How to Decide in Which Sector to Diversify?

How to Decide in Which Sector to Diversify?

When a firm decides to diversify there could be several possible factors to take into account when making the choice for the business or industry in which to diversify.

According to Neffke and Henning, the factor that matters most is skill relatedness. They argue that a firm will choose to diversify in areas requiring skills that are already held by its labour force. What they mean by relatedness is the collection of skills that a firm’s human capital already acquired and formed to achieve a competitive advantage. They hypothesize that the stronger the skill relatedness between the firm’s core activity and the activities in another industry, the higher the possibility of that firm diversifying in that industry (it should be mentioned that they consider diversification through internal development and not through acquisition or divestitures).
One other view is based on the market power perspective, which is focused on the dominance of large conglomerates in one market that allows them to tap into activities in other markets. This leads to the conclusion that firms that are widely diversified have the opportunity to “exert their market power across a larger number of fields, regardless of the type of diversification” (Neffke and Henning, 2013).
The resource-based view (RBV) considers diversification as a tool to use resources that are not currently used by the firm, or which are left idle by its activities (Penrose, 1959). This suggest related diversification as the excess resources of a firm could be usually used in businesses with similar activities.
The knowledge-based view (KBV) partially supports RBV in the sense that it considers knowledge and skills to be of a significant importance in a firm’s development and suggests that “relatedness based on human capital will capture the economies of scope in resources that are particularly strategically relevant” (Neffke and Henning, 2013).

Of course, not one single option supported by each of this views should be considered ideal for a firm that considers diversification without taking into account other external or internal factors that could influence that process.
Sources:
Neffke, F. and Henning, M. (2013) “Skill Relatedness and Firm Diversification”, Strategic Management Journal, 34, pp. 297-316
Penrose, ET. (1959) “The Theory of the Growth of the Firm”, Blackwell: Oxford, UK