Diversification, Should You Put All Your Eggs In One Basket?

To start with we must emphasize what is diversification and what is not. Diversification is not just spreading your money among several investments, but these investments must be unrelated, so that they don’t react the same to the market forces. Very simplified, if you invest in two businesses: one producing umbrellas and another one — raincoats, this is not diversification, because rainy weather and drought will influence the performance of both companies the same way.

All investment theory keeps reiterating the most important investment rule — diversification! On the other hand, all business strategy books teach companies to focus and specialise. For a simple reason. When investors decide to invest in a company, they don’t want its managers to diversify and disperse resources, but to focus and be best in what the company is doing in order to stay ahead of the competition. The task of diversifying they can manage on their own by investing in another company. Kenya Airways investors won’t appreciate if KA decides to branch out into telecom and start competing with Safaricom instead of enhancing its core airfreight business. Investors will just go and invest in Safaricom shares to get the best out of the diversification principle.

At the same time, we can witness that many tycoons on the emerging markets, like Russia, China, Brazil, usually owe their wealth to holdings with interests in many unrelated industries, from shipping to minerals to telecom and agriculture. In the East African context, Kenya’s Chandaria Group that started as a FMCG manufacturing firm and recently expanded into the real estate and even investments under the stewardship of its new CEO Mr. Darshan Chandaria, is the perfect example.

So should SMEs diversify or not?

Most business books are written by experts in the developed markets and for the conditions of the developed markets. Developed markets are characterised by low growth, tough competition in mature industries and few new opportunities. To beat competition, managers must direct all resources at their disposal to the core activity, to detect and realise even the smallest optimization potential, because even little differences may decide between a company’s success or demise.

Emerging markets, on the other hand, develop at a much higher pace. Social structures change more dynamically, with the middle class and nouveaux riches speedily developing and along with this, new needs arising every day. Recognising these gaps can be extremely profitable. For example, if next year you concentrate on optimizing your core business, you may earn KES 120 million instead of 100 million as last year. But if you branch out into a new area instead and earn 50 million in addition to the 100 million from the core activity, it would of course be logical to go for the latter. Profit margins are big enough and not crucial for survival as may be agile reaction, first-mover advantage and growth to grasp the market share.

But with growing competition profit margins start quickly experiencing a downward pressure. If you branched out before you optimised the previous business well enough, any change in the market conditions may spell the doom for it. The rule number one is therefore sufficiently robust (optimized) structures. Uchumi may have been profitable even without any controls as long as it was the only one on the market and the profit margins were high enough to cover any inefficiencies. But once a slightly better competitor entered the market, it had no chances of survival without serious restructuring and earnest control systems. Business is a game where the winner takes it all. If you sell the identical thing as your next-door competitor, but at a 10% higher price, it is not that this competitor will have 10% more customers. With time all your customers will switch to it.

Secondly, expansion of the holdings is rarely diversification in the academic sense of it, i.e. it is not entirely unrelated. They usually leverage on some competencies they acquired when doing the previous businesses. Critical success factors of triumphing in a new field were present. Chandaria through its supermarkets’ chain has probably acquired a profound knowledge of the real estate market. So its expansion in this area was not out of the blue; it actually leveraged on some already acquired internal competencies.

Since we are in Kenya, a developing market par excellence, an ultimate decisive factor for an SME is how robust your structures are. If it is you alone running between selling bananas, driving a taxi and braiding hair, any diversification will go at the expense of your existing businesses. You will never reach a meaningful size of operations and this minimal efficiency needed to survive, let alone excel and prosper. There are only 24 hours in a day, and you only have two hands after all. Many businesses in Kenya run down overnight because they fail to optimize their core activity well enough before leaping into diversification. If, however, you have built the structures and assembled a team, so that you can more or less safely move on and turn your attention to establishing a new business line, then you are well equipped for grasping new opportunities.