Since, the researcher's interest was 'the ramifications of diversification on two American Conglomerates (Berkshire Hathaway and General Electric). First, it is critical to look at why the researcher has chosen these two companies. Both companies have a wide range and diversity of product portfolios which are of particular interest. Following earlier research (Natter, Mild, Feurstein, Dorffner, & Taudes, 2001; Krishnan & Ulrich, 2001) the paper intends to narrow down section of focus to Berkshire Hathaway Inc and general Electric. Both companies are going against the trend of diversification, beginning with the last decade the trend has been becoming less popular, but both corporations remain diversifying their business lines. Berkshire Hathaway currently has 80 businesses and one of the reasons for the business's success might be strong management, the CEO, Warren Buffett is a core resource for Berkshire Hathaway, he's known for "buying excellent businesses at a price that produce business sense".
On the other hand, with so many businesses, diversification strategies might help companies in spreading market risks: adding products to the exiting lines of business may very well be analogous to an investor who invests in multiple stocks to "spread the risks". Diversification into other lines of business can especially seem sensible when the core product market is uncertain, which is the case for Berkshire Hathaway and General Electric.
4. 2. 2 Reasons for their success (Berkshire Hathaway and General Electric)
The Commercial Council that drives the business's growth initiative: Growth as a Process. This initiative has yielded record-setting organic and natural revenue growth going back three years (Annual report, 2008). There is also 'Leadership, Innovation and Growth team training program', each is meant to achieve the long-term profitability and success of the Conglomerate and also to develop communications expertise to set-up new ideas and foster existing ones. Also there is the Operating Council that was formed in 2007, which contains leaders from engineering, supply chain, sourcing, finance, and product management. The goal of the council was clear: create a $1 billion funnel of ideas, and increase the Company's operating profit percentage rate by 100 basis points to a world-class level of 18% (Annual report, 2008). Also, The Council is targeted on lowering product costs, reducing overhead, countering inflation, turning inventory, and enhancing price. It really is a forum to share guidelines on topics such as productivity, simplification, sourcing, restructuring, quality, and services -all critical disciplines within an increasingly competitive and global environment. The Council uses a common scorecard to measure progress across the company and spreads its success to all businesses.
In addition, General Electric has been a leading way to obtain corporate strategy concepts and innovations for over fifty percent a hundred years. The firm has been among the top five members of fortune magazine's "America's Most Admired corporations" because the listing began.
Considering the research question in this project which is "the reason why for the success of two American conglomerates through diversification strategy and their achievements, the researcher refers diversification as a rise strategy and both 9Berkshire Hathaway and General electric) are recognized for their wide selection of businesses and their growth through acquisitions.
Makron Associated discovered several conglomerates with exceptional performance in terms of ten-year shareholder returns. Berkshire Hathaway and General electric were part of the identified firms. The common characteristics of these companies were: "strict financial discipline, rigorous analysis and valuation, a refusal to overpay for acquisitions and a willingness to close or sell existing businesses (Kaye and Yuwono, 2003)
However, the case against conglomerates can be overstated and there are certainly potential benefits to unrelated diversification in a few conditions: Exploiting dominant logics, rather than concrete operational relationships, can be a way to obtain conglomerate value creation. As at Berkshire Hathaway, a skilled investor such as Warren Buffett, the so-called Oracle of Omaha and one of the richest men on the globe, might be able to add value to diverse businesses within his dominant logic (Prahalad and Betis, 1986, 1995). Berkshire Hathaway includes businesses in different regions of manufacturing, insurance, distribution and retailing, but Buffet focuses on mature businesses that he can understand and whose managers he can trust. Through the e-business boom of the late 1990s, Buffet deliberately avoided buying high-technology businesses because he knew these were outside his dominant logic.
Countries with underdeveloped markets can be fertile ground for conglomerates. Where external capital and labor markets do not yet work well, conglomerates provide a substitute mechanism for allocating and developing capital or managerial talent of their own organizational boundaries. For instance, Korean conglomerates (the chaebol) were successful in the rapid growth phase of the Korean economy partly because these were able to mobilize investment and develop managers in a manner that standalone companies in South Korea traditionally were not able to. Also, the strong cultural cohesion between managers in these chaebol reduced the coordination and monitoring costs that might be necessary in a Western conglomerate, where managers would be trusted less (Markides, 2002). Precisely the same may be true today in other fast-growing economies that still have underdeveloped capital and labor markets.
General electric has functions in many underdeveloped countries, For instance, in 2008; GE completed the Hamma Seawater Desalination Plant, the largest desalination plant in northern Africa, which provides 2 million Algerian residents with a reliable way to obtain fresh normal water every day. Through innovatory thinking and cutting-edge technologies from GE's Oil & Gas and Power & Water businesses, GE can solve some of the problems that Algeria faces under today's harsh climate, while assisting to position them for a brighter tomorrow.
Also, graduate students in US compete to get entry-level positions with diversified corporation such General electric and Berkshire Hathaway and this provides them opportunities like the hiring of high calibre of employees. Other General Electric Success reason is the corporation's strong core values: which are the underlying principles that guide an organization's strategy. Collins and Porras (2002) have argued that the long- run success of many US corporates-such as General Electric and Disney can be attributed (at least partly) to strong core values. The company employees consider their culture within innovation, a culture that was built over decades by their leaders and which is still the unifying force for the countless GE business units around the world.
While, communicating the strategy can be an important within the company: Both corporation communications should be centered on the key components of the strategy, avoiding unnecessary detail or complex language. For instance, CEO jack Welch's famous statement that General electric should 'either be number 1 or number two' in all its markets. This plan clearly implies that General Electric is a company that always strives hard to be a dominant player wherever the business competed. On the other hand, some of the main sources of value creation within diversified businesses will be the ability to apply common general management capabilities, strategic management systems, and resource allocations processes to different businesses. Such economies rely upon the existence of strategic rather than Operational commonalities among the several businesses within the diversified corporation (Robins and wiersema, 2002).
Berkshire Hathaway is involved with insurance, candy stores, furniture, kitchen knives, jewellery, and footwear. Not surprisingly diversity, each one of these businesses have been selected based on their ability to take advantage of the unique design of management established by warren buffet and CEO Charles Munger. The essence of such strategic-level linkage is the ability to apply similar strategies, resource allocation procedures and control systems across different businesses within the organization portfolio (Grant, 1988).
While, GE participates in a wide variety of markets like the generation, transmission and distribution of electricity (e. g. nuclear, gas and solar), lighting, professional automation, medical imaging equipment, motors, railway locomotives, aircraft jet engines, and aviation services. It co-owns NBC Universal with Vivendi (Annual Report, 2008). With each one of these many business divisions General electric remains still successful.
4. 2. 3 How the shareholders value is improved as the firm's product diversifies.
With so many fluctuations of corporate diversification, financial researchers have been worried using its benefits and costs.
Majority of the benefits associated with corporate diversification come all combined with the advantages of internal capital markets over external financing.
By avoiding transaction cost and additional cost of informational asymmetries diversified organizations with a greater internal capital market enable a far more efficient capital allocation (Chandler 1977, Stein 1997).
Also there are other benefits such as risk reduction on corporate level for diversified firms: lower cashflow volatility may raise the debt capacity of the company and thereby the tax shield of debt without facing prohibitive cost of financial distress (Lewellen 1971). Additionally lower volatility helps to reduce underinvestment cost when external financing is not available or only at prohibitive cost (e. g. Stulz 1990).
In addition, Berkshire Hathaway and general Electric are companies that create Value by acquiring companies at favorable prices, and they closely monitor their financial performance, and operate through a powerful internal capital market. At general Electric, Jack Welch was a particularly effective example of corporate initiatives as a way of driving organizational change. His initiatives were built around communicable and compelling slogans such as "General Electric growth engine, " "boundarylessness;" "six-sigma quality" and "destroy -your business-dot-com. "
The research assumes that diversification is a way by which a company expands from its core business into other product markets, and that is what the corporate management is actively engaged in, diversifying activities than ever before leading to a great deal of rise observed in diversified firms. Since it was earlier stated, companies diversify for three significant reasons, Growth, Risk reduction and Profitability in a simpler way. Normally, Growth and Risk reduction have been significant motives for diversification; they have a tendency to be not regular with the creation of shareholder value.
Therefore, both general electric and Berkshire Hathaway had but still have the want to grow. Berkshire has been acquiring and owning stakes in companies since early 70's. We evidently see from the company's timeline that the Berkshire continued growing through acquiring stakes in many companies. The latest acquisition was at February 2010 that was the Corporation's purchase of the rest of the shares of Burlington Northern Santa Fe Corporation for $26 billion, the company's biggest purchase ever. While General Electric has acquired Vital signs Inc for $860 in 2008 (Chicago Tribune, 2008) looked after announce in 2009 2009 that it will buy out Vivendi's stake in NBC Universal and sell a controlling interest of the company to Comcast, with General Electric retaining a 49& curiosity about jv (Goldman and Pepitone, 2009). With the Acquisitions history, Both Corporations have been growing and expanding their business with the aim of Maximizing Shareholder wealth.
Referring back to another motive for diversification which is 'the aspire to spread risks' To isolate the effects of diversification on risk, consider the case of 'pure' or conglomerate diversification, where separate companies are brought under common ownership but the individual cash flows of the business enterprise remain unaffected. As long as the money flow of the different companies are imperfectly correlated, then the variance of the cash flow of the combined businesses is significantly less than the average of this of the separate businesses, Hence Diversification reduces risk.
Both of the companies have engaged in various activities for decade, they have expanded their businesses. Rumelt (1974) discovered that companies that diversified into businesses closely related with their core activities were significantly more profitable than the ones that pursued unrelated diversification. According to Peters and Waterman (1982) "Virtually every academic study has concluded that unchanneled diversification is losing proposition". This observation provided the foundation for one of peters and waterman's "golden rules of excellence" -stick to the knitting:
Our principle finding is clear and simple. Organizations that do branch out but stick very near their knitting outperform the others. The best successful are those diversified around an individual skill, the coating and Bonding technology at 3M for example. The next group in descending order, comprise those companies that branch out into related fields, the leap from electric power generation turbines to jet engines from General electric. Least successful, as a general rule, are those companies that diversify into wide variety of fields. Acquisitions especially among this group tend to be wither on the vine (Peters and waterman, 1982).
Finally, the study paper postulates that shareholder value is increased when companies diversified in related businesses, since they share capabilities and core resources across the businesses. Plus the growth of such (GE and Berkshire Hathaway) conglomerates might improve the company's profitability, since new related businesses means spreading of risks and increasing of profitability across each business segments.
4. 2. 4 The expenses and benefits associated with undertaking product diversification.
In order to find out the expenses and benefits of product diversification, the research paper looks at: the relative costs and great things about corporate diversification will probably rely upon how the various business activities of a firm are related to one another. Where separate business activities use a typical, indivisible input, a diversified firm can exploit economies of scope.
However, 'One of the great things about diversification targets the existence of economies of scope in keeping resources: Economies of scope exist whenever there are cost savings from utilizing a resource in multiple activities completed in mixture rather than carrying out those activities independently' (Baumol, panzer and willig, 1982).
Also Economies of scope can arise in finance, by combing an professional company with a financial services company; General electric lowers its cost of capital to both sides of the business. Also, Economies of scope arise not merely from tangible input such as a common R & D department or a distribution system but also from intangible assets like brands and production know-how. For example, general electric has the fourth most recognized brand on earth, worth almost $48 billion (Business week, 2009).
While businesses within diversified firms can therefore be related in at least 1 of 2 ways: They may be related either because they share markets, distribution systems, product and process technologies, or manufacturing facilities (Ansoff 1965, Rumelt 1974, Teece 1980), or because they rely on common technologies, managerial functions and routines and repertoires (Prahalad/Bettis 1986, Kazanjian/Drazin 1987, Winter 1987, Grant 1988). The use of these assets may be transferable at negligible marginal costs. For instance, General electric shares of its activities like R&D and Distribution channels across its wide range of businesses. Also, the firms engage in lots of transaction costs and it's really very complicated to manage such businesses but in the end they reap Great things about high returns from their activities.
4. 2. 5 The incentives Top management expect as companies diversifies
In Berkshire Hathaway, managers are paid modest salaries and also receive very significant cash bonuses if performance goals are achieved. Buffett tailors the compensation intend to each business, predicated on its economics and competitive positioning.
Managers are compensated for elements of the business enterprise that are directly under their control (such as growth and profitability of insurance contracts). Major emphasis is positioned on the capability to return free cashflow to headquarters. The company will not grant equity-based awards because their value can't be as closely correlated to performance as can cash bonuses (meaning: In conditions of value realized rather than expected value on the grant date).
Still, cash bonuses can reach extreme levels-tens of millions for superior performance. So, Here the compensation have no relation with the size of the Company and so it doesn't matter for Berkshire Hathaway if they have many diversified business or not but the main focus is Reaching the targets and High performance is highly rewarded
However, on the contrary, Buffett and his vice-President Munger receive humble compensation. Their salaries are set at $100, 000. They receive no bonuses, options, or restricted grants. Instead, their financial incentive is driven by direct holdings of company stock that they purchased using their own money in the 1960s. By year-end 2009, the values of these holdings were $40 billion of Buffett and $1. 3 billion for Munger. Similarly, board members receive insignificant fees for their services and are encouraged to acquire substantial sums of company stock with the own money. To sum up, Berkshire's top management performance has no direct influence to how diversify businesses may be, Instead each manager is rewarded for the excellent achievement of his portion of control.
On the other hand, General electric's CEO, Mr. Immelt earns higher salary than Warren Buffet. Immelt's Base salary is $3, 300, 000 plus Bonuses. As the managers are rewarded based on a guiding principle of compensation program which ensures that the management has set up the right metrics and incentives, applied over the appropriate performance periods. The business rewards regular performance and discourage short-term-oriented behaviour that may yield a single period of good results without regard for proper risk management or the long-term health of the business.
The committee runs on the mixture of compensation that balances rewards for current and long-term performance. Performance metrics include growth in earnings per share, revenue, and cash flow. Managers believe this is the easiest way to stimulate innovation and ensure solid execution, while guaranteeing that risks are recognized and managed appropriately over the future. Although they have fine-tuned compensation programs as conditions change, the management believe it is important to keep consistency in the compensation philosophy and approach.
There is also a recognition that value-creating performance by an executive or group of executives will not always translate immediately into appreciation in GE's stock price, particularly in periods of severe monetary stress. Nonetheless, General Electric continues to reward such performances based on the firm's belief that, as time passes, true value creation does translate into stock price appreciation.
4. 2. 4 Risks associated with the strategy of diversification
Buffett is also mainly responsible for enterprise risk management. Risk oversight is not delegated to a committee or risk management function. According to Buffett, "I regard myself as the principle risk officer at Berkshire. " ( Berkshire Hathaway, Annual meeting 20080
"A whole lot of folks think if you just had more process and even more compliance, you could create a much better result in the entire world. Well, Berkshire has already established practically no process. We had hardly any internal audit until they forced it on us. We just try to operate in a seamless web of deserved trust and become careful whom we trust. " (Wesco Financial, annual meeting 2007).
Due to the global financial crisis was the failure of many executives and businesses the ability to understand and adequately manage and price risk. At GE, the corporation has strategies and management processes that effectively manage risk and maximize opportunities across its many businesses. Its process includes long-term strategic planning, executive development and evaluation, regulatory and litigation compliance reviews, environmental compliance reviews, GE Capital's corporate risk function and GE's senior level Corporate Risk Committee.
And as a result of the existing financial crisis; GE expects that managing risk will be even more important to competitive advantage and long-term success. The corporation's executive compensation program is designed to reward those executives who demonstrate an ability to determine and manage risk effectively. At exactly the same time as over the past year, General electric leaders have demonstrated the ability to identify risks and adapt strategies in order to protect the business. GE acted quickly to boost liquidity, raise capital, and transform the financial businesses. The business in addition has exited businesses with unacceptable rates of risk-adjusted return. Similarly, Berkshire Hathaway think that 'it is important to continue to reward those who demonstrate this disciplined ability to safeguard the firm;s businesses, but it's only appropriate that certain the different parts of compensation will decline during periods of economical stress and reduced earnings.
Both General Electric and Berkshire Hathaway, have ways to spread risks and overcome challenges and so their activities of diversified businesses. Since it was explained earlier, Berkshire's CEO considers himself as a chief risk officer even though the managers of both corporations have obligations in reducing the potential risks involved in the activities under their control.
In addition, both General electric and Berkshire Hathaway fits in the Prospector strategy of Miles and Snow. Since both companies have highly diversified businesses. This is actually the most aggressive of all the four strategies. It typically involves active programs to expand into new markets and stimulate new opportunities. Innovative product development is vigorously pursued and attacks on rivals are a standard way of obtaining additional market share. The both corporations have a way to respond quickly to any signs of market opportunity, plus they do this with little research. A big proportion with their revenue originates from services or new markets.
They are often highly leveraged sometimes with a considerable equity position held by venture capitalists. The chance of product failure or market rejection is high with the prospector strategy. Their market domain is continually in flux as new opportunities arise and past product offerings atrophy. They value being the first in an industry, convinced that their "first mover advantage" provides them with premium pricing opportunities and high margins. Price skimming is a common way of recapturing the expense of development. General Electric and Berkshire Hathaway are recognized for being opportunistic in headhunting key employees, both technical and managerial. Thus this explains why both companies spend much on advertising, sales promotion, and their personal selling costs are a high percentage of sales.
Typically organizations who easily fit into the prospector strategy are structured with each strategic business unit having considerable autonomy. With Berkshire Hathaway trusting responsibility of business performance totally in the hands of local managers and General Electric decentralising decisions within each business units, Risks might be reduced. And Firms in these industries have a tendency to be in the introduction or growth stage of their life cycle with few competitors and evolving technology which also provides opportunities such as less competition to both companies Products.
Example of GE acquired firms includes Vivendi in '09 2009, (which is a French international media conglomerate with activities ranging from filming, publishing, telecommunication, music, television looked after have Internet, and video games. The acquired firm had financial troubles due to over-expansion in the late 1990s and the early 2000s. In addition, General electric acquire Vital Signs Inc. for US$860 million in 2008 (Appendix 6. 2, GE timeline). The acquired firm makes disposable medical products used to help patients during surgery to breath.
Berkshire acquired several companies the last 2-3 years, for instance: the company purchased 80 percent stake in Iscar Metalworking for $4 billion in 2006, that was the firm's first purchase of a foreign subsidiary.
Johns Manville Corp, a business unit of Berkshire Hathaway Inc acquired Corbond Corp, a manufacturer of polyurethane spray foam insulation products in august 2009.
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