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The Corporate Portfolio

January 1, 1977 By Bruce Henderson

Diversified company portfolios are the normal and natural business form for efficiently channeling investment into the most productive use. All diversified companies, as distinct from holding companies of any kind, have one major characteristic in common. They are able to control the internal allocation of financial resources. In a holding company, each business must be self-financing and independent. In a corporation, cash flow and investment can be rechanneled from one business to another. This is a critical capability.

A diversified business portfolio enables a company to carry the process of business evolution to a higher level of complexity. Instead of developing a family of products, it is able to develop a family of businesses.

All products go through a life cycle. In the beginning they need far more cash input than they can generate. If they succeed, they generate far more cash than they can productively reinvest. Successive, overlapping generations of products smooth out this cash flow to some degree, but even the product family has the same life cycle. Cash input is needed when they are succeeding. Cash generation cannot be reinvested when they have matured successfully. This is what drives many companies to diversify into a family of businesses as well as products.

But businesses as a whole go through the same cycle. They tend to be unprofitable when very new, profitable but undercapitalized when their growth is the fastest, and then generators of cash when they become successful, mature and slow growing. The problems change with maturity. The young, fast growing business needs capital to take advantage of its potential growth and exploit its opportunity. The mature business has real problems in finding suitable investments for its cash flow.

The diversified company with a portfolio of businesses is exceedingly well positioned to discharge the function of directing capital investment into the most productive areas. It can be far more efficient and effective than the public capital market is likely to ever be.

Top management of even a far flung diversified company is better equipped to appraise the potential and characteristics of a growing business than an outside investor. Such a company has staff research capability and access to data that even the most detailed prospectus cannot provide to the general public.

This ability to divert and reinvest the cash flows of a mature business is very important. There is no reason to reinvest the profits of a business in further expansion of the same business merely because it has been successful in the past. General Motors is not the only successful company that would find it difficult to expand faster than its industry.

The U.S. tax structure severely curtails investment funds available for reinvestment, first when they appear as reported profits, and again when they pass through the hands of shareholders as dividends. The value of this advantage is not small. Income taxes would take away about half the reinvestable funds if the cash flow is reported as profit. If paid out in dividends before reinvestment, then only a fraction of this is left for reinvestment.

Any company which can treat its investments in growing businesses as an expense to be offset against other profit has a great advantage in terms of its cost of capital. Also, any company which can obtain its equity from internally generated funds has a far lower effective cost of capital than if it obtained those funds outside from stockholders who can retain only a fraction of the proceeds they eventually receive in dividends.

The diversified company with a portfolio of businesses is in an unexcelled position to obtain capital at the lowest possible cost and to put it to the best possible use. The question, of course, is: Will it?

Any company which treats each of its divisions or units as separate and independent businesses fails to take advantage of its own strength. The traditional profit center concept of management has a fatal defect. It concentrates attention on near term reported earnings rather than investment potential. This is why many successful diversified companies have been composed of mature businesses and have been notably inconspicuous for their success in incubating new businesses. A company must behave like an investor, not as an operator, if it is to achieve its potential.

Experience curve theory dramatizes how great the potential really is. This theory says that costs are a direct function of accumulated market share. It further says that investment in market share can have extremely high returns during the rapid growth phases of a product. As long as the growth rate exceeds the cost of capital, then every year in the future is worth more in present value than the current year. Today's losses therefore may be very high return investments, provided those losses protect or increase market share. If market share correlates with cost differential, then it can be translated into investment value.

If this is true, then the logical consequence of competition will be low prices initially on new products. These prices will tend to be so low as to be pre-emptive. They will also be stable. The result will be negative cash flows for a considerable period until costs decline to below the low initial price. This will be followed by even larger positive cash flows as costs continue their decline and volume continues to increase. This produces the return of investment and the return on that investment.

The diversified company is eminently well suited for this kind of “expense investment.” Only the diversified company can match positive and negative cash flows. Only the diversified company can pair off the tax consequences of “expense investment.” Only the diversified company can accumulate and analyze the detailed information required to make a wise investment involving a sequence of initial negative cash flows.

Everything favors the diversified company: tax laws, capital costs, sources of funds, breadth of business opportunity. Their inherent advantage lies in their ability to manage a set of portfolio tradeoffs. If the flexibility is not used, diversified companies are under a handicap. The individual business has no advantage except uncertain financial backing which is hardly to be called an advantage! The corporate overhead structure can be a real burden with no offsetting advantage. There are quite a few lackluster diversified companies. It can be quite different if the company is managed as a portfolio.

If a company is to realize its potential, it must have an investment and strategy development skill which goes well beyond the characteristic needs of the independent business. Some corporations are going to do this. Those that do are quite likely to be the pre-eminent and dominant firms of the future. They will manage their cash flow portfolios to continually increase the present value of future cash flows.

The Corporate Portfolio
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