536  Corporate Portfolio Strategy potential targets that perform well financially and are somehow related to the parent’s business lines. But through the best-owner lens, such characteristics might be less important or irrelevant. Potential acquirers might do better to seek a financially weak company that has great potential for improvement, especially if the acquirer has proven expertise in improving performance. Focusing attention on tangible oppor- tunities to reduce costs or on identifying common customers may be more rewarding in the long run than investigating a target for the vague reason that it is somehow related to your company. Companies following the best-owner philosophy are as active in divesting as they are in acquiring; they sell and spin off companies regularly and for good reasons. To illustrate, 50 years ago, many pharmaceutical and chemical companies were combined because they required similar manufacturing pro- cesses and skills. But as the two industries matured, their research, manufac- turing, and other skills diverged considerably, to the extent that they became distant cousins rather than sister companies. Today the keys to running a commodity chemicals company are scale, op- erating efficiency, and management of costs and capital expenditures. In con- trast, the keys to running a pharmaceutical company are managing an R&D pipeline, a sophisticated sales force, the regulatory approval process, and relations with government in state-run health systems that buy prescription drugs. So while it might once have made sense for the two types of business to share a common owner, it no longer does. This is why nearly all formerly combined chemical-pharmaceutical companies have split up. For instance, the pharmaceutical company Zeneca was split from Imperial Chemical Industries in 1993 and later merged with another pharmaceutical company to form As- traZeneca. Similarly, pharmaceutical company Aventis was split off from the chemical company Hoechst in 1999; it was later purchased by Sanofi Synthe- labo to create Sanofi Aventis, forming a bigger pharma-only company.6 Dynamic portfolio management has also driven the creation of three of the top four oil-refining companies in the United States, based on refining capac- ity. Marathon Petroleum, the largest U.S. refiner, was spun off from Marathon Oil in 2011. Phillips 66, the fourth largest, came into being as a spin-off from ConocoPhillips in 2012. Valero Energy, the number-two refiner, was originally spun off from Coastal States Gas in 1980. Valero grew into its ranking through major acquisitions in 2000, 2001, 2005, and 2011. Valero then spun off its gaso- line retailing operations in 2013, to become a pure refining company. In 2019, Marathon Petroleum also announced its intention to spin off its retailing op- erations. Executives are often concerned that divestitures look like an admission of failure, will make their company smaller, and will reduce their stock market value. Yet the research shows that, on the contrary, the stock market consistently 6 In 2011, Sanofi Aventis changed its name to Sanofi. The Myth of Diversification  537 reacts positively to divestitures, both sales and spin-offs.7 Research has also shown that spun-off businesses tend to increase their profit margins by one- third during the three years after the transactions are complete.8 Thus, planned divestitures are a sign of successful value creation. In recent years, prominent companies have decided that shrinking is a good thing. Notably, along with P&G’s 2014 announcement that it would dis- continue or divest 90 to 100 small brands, the company said it would sell its pet food businesses and spin off its Duracell battery business. This kind of thoughtful shrinking allows disparate businesses to focus on their unique needs and competitive situations. In another example of purposely shrinking, Kraft in 2012 split into two busi- nesses: Mondelez International and Kraft Foods Group. Mondelez is a global snack-food business selling cookies, crackers, and chocolate. Kraft is a largely North American–only grocery products company, focusing on cheese, meat prod- ucts, sauces, and coffee. Although both companies are in branded foods, manage- ment believed that the challenges and opportunities of the two businesses were different enough that they would be better managed as separate companies.9 The Myth of Diversification A perennial question in corporate strategy is whether companies should hold a diversified portfolio of businesses. The idea seemed to be discredited in the 1970s, yet today some executives still say things like “It’s the third leg of the stool that makes a company stable.” Our perspective is that diversification is intrinsically neither good nor bad; which one it is depends on whether the par- ent company adds more value to the businesses it owns than any other potential owner could, making it the best owner of those businesses in the circumstances. Smoothing Cash Flow Isn’t the Key Over the years, different ideas have been advanced to encourage or justify diversification, but these theories simply don’t add up. Most rest on the idea that different businesses have different business cycles, so cash flows at the peak of one business’s cycle will offset the lean cash years of other businesses, thereby stabilizing a company’s consolidated cash flows. If cash flows and earnings are smoothed in this way, the reasoning goes, then investors will pay higher prices for the company’s stock. 8 P. Cusatis, J. Miles, and J. Woolridge, “Some New Evidence That Spinoffs Create Value,” Journal of Ap- plied Corporate Finance 7 (1994): 100–107. 9 In 2015, Kraft merged with Heinz to form Kraft Heinz Company. 7 J. Mulherin and A. Boone, “Comparing Acquisitions and Divestitures,” Journal of Corporate Finance 6 (2000): 117–139.