Diversification as a growth strategy: Porter's 3 tests for successful expansion
HP split in 2015 - a sign of failed diversification. But not all diversifications fail. Michael Porter defined 3 tests that determine whether diversification creates or destroys value. Investors know these tests better than you.
Porter's 3 tests of diversification
Michael Porter, the god of strategy research, defined it in 1987 3 critical tests, which determine whether diversification creates or destroys value:
- Attractiveness test: Is the target industry attractive enough to justify the cost of entry?
- Cost of entry test: How much is admission? Can you get started cheaper than your competitors?
- Better off test: Do you create synergies? Will both businesses benefit from the combination?
If you only say “yes” to test 1 or 2, but “no” to test 3 – then diversification is a mistake.
Test 1: Attractiveness – Is the market attractive?
The first test used Porter's Five Forces. Ask:
- How profitable is the industry in the long term?
- Which macro trends are driving growth? (PESTEL)
- Are the barriers to entry high enough that only a few competitors get in?
Example (positive): Coca-Cola diversified into water & juice drinks - all profitable categories with stable margins.
Example (negative): HP diversified into servers and software services - markets with declining margins and intense competition.
Test 2: Cost of Entry – How much does entry cost?
Even if the market is attractive, if you have to get in too expensive, you will still destroy value. Examples:
- Organic growth: Slow, expensive, long wait until profitability
- Acquisition: Fast, but often overpayment, integration risks
- Joint venture: Middle way, but loss of control
Test 3: Better-Off – Do you create synergies?
This is the most critical test. Synergies can be:
- Cost synergies: Joint procurement, production, sales
- Revenue synergies: Cross-selling, co-branding
- Strategic synergies: Faster market entry, shared know-how
"Most failed diversifications don't fail on Test 1 or 2. They fail on Test 3 - there are no real synergies and administrative overhead increases."
– Michael Porter, Competitive Advantage (1985)Related vs. Unrelated Diversification
Related diversification (e.g. Coca-Cola → juice) has higher synergies. Unrelated diversification (e.g. Samsung → semiconductors + ships + insurance) has less synergies but risk reduction.
Rumelt (1974) showed: Related diversified companies outperform pure specialists – but unrelated conglomerates underperform.
The HP case: failed diversification
HP was focused on printers & workstations in 1990-2000. CEO Mark Hurd (2005-2010) diversified aggressively:
- Purchase of Compaq (2002) – Servers & PCs
- Purchase of EDS (2008) – IT Services
- Internal development of software services
The tests failed:
→ Test 1: Markets with falling margins (PC market competitive, servers/services dominated by competition)
→ Test 2: Massive Overpayments (EDS: $13B for a services company with falling margins)
→ Test 3: No synergies - HP didn't bring printer expertise to servers, and servers didn't bring printer sales
Result: 2015 split into HP Inc. (hardware) and HPE (enterprise). This split created ~€30B of value as focus returned.
Conglomerate discount and chaebols
“Conglomerate discount” is an empirical phenomenon: diversified companies are valued by markets at a 15-20% discount vs. focused companies (EV/EBITDA).
Exception: Asian chaebols (Samsung, Hyundai) and Japanese keiretsu. They work because:
- Family control (long horizons, not short-term gains)
- Relationship network instead of market (internal transactions have real synergies)
- Macroeconomic integration (chaebols are mini-economies)
Diversification in investor assessment
When you come to an investor and plan diversification – be ready for these questions:
- How attractive is the target market? (growth, profitability)
- How expensive is entry vs. organic growth in existing markets?
- What specific synergies are there? (Not “scaling” – that’s too vague!)
- Do you have management capacity for two different business models?
- How does this affect your exit? (Is the combination more or less attractive to a PE buyer?)
Family offices and PE investors prefer related diversification or focus. VC is less interested in diversification (too distracted from the core).
Academic sources
- Porter, M.E. (1987). From Competitive Advantage to Corporate Strategy. Harvard Business Review.
- Rumelt, R.P. (1974). Strategy, Structure, and Economic Performance. Harvard Business School Press.
- Grant, R.M. (1995). Contemporary Strategy Analysis. Blackwell.
Let us analyze your financial viability
Find out how WorldTimberToken can help you succeed by requesting a free initial analysis.