To diversify or to specialise is a question almost all companies have needed to ask themselves at some point – the answer often changes as their business matures. As investors we can relate; a similar question is often asked when forming a portfolio.
Oil and gas technology firm Weir Group (LSE: WEIR) seems to have asked itself the same question recently, and concluded it should focus its efforts.
Cutting dead wood
Weir Group has been forced to ask itself this question after it posted results showing full-year pre-tax profits falling from £86m to a loss of £372m for the 12 months ending December. Its numbers dropped so dramatically after its oil and gas business was forced to incur a £546m impairment charge last year.
The company said that much of its troubles stem from its North American shale business, where customers have been forced to cut their capital expenditure in large part due to softer crude oil prices. This is, of course, a trend also seen and felt elsewhere.
Weir CEO John Stanton referred to these troubles with the price of crude, saying, “Market dynamics have changed with shorter cycles and higher levels of volatility leading to a very different financial profile to our mining businesses”.
Following the poor results, Weir laid the ground for its intention to consolidate its business by saying it is focusing “now on becoming a mining technology pure play”.
Pareto principle
The trade-offs when considering diversifying or specialising are pretty simple. Diversifying generally reduces your risks by giving you multiple profit streams, perhaps in different markets. The downside, however, is that your resources are often spread thinly, both in terms of capital and in focus and expertise.
On the other hand, specialising allows you to hopefully focus your resources where they can add the most benefit. The risk, of course, is that if this one area fails, all your options fail. Not only that, but the problem is exacerbated by the fact so much of your resources will be focused in this one area.
An analogy perhaps would be the roulette wheel – placing all your money on just one number will give you a massive payoff if that number comes in, but you could lose everything if it doesn’t. Spreading your bets across the table will mean any win you do get will pay less, but you are also more likely to get a win.
This is in essence, the Pareto principle. Also known as the 80/20 rule, it states that in almost any case, the majority of outcomes (be them profits, technical failures, or fruit in an orchard) are brought about by a minority of causes. The 80/20 derives from an estimated 20% of actions resulting in 80% of the results.
The natural outcome of this is that if you can focus all your resources in the 20% of actions that bring the best results, those results will increase exponentially. I am a big fan of the Pareto principle, and specialising can be a gold mine for businesses and investors alike.
It’s early days for Weir, but taking advantage of Pareto is a sure way to make good money in my book.
