This two-part series highlights the need for diversification in your portfolio. However, I'm not looking for any old diversification; these two article are focused on the importance of international and internal diversification. International diversification was covered in part one. This article covers internal diversification -- i.e., the need for a company to have a well-diversified product offering and not depend upon one product or service for the majority of its sales.
While it's not so important as international diversification, internal diversification is a great positive for any investment. What do I mean by internal diversification? If a company relies on one good or service for the majority of its revenue, then it is not internally diversified.
The list of companies that fail to diversify internally is endless. Some of the culprits include Intuitive Surgical, Lorillard (UNKNOWN:LO.DL), and any of the gold or silver miners.
Lorillard in particular relies upon cigarette sales for almost all of its income. What's more, a large part of these sales are menthol cigarettes, which the FDA has had under investigation for some time. Unfortunately, if Lorillard falls foul of the FDA, it could lose around 90% of its sales overnight, and this would not be good for investors. While the risk of this happening is slim, it's still there. Personally, I would prefer to invest in one of Lorillard's peers, such as Altria, which has several income streams aside from cigarettes.
That said, Lorillard's drive into the electronic-cigarette industry through the acquisition of Blu eCigs has allowed the company to diversify slightly. Still, if the company lost 90% of sales overnight, Lorillard's turnover would drop to $130 million per quarter, enough to cover quarterly interest costs of $45 million but nowhere near enough to cover the cumulative quarterly dividend payout of more than $200 million.
In comparison to Lorillard, food and beverage giant PepsiCo (NASDAQ:PEP) has enough products within its stable to fill a superstore. If Pepsi lost the right to sell one, two, or even several of its products, it would be able to recover despite some initial setbacks.
Indeed, Pepsi has more than 20 brands across several different segments within its brand portfolio that rack up more than $1 billion in sales apiece every year. With this many high-value brands under its umbrella, PepsiCo is well-diversified internally. These brands include such household names as Tropicana, Quaker Oats, Walkers, 7up, and, of course, Pepsi.
Also, while the company might report declining sales across one of its brands, the company's other brands can pick up the slack. All in all, it's a much better choice than Lorillard.
Dependence upon a little blue pill
Of course, no matter how much a company diversifies, the reliance upon one product or service for a significant majority of sales always opens the company up to risk. The best-selling drug in history was Pfizer's (NYSE:PFE) Lipitor. Unfortunately, even the world's largest pharmaceutical is not immune to the loss of patents, and as soon as the company lost the exclusive manufacturing rights for the drug, Pfizer's profits collapsed 19%.
As of yet, Pfizer has not been able to recover from the loss of its best-selling drug. In particular, total revenue for the first nine months of this year fell 7% year on year as the company lost out to generic versions of both Lipitor and its Viagra drug.
Although the company has been hit hard by the loss of Lipitor, Pfizer still has the ability to research and develop new treatments that will hopefully fill the void. Indeed, the company currently has 81 new treatments within its development pipeline, up from 76 new treatments at the end of August. The company is investing heavily to stay ahead of the game.
All in all, while Pfizer's previous reliance upon Lipitor meant that the company did not look diversified, the subsequent loss of exclusive manufacturing rights for the drug has forced Pfizer to invest heavily in its treatment pipeline. Over time this should allow the company to develop a host of treatments that will increase the company's internal diversification and reduce its reliance on blockbuster drugs.
In conclusion to this two-part piece, diversification is potentially one of the most important requirements of successful investing. It's important to ensure that your portfolio is diversified outside of its domestic market and that your investments don't rely upon a single product.
Diversification is not so easy as it seems, but with a little extra work you can ensure that your portfolio is well diversified internationally and internally, allowing you to sleep soundly at night.