrelated diversification that leverages core competencies.
The fact that businesses are booming does not necessarily mean there is an unsatiable thirst for games, and vice versa. Yet, creating and distributing business software or online gaming subscriptions are quite similar in nature. To do both, you need server infrastructure and good software developers.
Another word of caution is important here. Gaming is a leisure industry, and leisure tends to perform well when the economy is doing great and people have more money to spend on the things they like. In turn, when the economy is doing fantastic, businesses are also expanding and in need of more software, so the correlation coefficient won’t be truly zero. However, it is worth noting that people do not spend for gaming exclusively because they have extra cash at hand. They may reallocate money to it that originally planned to spend for something else. Once again, think about the COVID-19 pandemic, people couldn’t go out to restaurants so they started playing more Xbox, and spending more for it.
Is Unrelated Diversification Good or Bad?
Now that we went through several unrelated diversification examples, you may start to wonder if it is good or if it is bad for your business. As always, the answer is that it depends.
Generally speaking, the idea of business conglomerates belongs to the 1980’s and it is now behind us. What business analysts tend to believe right now is that business should care about the interest of their owners, the shareholders. This means, if you are an airline, you should stick true to yourself and just be the airline you can.
If a shareholder feels the need to diversify because does not want full exposure to airlines, it can sell some stocks and buy something else, creating a stock mix suitable for him in his portfolio. Therefore, the airline itself should not try to diversify, but should try to concentrate itself on its core business. Having said that, if you have the possibility to apply your core competencies to different business that are unrelated (like Red Bull or Microsoft do), then you should.
To summarize, you can expand into any business performing unrelated diversification as long as you have core competencies supporting what you are doing. If you do not, then it is better to do not pursue such diversification.
Now, if you want to dive deeper into diversification and correlation of stocks, the ultimate guide on Net Present Value is where you should start.
