“Put all your eggs in one basket, then watch that basket “ - Andrew Carnegie
Diversification is a cornerstone of modern-day risk management. If you put all your eggs in one basket and somebody accidentally steps on that basket, you are ruined. If you put them in different baskets, and somebody steps on one of them, you have a minor loss, nothing from which you cannot come back from. That is the intuitive logic behind diversification.
This metaphor applies particularly to portfolio theory. If all your financial wealth is tied to one stock, and this company has an unexpected crisis, you will be worth a lot less. However, if you spread out your investments over many different companies, preferably within different sectors and industries, one company experiencing a crisis only affects you very slightly. Of course, if one company has incredible growth, the effect of that is also smaller in a diversified portfolio. Essentially, you trade potentially huge returns in either direction for modest returns in either direction.
But diversification is not only relevant in portfolio theory. Companies themselves use diversification to minimize their risk and variance of their earnings. Most often, this is accomplished over time, as a natural progression of the company. Usually, a company starts selling one product in one market. Given success of this product, they will look to sell it in more markets, going from local sales to regional sales to national and finally to international sales. This is called market diversification. The risk of a negative event for earnings is lowered since the company makes earnings from all different locations. A flood in one market will affect the company less if it is not the only market the company depends upon.
The rise of the internet and e-commerce has made this progression much faster and much blurrier. A lot of companies nowadays will have websites, where anyone from anywhere can purchase their goods quickly after launch. While still relevant, for a lot of the company’s market diversification is not the main focus, but rather a byproduct of efforts to grow.
Another type of diversification is product diversification. Over time, a company can introduce new products, both related and unrelated to the original product. As a company progresses, its original product may start selling less. There are many possible reasons for this: the product falling out of style, more useful products being introduced, everyone already owning the product. By developing new products, the company can offset the risk and the effect on earnings.
Virtually all companies use product diversification once they are established. Think of any company and think of what they first sold. You will find that by now, this original product is either not sold at all anymore, or part of a large offering.
Product diversification has no limits. Companies that started out in one industry may over time develop products for other industries, in the end finding themselves in an entirely different position and sector than when they started out. Other will continue to add products from different sectors and industries, developing into a conglomerate which does not depend on any singular industry. The attractiveness of achieving this last model is clear: a decline in one of your products, or one of your industries, does not affect your earnings all that much.
If you are in the business of engines for cars, trucks and airplanes, and all of a sudden nobody needs airplanes anymore, you will have a decline in earnings, but you will survive. Whereas all the firms that only manufactured airplane engines will either go bankrupt or quickly have to find a new business to be in.
For all the positives of diversification, there are drawbacks. One is that it adds complexity to the business. Running one company focused on one industry is already challenging, doing so for many different industries requires extensive knowledge, skills and oversight.
Another important danger is the false sense of security one can gain from diversification. Even a very well diversified firm can simultaneously experience declines in all its major markets. Its more unlikely, but still totally possible. But sometimes, a seemingly diversified firm just isn’t actually all that diversified. They might sell different products in different markets, but a previously unobserved connection between them could lead to devastating impacts on a firm. Such was the case of Rayovac.
Rayovac was an American battery manufacturing company, founded in the early 20th century. With growth in their domestic battery business slowing in the late 20th century, the company started to look towards diversification. At first, it used market diversification, acquiring battery manufacturers Varta in Europe, ROV in South America and Microlite in China. Later, It sought to diversify its product as well, acquiring Remington Products, a personal care brand best known for electric shavers. Subsequently it acquired United Industries, a producer of lawn and pet supplies and Tetra Holdings, another Pet supply company. After all these acquisitions, Rayovac looked to be a well-diversified company. With sales in all different markets in the world, and a wide portfolio of products in different industries, Rayovac even changed its name to Spectrum Brands, to properly reflect the nature of its business. It had taken a lot of debt to be able to purchase all these companies, almost $2.3 billion USD in July 2005. But the company looked very successful in its strategy, the stock price having quadrupled in the preceding two years. Everything seemed to work out just as management expected.
What Rayovac ultimately failed to consider is that even though its products and markets were diversified, their ultimate customer was still the same. They sold items largely falling under consumer discretionary, non-essential items consumers purchase if they have the disposable income. Some items were of course more essential, pet supplies for example, while others were almost a luxury, such as a high-end electric shaver. The continued success of the brand therefore depended on continued spending of consumers on all those goods.
Now what could threaten this consumer spending? A recession. If such recession would be bound to one region of the world, say Latin America, Rayovac’s market diversification would mean the impact to be relatively small, almost immaterial. But a global recession, in which consumer spending on non-essential goods decreases everywhere, could lead to a large loss in sales. And that is exactly what happened.
The 2008 financial crisis, unfolding only 3 years after the last major acquisition, was the perfect storm that showcased the ultimate lack of true diversification in Rayovac’s business. As people around the world lost their jobs, and consumers spent less and less fearing for their own livelihoods, Rayovac’s sales plummeted. The huge debt loads left room for no such error, and in 2009 Spectrum Brands filed for bankruptcy protection, unable to make a measly $25.8 Million interest payment. After a restructuring which wiped out all former shareholders, the company continued its operations, ultimately selling its battery division to long term rival Energizer in 2018.
The false sense of security provided by seemingly good diversification can be dangerous, taking down billion-dollar companies in the worst cases. Rayovac failed to understand the true extent of its diversification: Although unlikely, a global decrease in discretionary consumer spending would affect the entire business, not just segments of it. There was only partial diversification, the ultimate customer was always the same. And once that customer cut back on spending, it didn’t just hort one area of the company, but all. The people ultimately paying for this lesson was not management, it was the investors bidding the stock up before being entirely wiped out. It is always good to remember that just because your eggs are in different baskets, doesn’t mean they cannot all be crushed.