1.0 Introduction

This paper illustrates three particular concepts, namely, portfolio diversification strategy,

strategic divestment policy and corporate collapse or failure. Firstly, portfolio diversification has

been the trend among investors since the ‘30s. Until the introduction of the modern portfolio

theory in ‘50s, the diversification strategy by many firms used to follow a simple risk and return

comparison analysis. However, following the unsystematic risks and declined returns from the

portfolio assets led the investors consider the modern portfolio theory and take the correlation

among different assets into account. Secondly, corporate strategic divestment is a two decades

old trend that came into practice after the conglomerates failure of ‘70s and ‘80s. The strategic

divestment policy reveal that whereas, firms may look for expansion strategy such as, mergers

and takeovers to grow bigger, divestment policy such as, sell or spin off a particular business unit

can be profitable for some other kind of firms. Thirdly, corporate failure is a regular

phenomenon had happened to a number of renowned companies worldwide due to several

internal and external factors which have been described in the paper.

The paper consists of two sections. The first section provides comprehension to the executive

summary of a management consultant of Brad Limited the reasons behind strategic divestment.

The second section illustrates reasons of corporate failure and recommendations to overcome it.

(Answer to Question 1)

2.0 Portfolio Diversification Strategy

2.1 Description of Key Terms

2.1.1 Portfolio Theory

Portfolio theory, also known as modern portfolio theory (MPT) and introduced in 1952 by Harry

Markowitz, attempts to select an optimal portfolio from a set of possible portfolios

(Levisauskaite, 2010; Marling & Emanuelsson, 2012). Portfolio is defined as a collection of

securities with diversified risk and expected return. According to MPT, an optimal or best

portfolio can be selected by composing portfolios of assets determined by risks, returns,

covariance and correlation with other assets (Kierkegaard, 2006). The theory also states that on

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order to choose an optimal portfolio, an investor would either choose the portfolio with higher

return for the same level of risk or with lower risk for the same level of expected return;

nevertheless, investors are assumed as risk-averse (Atzberger, 2010; Kierkegaard, 2006).

2.1.2 Unsystematic Risk and Systematic Risk

Unsystematic risk is the type of risk that is resulted from the difference in the corporate financial

decision among the firms (Kierkegaard, 2006). However, this risk is firm-specific and can be

minimized by following diversification strategy (Modigliani & Pogue, 1973). That is why it is

often called diversifiable risk. Unsystematic risks include R&D failures, unsuccessful marketing

or losing major contracts and all other events affecting a firm solely (Kierkegaard, 2006).

However, there is another type of risk which cannot be minimized by diversifying the portfolio.

This is the risk that affects all or a large number of firms in an industry and that is why called

systematic risk (Hotvedt & Tedder, 1978). Systematic risk include risk arisen from business

cycle, inflation, changes in interest rates and exchange rates (Kierkegaard, 2006).

As mentioned earlier, through diversification of the portfolio assets the unsystematic risk can be

eliminated and at a point when unsystematic risk becomes ‘zero’, the portfolio return becomes

perfectly correlated to the market (see Figure 1 below) and thus, if any uncertainty in the market

resulted as systematic risk affects the portfolio assets, even the best diversification portfolio may

not stay safe from the consequences (Modigliani & Pogue, 1973).

Figure 1: Unsystematic risk and Systematic risk

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2.1.3 Risk Profile of a Business

A risk profile of a company ensures that the risk management process is aligned with the

corporate objectives and investor expectations (Lopatina, 2012). According to Kellysears

Consulting Group (2015), the risk profile of a business or organization should include several

elements. Firstly, it should address the key risk areas such as, strategic decisions, operations and

projects. Secondly, it should address the strengths and weaknesses of each department and

branch. Thirdly, it should also indicate major opportunities and threats related to the business.

Fourthly, it should indicate the risk tolerance levels and characteristic of the business,

particularly whether the investors are risk-averse or risk-seeker. Fifthly, it should also illustrate

the capacity of the business to manage and mitigate different types of risk associated with the

business. Sixthly, it should demonstrate linkages between different types of risk and also

between the risks and risk management process.

2.1.4 Coefficient of Correlation

Coefficient of correlation, also known as correlation coefficient and denoted by ρ (rho), is a

numerical value that summarizes the direction and closeness of linear relations between two or

more variables, i.e. investments in portfolio (Shen & Lu, 2015). The values of correlation

coefficient ranges between -1 to +1. When the value of correlation coefficient is greater than zero

(ρ>0), there is a direct relationship between two variables; hence, if one variable increases, the

other one increases accordingly. However, a negative value of correlation coefficient ( ρ<0), the

relationship between two variables is inverse and if one variable increases, the other one

decreases (Shen & Lu, 2015).

While investors tend to reduce risk by diversifying their portfolio assets, they prefer two or more

assets with very low or negative correlation (Philips, Walker & Kinniry, 2012). On the contrary, a

high or positive correlation between assets does not reduce risk when portfolio is diversified.

2.1.5 Comprehension of the Executive Summary

As mentioned earlier, the executive summary reported by the management consultant consists of

two sentences. For reading convenience, the explanation as well has been divided into two parts

following each sentence.

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Firstly, the management consultant stated that “portfolio theory indicates that your ability to

spread the unsystematic risk by developing a portfolio of shares of companies in two industries

can only benefit the risk profile of your business.”

The essential terms, such as, “portfolio theory”, “unsystematic risk” and “risk profile of a

business” have been discussed in the previous sections. A revision of the discussion may help

readers better understand the following comprehension.

Herein the consultant has indicated that since Brad Limited intends to diversify their portfolio by

investing in shares of companies both in property development industry and construction

industry in order to spread the unsystematic risk (the inherent risk of each industry), this

diversification strategy will only benefit the company in relation to the risk profile (such as, key

risk areas, risk tolerance level and characteristics, risk management capacity) of the company.

For example, if the shares of companies in property development industry are exposed to more

unsystematic risks than the shares of companies in construction industry, it will affect the risk

profile of Brad Limited as well as the risk management process and corporate objectives.

Consequently, Brad Limited management will have different risk management strategy for the

companies in two different industries; i.e. they will be more cautious in managing risks

associated with shares of companies in property development industry due to higher risk.

Accordingly, they will be risk-seeker in investing in the shares of companies in property

development industry and risk-averse in investing in the shares of the companies in construction

industry.

Secondly, the consultant also stated that “however, the concern is in relation to the extent to

which risk can be diversified, as the coefficient of correlation between the property development

and construction industries stands at plus (+0.8).

The essential terms mentioned herein, such as, “coefficient of correlation” have also been

discussed in the previous sections. Nevertheless, according to the discussion, the aforementioned

statement indicates that since the correlation coefficient is positive (+0.8), both the industries are

likely to move along with each other in terms of financial prospective. Meaning to say, the

consultant pointed out a different scenario, regardless of the previous statement of comparative

advantage from diversification strategy, and that is, if for example, the risks associated with the

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shares of companies in property development industry increase, the risks associated with shares

of companies in construction industry will also be increasing and vice versa following a similar

trend.

However, it has been discussed earlier that in order to benefit from portfolio diversification and

unsystematic risk spread, investors seek negative correlation. A negative correlation between the

two industry shares indicates that if risks inherent in property development industry increase, the

risks associated with construction industry shares will move inversely to the other side and will

decrease.

It is also important to note that coefficient correlation of ‘+1’ (perfect positive correlation)

implies that the two industry shares follow similar trend equally; in this case, no benefit from

diversifying the two assets. However, in our case, the value of coefficient correlation is +0.8

which is very close to +1. Hence, the risk spread and advantage from portfolio diversification in

the two industries would be very minimal, financially unsecured and unprofitable.

Therefore, the extent of risk diversification is minimal and not in line with the company’s risk

profile and expectation from its risk diversification strategy. If Brad Limited really desires to

diversify their portfolio in order to spread risk, they should not invest in shares of construction

industry, rather invest in shares of companies in an industry which has negative correlation with

the investment in shares of companies in property development industry.

2.2 The Policy of Strategic Divestment

Strategic divestment policy simply refers to sale, closing or spinning-off of a business unit,

operating division and product line of a business (Thomas, 2015; Benito, 2003). It became a

trend to divest a portion of the company business in the United States in ‘90s due to the

unsuccessful Mergers & Acquisitions in the earlier two decades (Haynes, Thompson & Wright,

2000). Divestment once, whereas, was a short-term tool for firms to raise cash or pay debts, have

now become a strategic factor for long-term growth and strategic competitiveness (EY, 2014).

However, divestment is never the first and foremost goal of a business, rather it only comes into

investors thought to be undertaken due to continuous failure of a particular unit to raise sales or

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earn expected profit, smaller market share of the business unit and the need for increasing

investment in other business units or product lines. Thus, there are several reasons due to which

companies around the world divest a portion of their business.

2.2.1 The Reasons of Strategic Divestment: Real-life Examples

2.2.1.1 Too Small Market Share

Strategic divestment policy may be undertaken if the market share is too small for the firm to

stay competitive or market is too small to provide its expected rate of return (Thomas, 2015). As

such, firms may consider divesting a brand or business unit when a particular product is found to

be off-trend with decline in demand for it and consequently, losing market share.

According to the broad-scale EY Global Corporate Divestment Study surveyed on 720 corporate

executives worldwide and released in 2014, 58 percent of the executives consider divesting if a

particular unit or product line is found to be off-trend and more than 40 percent would consider

selling if there is decline in the product demand as well as the market share (EY, 2014).

Following this trend, Glaxo SmithKline sold its Ribena brands and Lucozade to Suntory

Beverage & Food, a Japanese company, since Glaxo found its products were not well-recognized

in its business focus area, the emerging markets (EY, 2014). Unilever has divested its lower-

growth food brands, such as, Skippy peanut butter and Wishbone dressings in order to focus on

higher-growth market share (EY, 2014). Campbell Soup Company sold its European soups and

sauces division to CVC Capital Partners due to slower demand, sales and growth in the division

in the recent years.

It also happened to Levi Strauss & Co. which found a decline in its market share with almost half

in its 14-19 years old male target group and no introduction or development of a new or

successful product in recent years (Thomas, 2014). Therefore, the company decided to shut down

29 factories in North America and Europe with a retrenchment of over 16,000 employees since

1997 (Thomas, 2014).

2.2.1.2 Availability of Better Alternatives

Divestment policy may be influence by the availability of better investment opportunities, such

as a particular line of business, focus on which can have great impact on the firm’s profitability

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by divesting the other certain business line(s) and diverting the limited resources into the

intended business product line (Thomas, 2014).

IBM’s divestment strategy can be an appropriate illustration in this context. Though the PC

business of IBM was still profitable in 2004, there was an internal debate in the company that the

PC division may not accommodate any more sustainable innovation (Sheffer, 2012). Actually,

the company was intending to invest in other sectors than PC division such as, consulting

services to IT firms, though the main reason was reported by the CEO of IBM, Samuel J.

Palmisano that IBM that it was looking for an opportunity to establish in a new market that is

vibrant and lucrative, i.e. China (Sheffer, 2012; Badenhausen, 2005). Eventually, it sold its PC

Division to Chaina’s Lenovo Group.

2.2.1.3 Need for Increased Investment

The need for increasing investment in other sectors such as, machinery, marketing, research and

development can be more beneficial and viable for a firm rather than investing in monetary or

management resources (Thomas, 2014).

Zhu (2014) reports that Merck, the pharmaceutical titan announced divestment of its RNA

interference (RNAi) business line, Sirna in January, 2014 it was not aligned with the core

business of Merck. It was only back in 2006, when Merck acquired Sirna for US $1.1 billion;

however, when Sirna was sold to Alnylam Pharmaceuticals, the value was under-priced to as low

as US $290 million (Zhu, 2014). Merck’s Head of Business Development Team, D. Dukes states

that it was the R&D that Merck wants to focus on and Sirna lacks it very much, this made Merck

prioritize its divestment decision even with a big difference in selling from its original price

(Zhu, 2014).

2.2.1.4 Lack of Strategic Fit: Failure in Mergers & Acquisitions

As mentioned earlier, divestment policy was common in companies within United States in the

‘90s due to Mergers & Acquisitions failure. Hence, firms may undertake strategic divestment

policy if the acquired firm’s objectives and strategies are not in line with the acquiring firm.

Firms may then divest the business line by restructuring if selling process of becomes difficult or

otherwise by selling it off to other potential buyers.

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There are numerous examples of this scenario worldwide. Abbott’s decision to spin-off its

research-based pharmaceuticals business, AbbVie in 2011 for US $4.5 billion and Pfizer’s

divestment of its animal health business, Zoetis in 2013 for US $12.4 billion were resulted from

their failure in expansion strategy facing less profitability in the aforementioned divisions (KY,

2014). The aforementioned Merck’s divestment of Sirna in 2014 after acquiring it in 2006 can

also be a good example of lack of strategic fit.

2.2.1.5 Legal Pressure to Divest

Legal pressures may also force firms to undertake strategic divestment policy (Thomas, 2015).

Regulatory changes can sometimes be the major factor for companies to decide for divestment

which is revealed by the global EY study that 57 percent of the executives identified regulatory

change as the major factor in the decision of divestment (EY, 2014).

The divestment policy of Service Corporation Inc., a large funeral home chain, can be a good

example in this context. Service Corporation Inc. acquired many of its competitors in some areas

that made the company to monopolize the industry regionally. However, in order to restrain its

monopolistic trade, the Federal Trade Commission informed the company to divest some its

operation in order to avoid penalties (Thomas, 2014). Eventually, the company had to divest

some its operation.

RJR Nabisco had also suffered from legal constraint due to the law-suits on its tobacco business

line. R.J. Reynolds, the manufacturer of Winston, Camel and other cigarette brands, purchased

Nabisco brands in 1985 (Thomas, 2014). However, due to the law-suit, RJR Nabisco had its

domestic tobacco operations divested into a separate company and overseas tobacco operations

sold to Japan Tobacco.

2.2.1.6 Capital Needs

Besides the aforementioned scenarios and reasons, strategic divestment policy could also be

undertaken facing need for capital. As such, divestment may be done to increase shareholder

returns, pay-off debt and stabilize leverage ratio (Zhu, 2014).

Chemtura, a global manufacturer of specialty chemicals decided to divest its Consumer Products

Unit in 2013 that were used to produce pool and spa chemical and it was subsequently sold to

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KIK Custom Products for US $300 million (Zhu, 2014). The main reason articulated by the

Chariman, President and CEO, Craig A. Rogerson that the divestment decision was taken to

provide a substantial and increased amount of return to the shareholders (Zhu, 2014).

(Answer to Question 2)

3.0 Corporate Collapse or Failure

With the emergence of globalisation and increase in mergers and takeovers, contemporary

companies, their strategic decisions and operations are becoming more and more complex.

Besides, the occurrence of unsystematic crisis related to renowned companies makes the existing

companies either vulnerable or cautious for a potential collapse.

Corporate failure or collapse is defined as a short-term, undesired, unfavourable and critical state

in a company which is derived from both internal and external causes and further the existence

and growth of the company (Dubrovski, 2007).

According to Mbat and Eyo (2013), a corporate failure is recognized when a company is found

to have lower returns, be insolvent or bankrupt. As such, a firm having lower returns would be

unable to grow further, being insolvent would face tremendous difficulties in paying off debt or

credit to its creditors, and being bankrupt would need government support to sustain its business

(Mbat & Eyo, 2013). Hence, simply saying, corporate failure is an indication that a company is

unable to generate positive cash flows, achieve its strategic goals and comply with legal

requirements.

3.1 Reasons behind Corporate Collapse, Real-life Examples and Recommendations

The causes of corporate collapse have been discussed in numerous papers from different

perspective and hence, the opinions of researchers in relation to illustrating causes have differed

from each other. For example, Dubrovski (2007) argued that a corporate failure is affected by

both internal and external causes. Internal causes are the scenarios that emerge within the

environment of the company, such as, improper competences of the management, uncompetitive

market position, over-expensive production and inefficient information system; whereas, the

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external causes emerge in the outside environment of the company, such as, sudden economic or

regulatory changes.

However, according to Mellahi and Wilkinson (2004), an organizational failure may be caused

by environmental factors (regulatory and economic changes), ecological factors (density, firm

size, industry life-cycle), organizational factors (succession planning and historical performance

of the firm) and psychological factors (managerial perceptions). In another research, Hamilton

and Michlethwait (2006) suggested six main causes of a corporate collapse, namely, poor

strategic decisions, over-expansion, dominant CEOs, greed and desire for power, failure of

internal controls and ineffective boards. Nevertheless, this section of the paper will discuss major

reasons of corporate failure illustrating real-life examples and subsequently my own

recommendations to help firms avoid corporate failure.

3.1.1 Managerial Misconduct

Managerial inefficiency and ineffectiveness seems to be a major cause to corporate collapse, as

has been suggested by Mbat and Eyo (2013). Managerial expropriation and abuse of

compensation may lead to mismanagement and ultimately leading to corporate failure.

Enron’s (a US-based natural gas pipe line company) corporate failure in the past decade have

been widely discussed due to its unnecessary managerial expropriation and compensation policy.

Enron’s senior managers used to be paid with performance-based compensation and stock

options through which they could control the company internally and expropriate property even

when the business was underperforming (Mehta & Srivastavaare, 2009). Last but not least, the

board permitted its employees to suspend the company’s own code of conduct that led to create

principal-agent conflict of interest (Nakayama, 2002).

3.1.2 Poor Financial, Operational and Risk Management Strategy

Firms affected by poor overall management strategy may be resulted into corporate failure.

According to Mehta and Srivastavaare (2009) the corporate failure of Tyco had been caused due

to inability of management in identifying potential and inherent risks and setting up an effective

financial, operational and risk management policy.

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This type of corporate failure is prevalent in mergers and acquisition cases as well. When AOL

and Time Warner merged in 2001, the company management were unable to predict the financial

fortune effectively and as well had weaker management strategy. Even knowing the failure of

Lycos-USA Networks merger, AOL and Time Warner went for merger deal in 2001 and

wrongly forecasted the future stock value (Ghaly & Rotaba, 2013). As after the failure of Lycos-

USA Networks merger, the share price started to decline which affected AOL-Time Warner

tremendously; as such, the US $350 billion worth stock value came down to US $205 billion

subsequent to the execution of the merger deal (Ghaly & Rotaba, 2013).

3.1.3 Low Productivity and High Production Cost

Firm management may sometimes show inefficiency in forecasting customer demand, managing

supply chain, purchasing inventories at high cost which may lead to higher production cost,

lower productivity and decline in the market share making it difficult for the firm stay

competitive (Mbat & Eyo, 2013).

3.1.4 Corporate Governance Failure

This is the most contemporary cause to corporate collapse that may result from non-compliance

to disclosure of corporate governance framework. As argued by Haat, Rahman and Mahenthiran

(2008), transparency and accountability are seen as the two major elements of corporate

governance framework, however, when these elements are violated and companies fail to

disclose transparent, reliable and accurate information in relation to both corporate and financial

reporting, it may lead to flow of information asymmetry to its stakeholders, inaccurate decisions

by the shareholders and eventually a corporate collapse.

Perwaja Steel Sdn. Bhd., a Malaysian company fell into corporate collapse due to directors

misconduct as well as reporting failure. It started when the directors of Perwaja paid RM74.6

million to Japan’s NKK Corporation without the approval of Perwaja’s board of directors over

the period of 1992 to 1995 (Norwani, Mohamad & Chek, 2011). It was further followed by

omission of the transaction from Perwaja’s financial report and weaker internal control

mechanism that led to its ultimate collapse.

Another Malaysian company, Transmile suffered from corporate governance failure when it

overstated its revenue by RM522 million and fabricated its property, plant and equipment

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account by RM341 million in the financial report for the period of 2004 to 2006 (Norwani,

Mohamad & Chek, 2011).

Enron’s fraudulent accounting and disclosure practice should not be forgotten. Enron fell into

corporate collapse when it overstated its net income by US $545 million and equity capital by

US $828 million in its financial statement (Norwani, Mohamad & Chek, 2011).

3.1.5 Capital Inadequacy

The most prominent reason of a corporate failure would probably be the inadequacy of capital in

a firm. As capital is theoretically assumed as the backbone of financial support against high

leverage ratio, a firm may collapse when adequate capital is not found to pay off its liabilities

and no financial assistance from the last resort is obtained.

3.1.6 Economic Instability

Economic instability is an external or exogenous factor indicated by Dubrovski (2007) may

affect firms when the government announces its fiscal and monetary policy. Firms with poor

strategic fit, mismanagement and inaccurate prediction of environmental changes are more

susceptible to the corporate failure caused by exogenous factor. As such, a single or few firms in

the industry may unsystematically be exposed to interest rate risk and foreign exchange risk.

3.2 Recommendations

As noticed from the discussion above, companies face corporate failure due to non-compliance

to disclosure of corporate governance framework and financial reporting standards, managerial

misconduct, poor management strategy and policy, capital needs and impulsive external changes.

Therefore, some recommendations can be made in order to solve these issues and avoid

corporate collapse.

3.2.1 Enforcement and Monitoring by Legal Entity

Even though disclosure of corporate governance practices have been made mandatory in almost

all the countries, it may still prompt for a corporate failure in the industry. However, if necessary

enforcement and continuous monitoring is undertaken, the unsystematic corporate crisis can be

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avoided and minimized. It is argued that in case of a company that is well-connected, a person

who is linked to government and possess local and international power may not be adequately

penalized by regulatory commissions (Norwani, Mohamad & Chek, 2011). Therefore, proper

enforcement of corporate governance disclosure by all citizens and firms are to be practiced and

monitoring should be made at least on yearly basis by government-run agency over all the

companies.

3.2.2 Directors with Ethical Values to Ensure Best Corporate Governance Practice

As transparency and accountability are two of the major elements of corporate governance

framework, the best practice of corporate governance would display disclosures of transparent,

reliable, accurate and relevant information in the annual report. In addition, voluntary

disclosures, such as, sustainability disclosures and in case of Islamic firms, Shariah-governance

disclosure can add values to the reporting standard of the company and help investors to take

correct decisions and stakeholders to have a faith on the company’s strategy and operations.

Hence, firms need to develop human capital with ethical values in order to ensure the

aforementioned practices.

3.2.3 Ensuring Accountability of Auditors

Since auditors are important stakeholders to a company helping other stakeholders receive

accurate and transparent information and helping the company to better allocate its resources, it

is crucial that the auditors stay accountable to the board of directors of the company and upon

their responsibility in auditing and consultancy. Otherwise, auditors’ involvement in corporate

scandal will be under investigation and their reliability will be questioned, as what happened to

Enron’s case where the same auditing firm used to provide both auditing and consulting services

and notwithstanding, the financial reporting failure had been revealed.

3.2.4 Minimizing Managerial Expropriation, Compensation and Misconduct

Companies should take additional steps to minimize expropriation and high-scale compensation

by its senior managers especially when the firm is underperforming or having a lower sales,

revenue and market share. The board may play an important role here by charging penalties upon

any high-scale compensation being caught.

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3.2.5 Developing Adequate Managerial Expertise

In order to structure a flexible and organised financial, operational and risk management policy,

companies need to focus on developing adequate corporate expertise who are equipped with

talents, skills, experience and trainings.

4.0 Conclusion

As discussed in the section of portfolio diversification policy, Brad Limited can only gain from

the portfolio diversification, if the shares of investment have negative correlation between each

other; otherwise, the risk of one investment may affect the other one.

Understood from the section of corporate strategic divestment policy, companies sell or spin off

their non-profitable business units in order to get immediate cash flows, higher returns and stay

in line with strategic goals. However, the consequence of a strategic divestment may not always

bring glory to a firm regardless of the growth in market share or higher expected return. Rather,

it usually comes with lay-offs of a lot of employees and in some cases, results into defaming the

divestment strategy undertaker, as what happened to Robert Haas, the CEO of Levi Strauss &

Co. as he was questioned for his divestment decision that resulted into layoffs of over 16,000

jobs (Thomas, 2015).

The last section on corporate failure discuss major causes of and some recommendations to the

failure. The major causes of corporate collapse have been presented are managerial misconduct,

corporate governance failure, capital needs and external (economic, regulatory, legal and

environmental) factors. The recommendations as remedies presented are enforcement of

corporate governance mechanism and monitoring by legal entity, such as, government agency,

developing directors with ethical values and management with adequate expertise and training,

ensuring accountability of auditors and minimizing managerial misconduct.

(4,614 words)

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