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Bloopers & Blunders: Objective of Diversification

Quotation

Commenting on Gillette’s announcement to buy Duracell, consider the following quotation:
"The move by Gillette, based in Boston, allows the company to strengthen its already-strong line of household products and diversify out of its traditional base in shaving products." (WSJ, September 12, 1996)

Answer
The problem has to do with "diversification," which means that you shouldn’t put all your eggs in one basket. That might sound like a great advice in general, but not as applied to corporate earnings.

Suppose you’re the shareholder of Gillette and you would like to diversify into, say, a company that has cash flows similar to Duracell. What would you do? How much would it cost you? Now compare that cost with the premium over market price that a company has to pay the acquiring firm.

Thus, as a shareholder of Gillette you get the same diversification effect whether you own the shares of Duracell or the company itself, other things being equal. However, under the first scenario the cost of diversification is brokerage commission, which is approximately 1% of the price of the stock, compared with a 20% premium for Duracell (see Financing section of the acquisition story). In fact, the latter option’s cost is higher once you include an additional 1.5% in fees that you have to pay your investment bank for their services in structuring the deal.

Therefore, diversification, for the pure sake of diversification, does not make any sense. I am not saying that this deal does not make sense. I am saying that the diversification argument is not sufficient reason for a merger.

By Alex Tajirian