Of all the levers that a CEO can pull to achieve superior performance, managing a corporation’s scope may offer the greatest potential to generate strong shareholder returns. Economic cycles and other factors that contribute to a company’s fortunes or misfortunes may be beyond even the boss’s control, but among the activities that he or she can influence, adjusting the breadth of a corporate business portfolio represents a significant portion of the company-specific drivers of shareholder returns.¹

It is therefore odd that so little consensus exists on the topic. True, long-standing conventional wisdom maintains that "focus is the answer." Volumes of finance theory argue, correctly, that investors allocate capital among diverse businesses more efficiently than corporations do and that good projects can typically attract funding in public or private capital markets. Conversely, markets are quicker than ever to discount the valuations of diversified companies as a result of their perceived shortcomings, including the cross-subsidization of financially unattractive projects and difficulties in aligning the management incentives of diverse business units with the fortunes of the corporation at large.

And yet . . . every CEO knows that no matter how focused his or her business is, at some point diversification is necessary to regenerate growth and create value over the long term. Companies must branch out into new businesses to compensate for the declining prospect of creating value in older ones. What is more, many CEOs of successful businesses assert, in a kind of street-smart amendment to the findings of academics, that investors implicitly fund strategies and management teams, not individual projects.

Our research has uncovered a particularly fertile middle ground between focus and diversification. While focused companies generally do trump more diversified ones, companies we categorize as moderately diversified perform at least as well as, and often better than, their focused counterparts. Focus, in short, isn’t always the best answer. Moreover, these moderately diversified companies share a common approach to managing scope—an approach that, applied at the right time in the life cycle of a business, generates superior returns through higher growth that is both realized and anticipated by capital markets.

Finding the sweet spot

In our research, moderate diversification emerged as a strategic sweet spot between pure business focus and broader diversification. This trick isn’t easy to pull off: the optimal balance can vary widely from company to company and from point to point in the stages of a business’s life cycle. Furthermore, managers of scope shouldn’t think of moderate diversification as a steady state; they must direct a process of continuous balancing between tightening a company’s focus and branching out through business building, acquisitions, and other forms of related diversification. We believe that the goal should be a portfolio with an appropriate balance of current performance and growth potential and that an intense management focus can meet the markets’ expectations through the dynamic reshaping of assets.

Moderate diversification can be positive indeed. We began our analysis by using publicly reported revenues to classify 412 S&P 500 companies as focused (that is, deriving at least 67 percent of revenues from one business segment), moderately diversified (with at least 67 percent of revenues from two segments), or diversified (with less than 67 percent of revenues from two segments).² Then we validated our results by testing them against two other common measures of focus.³ Even a broad analysis based on publicly reported revenues by a Financial Accounting Standards Board (FASB)- defined segmentation scheme confirmed the idea that in total returns to shareholders (TRS), focused companies outperformed diversified ones (Exhibit 1).

When we honed our research further to compensate for a lack of consistency in some standard measures,⁴ however, we made a more subtle discovery. Across all three measures of scope during the decade from 1990 to 2000, focused companies boasted a median annual TRS that was 8 percent in excess of the average of their industry peers—more impressive than the 4 percent for the diversified group. But the moderately diversified group notched up 13 percent a year in annual excess returns. The results were similar over a 20-year period.⁵ Indeed, moderately diversified companies outperformed focused and more fully diversified ones in 81 percent of the three-year-rolling-average time periods and generated higher TRS in every year but one since 1985 (Exhibit 2).

Moderately diversified business models, we have therefore concluded, are quite capable of generating shareholder returns that are at least as strong as, and frequently even stronger than, those achieved by the more focused models. Indeed, the popular view that "focus is better" simply isn’t right at all times and certainly isn’t applicable at each and every stage of a corporation’s life cycle.

Diversifying for superior growth

What about moderate diversification contributes to the success of this approach? One answer is that it can help a corporation navigate key transitions in business life cycles more effectively than a focused route does and thereby helps generate more sustainable longer-term growth.

Consider, for example, a company that has historically operated as a single business entity but competes in a rapidly maturing industry whose growth rates are trailing off. As the company matures, it must put the value of its legacy business to best use by making trade-offs between strategies to maximize its short-term cash flow and efforts to retain customers and extend its profitable growth. At the same time, the company must somehow reinvigorate its growth expectations and build a sustainable, dynamic organization that can attract and retain talent and create broader interest among investors and analysts.

Corporations that have pulled off this feat have used their existing strengths to diversify moderately so that they have a strong position to exploit emerging opportunities. Such diversification usually takes companies into related industries, but it can also involve new business arenas that present clear opportunities to build on developed capabilities.

Take Broadwing, which began life as the Cincinnati Bell local-telephone company. In the 1980s, Broadwing recognized that as a stand-alone, regulated entity its growth prospects were likely to be limited. Management explored the company’s existing capabilities and saw strengths in certain telephony-related systems and services, including billing, customer care, and telemarketing. Rising market demand made the third-party provision of such services an opportunity worth exploiting. Broadwing thus built a significant new business to provide call-center and back-office services to other companies, and by the late 1990s the company’s call-center services boasted higher revenues than its traditional fixed-line telephony operations. In 1998, Broadwing spun off the call-center services business as Convergys (which had approximately $1 billion in revenue), thereby creating more than $3 billion in value for Broadwing and Convergys shareholders from the day the spin-off was announced to early 2002.

Naturally, companies with widely diversified portfolios and companies that have all but exhausted the synergies across their business units can add value and build confidence in the capital markets by imposing a greater degree of focus. In the mid-1990s, for example, poor performance in the capital markets and negative comments from analysts forced the pharmaceutical company Ivax to recognize that it was hampered by an imbalance between focus and diversity, since the long-term growth prospects of its diverse portfolio were seen to be weak. In 1997 and 1998 the company divested its cosmetics, intravenous-products, and specialty-chemicals businesses. In 2000 it made a series of international acquisitions to build a moderately diversified position as a producer of branded and generic pharmaceuticals. Recalibrating the company’s scope worked: the share price of Ivax has more than tripled since 1998, and better long-term growth expectations are thought to be responsible for more than half of the increase.

Companies with overly focused portfolios also can benefit from moderate diversification. Consider Alltel, which like many telecom companies launched a wireless business in the mid-1980s. Recognizing that changes in technology and consumer demand represented opportunities, Alltel bolstered its moderately diversified position with a series of acquisitions, including 360 Communications, Aliant Communications, and Liberty Cellular (Exhibit 3). By 2001, Alltel’s wireless business, with $3.2 billion in revenue, had substantially surpassed even the company’s traditional wireline telephony business. Alltel’s share price, which has roughly doubled over the past five years, reflects investor recognition of these improved long-term growth prospects.

Scoping out scope

To get started in active scope management, a company must consider the timing. Companies in an emerging or growth industry should devote the majority of their management time and attention to meeting the challenging expectations likely to be factored into their stock prices, so a strong degree of focus is warranted.

By contrast, corporations in maturing industries have reached the juncture where most of the benefits of moderate diversification are to be found. Such a company must begin with a candid assessment of its capabilities—the crucial first step in shaping, and reshaping, a corporate portfolio. Managers must also establish a clear understanding of its current degree of focus—an understanding based on the share of the company’s total revenues generated by its different, discrete business units. They must also calculate the company’s relative expected long-term growth rate⁶ as reflected in the capital markets. Once this exercise is completed, a company can develop an initial hypothesis about the opportunities available to reshape its portfolio.

Logically, companies with little diversification and low expected long-term growth would do well to diversify by introducing growth businesses into their stagnating portfolios. Conversely, highly diversified companies in which the market lacks confidence would benefit from focusing their portfolios. Diversified companies, even those with high growth expectations, need to anticipate the point when business units will probably become so mature that their prospects of creating value will start falling—and to divest them proactively rather than wait until they begin to lose value.

The most successful scope managers we studied share a number of traits. Such companies continually and proactively monitor and match their current and emerging internal capabilities with external discontinuities—changes in technology, regulation, and consumer behavior that may create opportunities in related industries or require management skills they already have. They rapidly divest businesses that show early signs of potential failure. Further, they separate successful new businesses earlier than their peers do and actively and continually trade their business portfolios.

In particular, a process of active and balanced trading of assets to achieve an appropriate level of focus is critical. Companies that actively manage their corporate portfolios (in the top third of total M&A activity) create 30 percent more value over the long term than do relatively passive companies. Furthermore, for mature companies, strategies that involve both acquisitions and divestitures outperform strategies focusing on one or the other.⁷

Another characteristic of the moderately diversified companies we studied is a willingness to part early with strongly performing businesses. This approach may seem counterintuitive if not downright foolhardy, but we see it as one of the hallmarks of successful scope managers. Given what we know about the success of companies that actively manage their portfolios, executives should probably be divesting businesses far more proactively than they typically do; during the 1990s, nearly 60 percent of the largest US companies completed no more than two divestitures exceeding $100 million.⁸ Moreover, three out of four divestitures are completed during a fire sale or a shutdown or under the pressure of persistent long-term underperformance by a business unit and irresistible investor pressure to divest it when that underperformance becomes totally obvious to the market.⁹

Holding on too long can cost a company dearly not only because a foundering business fetches less on the market when sold but also because propping up a unit in decline drags down the whole organization and exacts an opportunity cost in the form of scarce management time. Typically, it is less successful companies that hold on to underperforming businesses too long in the often vain hope that they will eventually turn around and so vindicate management’s judgment about them. By contrast, successful scope managers sell or separate high-performance businesses as soon as the majority of synergies have been captured. In this way, the benefits of separation—such as improved management focus, targeted management-incentive programs, and enhanced strategic freedom—can be banked earlier.

Kimberly-Clark is one example of a moderately diversified company that dynamically reshuffled its portfolio to take advantage of internal capabilities. From origins in consumer products and newsprint, Kimberly-Clark eventually diversified even to the extent of building and managing a small airline business by leveraging the capabilities it developed while managing its own corporate jet fleet.

Over the course of the 1990s, Kimberly-Clark actively traded its portfolio, continually buying and selling as well as looking for spin-off opportunities. Its management closed a number of relatively small underperforming businesses that had limited opportunities to improve and spun off its airline business as Midwest Express. The company also added to its business mix, acquiring Tecnol Medical Products in 1997 and the disposable-latex-glove manufacturer Safeskin in 1998, thereby using its existing skills to diversify into a small but growing health care business. Kimberly-Clark’s active approach to trading has clearly generated superior returns for shareholders: the company has maintained long-term growth expectations, on a rolling basis, of up to 30 percent of its share price.

The appropriate breadth of the corporate portfolio is a critical component of the CEO’s agenda. Yet a consistent view of how best to manage a company’s scope is elusive. While it is clear that a tendency toward focus generally leads to superior performance, we have found that the ongoing processes of moderate diversification—ensuring an appropriate balance among growth potential, current performance, and the intensity of management focus—can help a company deliver significant additional growth and superior shareholder returns.