Reliance Industries neglects core strengths, seems to be in a ‘Diworsification’—or diversifying for the worse—phase
Rahul Sonthalia 11 May 2011

The company’s scrip has languished over the past year due to its inability to execute the massive diversification exercise that it has already launched, in retailing. And now Reliance is looking at further forays into uncharted areas—power generation, fertilizers, cement and the overcrowded telecom sector. Its projected growth rate is also not very promising

The term 'Diworsification' may sound a little absurd and unusual; but it has been coined by legendary fund manager Peter Lynch of Fidelity Magellan Fund. He argues that at some stage of its operations, a company starts diversifying its line of business and enters new territories.

As per his analysis, such diversification happens in unchartered areas and leads to the worsening of a company's profitability and growth and hence more often it is 'Diworsification'—i.e., diversifying for the worse.

The same seems to be the current phase which Reliance Industries is going through—the Indian stalwart with a staggering market cap of over
Rs3 lakh crore. Since its AGM (Annual General Meeting) in June 2010, the stock has fallen by something over 10%, while the Sensex has gone up by around 12% for the same period. Indeed, the stock is below what it was exactly two years ago—when the Sensex was at 12,600!

The main reason behind this underperformance over the past one year is the company's inability to execute the massive diversification exercise that it has already launched—in retailing. And now Reliance is looking at further diversification.

Last year, at the AGM, the company's head Mukesh Ambani unveiled a large number of new business plans, and most of them were into areas which were beyond the core strengths of the company, which is mainly into textiles, petroleum, chemicals and allied products. The company plans to enter segments like power generation, fertilizers, cement and the worst of all, the already overcrowded telecom sector.

Moreover, Mr Ambani also said that over the next decade, Reliance plans to double its total enterprise value and also received great applause for this statement from his shareholders. However, a simple back-of-the-envelope calculation will reveal that doubling enterprise value over 10 years is not that big a deal. If Reliance doubles its enterprise value in 7-8 years (this is an optimistic estimate) this means a Compounded Annual Growth Rate (CAGR) of around 9%-10%. So for an investor, Reliance is an investment which promises to offer around 9%-10% compounded growth over the next 8-10 years, only slightly better than the current bank fixed deposit rate of over 9% (which is almost risk-free).

Hence, the risk premium which an equity investment should offer is missing in Reliance and thus this is another strong reason for its underperformance.

RIL has underperformed and may continue to underperform. Why would a fund manager allot premium valuations for a company, which on the one hand is entering into new segments beyond its core competency, and on top of that, is saying that it would only grow at around 9%-10% compounded growth over the next 10 years or so?

An investor—or a fund manager-would rather buy faster-growing companies and examine the prospects of RIL which Mr Ambani is highlighting. RIL is one of the largest institutionally—held Indian stocks, both in India and globally, but no global fund manager will be foolish enough to pay 17 times P/E multiple for a company with this kind of expected growth rate and a 'Diworsification' business model.

Hence, the current correction is no signal to buy RIL; it's just the P/E re-rating which is happening... and which will continue to happen.

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