Thursday, November 20, 2008

Focused versus Diversification Strategies in Emerging Markets

By Olu Akanmu
Which one creates better shareholder value: Conglomerate diversified companies or focused corporations? Strategy scholars have converged that focused companies tend to create better shareholder value than diversified conglomerates. Two Harvard Professors, Tarun Khanna and Krishna Palepu in their article titled " Why Focus Strategies May Be Wrong for Emerging Markets" in the Harvard Business Review, July-August 1997 posited however that there is an emerging market context and exemption to the "focused companies create better shareholder value theory". The first commentary below is my critique of the Khanna and Palepu's article also published in the Harvard Business Review, November-December, 1997, page 178. The second article that follows titled "Critique of the Korean Chaebol Business Model in Nigeira" was inspired by developments in the Nigeria market in 2006. It pursues the same theme as the HBR 1997 Commentary, that even if Korean and Indian Conglomerates were successful in the 1960s to 1980s, it cannot be exactly replicated in Nigeria as a success and development formula becasue the global economic context has fundamentally changed. Please, read on.
Article 1:
Olu Akanmu, Strategies Focusing on Emerging Markets; Harvard Business Review, November-December, 1997, page 178

Khanna and Palepu’s article is an interesting contribution to business strategy in emerging markets. There is however a real danger that advocating diversification in emerging markets might be taken out of context. Many of the conglomerates discussed in the article owe their success to government protectionism, which insulated the companies from international competition (at the time). Those conglomerates have been able to maximize profit not because they were efficient but because their customers did not have access to goods from abroad that offered better value for money.

Today, as national barriers to trade are broken down, the basis for successes of these highly diversified conglomerates in emerging markets can only be short-lived. The licensing and partnership agreements between these conglomerates and foreign companies are a transitional step towards the full scale entry of the foreign companies into emerging markets. Even if the conglomerates acquire technology from such agreements, their national markets are probably too small to offer the economies of scale they will need to compete with companies from abroad.

Conglomerates in emerging markets should therefore move abroad to exploit the competencies they have successfully developed in their core business. While doing so, they will need to re-structure their portfolios to eliminate businesses unable to sustain long-term competitive advantage against new entrants from abroad. That will also help them raise the cash they’ll need to accelerate their entry into foreign markets through acquisitions of fully owned subsidiaries.

That is the trend in South Africa where, for example, the highly diversified conglomerate Anglo American Corporation divested certain businesses to focus on its core mining business while actively pursing related opportunities abroad. Gencor also restructured its business and later divided into two separate companies, Gencor and Billiton, who stock will be sold not in South Africa but on the London Stock Exchange.

Conglomerates in emerging markets should work actively to promote ethical business practices, build local managerial capabilities, and lobby their governments to establish the regulatory and supportive institutions that the conglomerates have thus far been providing themselves. A most dramatic expression of this in South Africa, was the acceptance by the Chief Executive of the (then) diversified South African Breweries (SAB) to head the national police force and bring his managerial know-how to bear on strengthening the crime prevention system.

Rather than celebrate the achievements of the past, the conglomerates in emerging markets should look forward and restructure to create as sustained competitive advantage.

Article 2:
Critique of the Korean Chaebol Business Model in Nigeria
by Olu Akanmu (January, 31, 2006)
Transcorp is a public subject. It was midwifed by the Nigeria state while being a private institution. It has very privileged access to government. Its reason-for-being is noble. It is a timely empowerment vehicle for Nigeria businessmen and women in their own country. National competitiveness in the global economy has to be supported by a private sector that has the capacity to create sustained economic wealth for the Nigeria people. Size is a competitive factor even in national markets where local players have to compete with players from abroad. A Nigeria mega-corporation is therefore an idea whose time has come.

Transcorp seeks to replicate the economic model of the Korean chaebols which are also known as business conglomerates. It intends to play in fields as diverse as hotels, oil and gas, power, information technology, industrial park and agro-allied businesses. If Transcorp will succeed on its mission however, it is important that it recognises that the global context of the evolution of the chaebol business model has changed in the last decade. The global economy in the 1960s when the chaebol phenomenon took-off was far less liberalized and integrated than today. National protectionist barriers at the time insulated local players from international competition. Markets were far less efficient in many emerging economies. These emerging economies were quite backward and sometimes primitive characterized by the absence or weakness of market institutions and intermediaries that ensures the efficient allocation of factor resources like capital and labour. Local consumers were also un-sophisticated in their taste and preferences due to little exposure to goods and services from abroad.

The emergence of business conglomerates pursuing diversification strategies in unrelated businesses, in the emerging economies in the 1960s to 1980s were largely as a result of extreme market imperfections. Policy distortions, entrepreneurial scarcity, extreme information asymmetries in markets, absence of specialized intermediaries in capital, labour and product markets that enable markets to function efficiently were the characters of these countries. Business conglomerates attempted to fill these institutional voids by creating internal parallel markets in their organisations that substituted for well-functioning markets for capital, managerial talents and products. In doing so, they also naturally exploited theses voids and market asymmetries to create diverse businesses. They move capital and managerial talents around their diverse unrelated businesses and sell products and services among their subsidiaries. Artificial institutions cannot however substitute for well functioning markets. The internal markets of these conglomerates in themselves were also inefficient. Such markets were characterized by high internal transfer prices, high transaction costs, lack of transparencies and poor accounting practices. In the last ten years, as market institutions in emerging economies got stronger, and economic policies got more liberalized, businesses that pursue more focused strategies and take advantage of the strengthening market institutions rather than their own artificial internal markets have performed far better than the conglomerates or chaebols. This pattern has been repeated across many emerging markets in South Korea, India, Chile and South Africa.

The South Korean chaebols took advantage of every opportunity without regard to economic synergies among their businesses. Over time, they found it difficult to compete with more focused national and international players who have built deeper competencies in specific industries. Daewoo and Ssangyong for example, could not compete with focused international players in automobiles. The over-stretched nature of Daewoo eventually led to its bankruptcy. Samsung on the hand fared better because of its semblance of focus, earlier than its peers on the electronic industry. Other Korean chaebols have had to restructure since the 1990s to become more focused in related industries where they enjoy economic synergies and have built core-competencies. Also in India, as a result of a similar context, companies like the Tata group have had to grapple with the challenge of wealth creation. While Tata’s information technology business has performed poorly, focused Indian players like Infosys, the Wipro Group and Satyam have returned strong business performance. Infosys and the Wipro Group have even become strong international players in information technology. Ranbaxy also became a strong trans-national pharmaceutical/ chemical powerhouse by pursuing focused strategies based on its core-competencies. And in South Africa, Anglo-America had to unbundle its huge empire which used to transcend mining, breweries, financial services, media and consumer goods to become more focused on its core business.

The chaebols with the active protection of the Korean state, using highly debt -leveraged balance sheets, were encouraged to expand arbitrarily into industries as diverse as shipping, automobiles, electronic and steel. It did not matter in the 1970s and 1980s whether those corporations were efficiently using resources to create wealth in the diverse fields where they play. Their markets were protected. The chaebols enjoyed special favours from government and had access to foreign loans through special vehicles channelled or guaranteed by the Korean government. With such resources, the chaebols could purchase foreign technology and exploit the comparative advantage of South Korea in labour costs to play strongly in the export markets. Hyundai for example started its automobile business with engines developed by the Mitsubishi Corporation in Japan. The capital appetite of the chaebols could however not be supported by the low level of savings in South Korea as typical of many emerging market economies. Foreign loans had to fill the wide gap between the local savings and the huge investment rate fuelled by the chaebols. Koreans debts began to mount such that with the emerging markets economic crises of the 1990s, South Korea economy was badly exposed. The weakeness of the ‘Jack of all Trade’ business model of the chaebols became clearly manifest as many of them could not repay their debts. If they have stopped creating wealth due to an outdated business model, how could they have paid their creditors? The chaebols and their huge debts through their over-leveraged balanced sheets nearly brought down the Korean economy. Transcorp’s corporate strategy must therefore recognise the new global context of a liberalized economic world that does not provide hiding places for sub-optimal resource utilization among emerging economy players. To win, even in the emerging markets, you have to be the best at what you do.

Like the chaebols, Transcorp may also have privileged access to commercial loans. The cross-membership of its board with that of some leading financial institutions suggests so. The close relationship of the Korean chaebols, the government and the financial institutions created a situation of overinvestment and credit expansion without the typical discretion that should have been exercised by the lending institutions. The consequences for Korean economy were serious. Bad loan portfolio and poor asset quality spiralled in the banking sector. What are the implications of the cross membership of the board of Transcorp and some of the leading financial institutions to which Transcorp may turn to borrow funds? Would those financial institutions some of which are publicly-owned exercise rational economic judgements on Transcorp’s loan applications? These questions will have important structural implications for the Nigeria economy as Transcorp grows bigger in the future.

While the Transcorp idea will always be laudable, government must recognise that other Nigeria mega-corporations are emerging in natural ways in the oil, energy, and telecommunications industries. Government must pay attention to these emerging potential mega-companies as much as it pays to Transcorp. It must provide incentives to encourage their competitiveness without granting them unfair privileges. National companies that will travel far outside our shores are those who have learnt to compete well with international players at home. Whatever is good for Transcorp must be good for Ooando, Globacom, Zenon, or Zinox. One of the positive lessons from South Korea is that strong domestic rivalry is critical to developing strong competitiveness by local firms. Competitive advantage rarely comes out of easy life. It is a product of business pressure, market challenges and sometimes competitive adversity. National corporations, even when favoured collectively must be encouraged to compete strongly with themselves. Such competitive rivalry drives innovation and improvement within the firms and helps them to develop the muscle to play on the global stage. There was not one particularly favoured chaebol but as many that could muster the minimum capacity to play on the big stage were encouraged by the Korean government. There were at least three major chaebols competing in every strategic industry. Samsung, Daewoo and Goldstar competed in electronics while Hyundai, Daewoo, Ssangyong and Kia competed in automobiles. Of course, it will be critical to ensure that the emerging Transcorp and Transcorp-like organizations do not get too small as to loose the minimum size needed to play seriously in the highly capital-intensive strategic industries. A competition policy is long over-due that will provide a framework for managing the complex issues of firms’ size, national competitiveness, passages/ incentives to local firms and fair competition.

Our mega-corporation development model must also ensure that small and medium size businesses can co-exist with the mega players in a balanced business ecosystem. Big size can be a disadvantage in certain parts of an industry value chain. Where smaller players have economic advantages, they must be able to co-exist in co-opetition with the Trancorps. The South Korean chaebols had sometimes over-integrated across their industry value-chain into areas where smaller players could have created value more efficiently. Some of them have had to deploy predatory tactics to drive out the small and medium size players creating an unbalanced and sub-optimal business ecosystem. This has become an issue for South Korea in crossing its next threshold of international competitiveness. Strong supportive firms in the value chain and distribution channel which will complement and enhance the value creation of Transcorp and its peers should be therefore encouraged. Given the typical emerging economy scenario in Nigeria, where market intermediaries and institutions may evolve too slowly creating voids within the value chain, Transcorp may have to become a pro-active value-chain organizer as part of its competitive strategy.

Our national competitiveness program must include a program to strengthen Nigeria factor endowments which a Transcorp could exploit to build international competitive advantage. Simultaneously, with the development program of the cheabols, the South Korean state invested significantly in developing its human resource base especially in the areas of technical education. There has to be an organic framework to link the Transcorp program to a national capacity building program in science and technology. What role, for example will the National University Commission play in re-directing resources to the educational areas that will provide the skilled pipeline for strategic industries that will be the focus of Transcorp and its peers? Will there be need for industry specific technical institutions? How will these institutions be funded? What incentives such as tax breaks would be given to private firms to encourage training and development of Nigerians in priority areas targeted for national competitiveness? The Nigerian population is a strong factor endowment if we can convert our raw quantity to good quality. Our population provides a natural fit for utility industries such as telecommunications, power and water where scale is critical to competitiveness and organisation learning. Government policy in these industries should encourage national players who can compete with foreign firms at home and ultimately expand into Africa with the lessons learnt in the home market.

The Transcorp initiative is very commendable. Nigeria needs its own mega corporations, now. Strong and big business firms are critical to economic growth and national competitiveness. Our mega-corporation development strategy must however fit the current context of Nigeria of a global, more integrated and liberalized economy. Government should consider a complementary mega-corporation model of encouraging mergers or joint ventures of Nigerian firms in the same industries. Why should Ooando and Zenon not bid together for the Port Harcourt refinery and win, rather than both of them loose to a foreign firm? Can we replicate such models in other strategic industries? Transcorp itself, while it may objectively start as a business in diverse industries, it must as early as possible make long term choices of focus on few related industries. It may play wide in the short term by exploiting diverse market asymmetries using its political and social capital. It must however consider this as a short term strategy like buying stocks to sell as quickly at it appreciates, rather than keeping for a long term. It will need to build hard-core superior competencies in focused markets, if it will deliver on the dreams of its founding fathers.

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