Nobody understands the world completely. It’s far too complex for a single brain to comprehend. Even the best minds identify that tiny part or minuscule patch as a runway to take off and fulfil their dreams. Legendary investors Warren Buffet and Charlie Munger term this “tiny part” as “circle of competence,” an area that one knows more than others. It has served as a life motto for both: know your circle of competence, and stick within it. The size of that circle is unimportant but knowing its boundaries is vital. Tom Watson, Founder of IBM, a true believer in the philosophy to operate within ones’ circle of competence, has famously added, “I’m no genius. I’m smart in spots – but I stay around those spots.”
Our circle of competence can be widened, but only slowly and over time. Investors often tend to confuse familiarity with competence, leading to disaster. In fact, circle of competence, as a theory, explains several corporate failures throughout history, including the fall of iconic brands back home such as Kingfisher Airlines and Reliance Communications.
Yet, no discussion on ‘circle of competence’ and ‘diversification’ can be complete without General Electric (GE).
Market capitalization of GE, under Jack Welch, grew from $12 billion in 1981 to $410 billion in 2001. GE acquired 600 businesses, allowing it to beat organic growth expectations. Fast-forward to 2019—GE’s market capitalization has shrunk to $76 billion and it was ejected from Dow Jones Industrial Average (index representing largest public companies in US) in June 2018.
One of the key reasons for GE’s eventual failure, experts agree, is the same that got GE to its ‘stardom’ in first place—diversification—and this is a paradox because in a way, GE both validates and contradicts theory of ‘circle of competence.’ And yet, it is not just the large conglomerates, even startups are breaking out of their ‘circle of competence.’
India’s top unicorns, Flipkart and Ola, have diversified into a variety of businesses from book review and music to lending and food delivery, many of which were not as successful and closed down within a year of operations.
In hindsight, often diversification decisions are perplexing.
A traditional point of view is offered by ‘agency theory,’ that argues that managers, who decide on diversification decisions, are not full residual claimants (not owners of the firm) and hence make decisions that increase their short-term utility and pay-out, while potentially decreasing the firm value. In fact, investors tend to increase the discount (conglomerate discount) rate to value very diversified firms and yet companies keep falling back to diversification, as a growth model.
Other point of view is pursuit of ‘growth’ – companies, often move into new markets or businesses, in pursuit of ‘high growth’ that could translate to ‘higher valuation,’ especially if the core business is unable to deliver expected growth. Such motivations are more plausible ones now, particularly in the world of over-capitalized startups which have a constant need to justify high valuations, thereby feeling a pressing need to keep painting a new growth story all the time.
Look at Uber, whose core business – cab hailing services – registered a slowdown in the last quarter of 2018 as per it’s S1 filings, has diversified into food deliveries and logistics, to keep the revenue growth rates up. Uber’s Q4 net revenues minus incentives fell compared to Q3. Its year – over- year revenue growth has slowed in each of the past six quarters, with the rate it reported for the second quarter of 2019 – 14% – its slowest yet.
Oyo, yet another Softbank backed hotel and homes aggregator, is moving into an already competitive markets: co-working, co-living, leisure and reportedly coffee chains. In th long run start-ups operating in ‘conglomerate’ style, diversifying horizontally, may not add as much value as expected. In fact, investors tend to discount the sum-total valuation of very diversified-conglomerate (‘Conglomerate discount’). However, often outsiders tend to misjudge the circle of competence of companies, more so when it’s an agile technology start-up.
In my recent candid interaction with Ritesh Agarwal, founder of Oyo, he clears the air on the circle of competency of Oyo, which he defines as ability to acquire real estate and renovate it in real time, operate it well, and ensure best yield per square feet – all of which resonates with the new business ventures Oyo is planning. Traditionalists may differ.
On the other hand, India’s most successful conglomerate, Reliance Industries’ core hydrocarbon business has delivered tremendous wealth for the group. And yet, company is exploring divesting its hydrocarbon business – it has divested 49% of its petroleum retailing arm to BP (UK) for a consideration of $1 billion, and plans to divest 20% its refinery business to Saudi Aramco for $ 15 billion – and expanding its digital operations under ‘Jio’ brand (from Connectivity, Bundled Data Services, Cloud datacentres, E-Commerce and Internet of Things) in de-novo, unexplored territories.
A look at the cover-page of Reliance Industries’ annual report (“The Jio Revolution”) conveys the intent and scale of diversification, that extends beyond just business to perception and culture in the group.In case of Reliance, diversification is about allocation of its capital in high growth space. As we witness the end of hydrocarbon supercycle due to climate change concerns, growth of clean-technologies and discoveries in shale, allocation of investable capital in ‘new economy’ areas will create significant value for shareholders. Just to illustrate this, petrochemical business is valued at 6.5-7.0x EBITDA (at best), while online/ digital services are valued at 17-18x EBITDA (at least).
So, the paradox remains – can businesses create wealth outside their circle of competency.
Successful companies, such as Alphabet and Amazon are able to do this day-in and day out. But the key learning here is to fix the core first.
Many practitioners believe that the recipe lies in balancing the portfolio of products and services in an innovation ecosystem.
One of the framework, that lends a perspective to this portfolio balancing, is Nagji and Tuff’s Innovation Ambition Matrix that defines innovation as either core (improving existing products for existing customers), adjacent (expand into new areas, i.e. new markets or products, that are already tested by someone else), and transformational (create products that do not exist for markets that do not exist). Research suggest that the ‘magic ratio’ of allocation of capital that has worked for most successful companies is 70:20:10 across core, adjacent and transformation innovation (45:40:15 for technology companies). Irony, is that companies such as Oyo and Reliance are even defying these principles set out by practitioners. Oyo, for example, is leap-frogging to transformational innovation without even consolidating its core business that is still loss-making. Reliance on the other hand, seems to completely, invert the ‘magic ratio’ of allocation of capital: maximum allocation of investments in transformation innovation.
While the jury is still out in this battle of convictions, one can sit and watch as the game unfolds.
Shrija Agrawal is Mint’s associate editor. Due Diligence covers issues in venture capital, private equity, deals and startups space.
U.S. Stocks Open Higher as Bank Earnings Reports Roll In