Las Vegas and the Ugly Truth about Diversification

The next big theme I want to talk about is: “Las Vegas and the Ugly Truth about Diversification.” I used to live in Las Vegas, and I love it there. It’s wonderful, beautiful—an amazing city. It’s one of the few places in the world where you can find the most amazing restaurants open at 6 a.m. Vegas is a boom and bust town. It does amazingly well when the world is happy and wants to travel and spend money. It does terribly when the world is not happy, cannot travel and does not want to spend money. I was in Vegas just before the financial crisis of 2007, running all the way into 2008 and 2009. I was there at the launch of some major brand, and everyone was so excited and telling me about how Celine Dion had just bought a house in Vegas. I don’t know if that was true—real estate agents will tell you anything to sell property. Then the financial crisis came and everything collapsed. Vegas said they would diversify—whether they actually meant it is another thing. They didn’t really diversify much, or at least the fruits of that diversification have not come through because during the COVID-19 lockdowns, Vegas suffered I think more than just about any other major city in the US because it’s a purely tourism-run city.

I want to talk about some of the misunderstandings about diversification. When I was a senior partner and talked to executives around the world, they would always tell me that they wanted to diversify. They didn’t want to be the CEO that wasn’t diversified.

Diversification doesn’t mean what many people think it means. It’s not about entering a new market or entering a new product. That’s not diversification—that’s entering a new market. Diversification is about financial diversification. For example, that means that when the returns from one division are going up, the returns from another division are going down. You’re hedging. That means that at no time do all of your revenue, earnings, profits, etc. collapse at the same time. Shareholders want this. Executives want this. But many of them do it incorrectly, and here’s the deep insight: There are two ways to diversify. One is that you hold one class of assets that go up when another class of assets go down. That’s what most companies do. They look for hedged assets. But what’s the ugly truth about this? In a well-diversified portfolio, you’re always going to have one class of assets performing miserably. Can you imagine if you’re the CEO of a company, and you stand up and say, “We’ve done a brilliant and amazing thing here. We have a diversified portfolio. That means that we’re never going to go through boom and bust cycles.” True enough, but it also means that at any given time, you’re investing half of your capital in businesses that don’t earn anything—or at least not enough. Nobody wants to be that CEO. That’s the ugly truth about diversification: it’s often done incorrectly.

Any CEO that tries to diversify is basically saying that they’re deliberately putting their capital into things that aren’t going to make money. So, how do you truly diversify? There’s another way. Going back to the example of one group of assets—or division earnings going up and the other one going down—there’s another way to do it.

What if when one division’s assets went up or down, the diversification play you have—the division you invest in—has what is known as stable or static returns? That’s a diversification as well. When one goes up, the other one is not moving in the same direction; it’s moving steadily because you’re not diversified if all your earnings move together in the same direction. So, what people do is find earnings that move in opposite directions, but then you’re damaging half of your capital. But what if your earnings and your other class of investments are just static and go in one direction?

If you follow all the programs we have on FIRMSconsulting.com, you know that I talk a lot about how I built my career as a corporate strategy partner, not on understanding the revenue side, but on understanding the risk side of strategy. This is the big insight I had, and I did a lot of this work with utilities. This was when climate change was already a big issue.

So you go to power utilities in emerging markets—and in the Western world—and they were producing a lot of coal-fired emissions because coal is, was, and will be for a long time a major source of fuel. I talked to these power utilities, and they’d always tell me the same thing: “Michael, tell me about the latest developments in utility strategy and least-cost planning.” Because that’s how utilities work. They want to know which source of fuel is going to produce the least cost. Because, obviously, they would want to burn whatever fuel that’s cheapest. That’s least-cost planning. If something is least cost, it doesn’t matter who they’re upsetting. It doesn’t matter how many environmentalists don’t want to be their friends on Facebook—they are going to build that power station.

I started thinking about the risk they’re introducing to their balance sheets. One of the deep insights I had is that many people are thinking about renewables incorrectly. The entire case for renewables being made at that time—and being made very badly—was that you need to invest in renewables because it’s the right thing to do; you’re going to save a polar bear.

The second big theme was: “In time, renewables are going to become so cheap and so cost effective that they’re going to be a least-cost alternative for you.” That’s not true. That wasn’t true then. It will probably be true in the future, but now, it’s not there yet, but we’re getting close.

The insight I came up with is that all utilities are looking at least cost. What if they looked at the risk? If you look at the biggest cost a utility incurs once it builds a plant, it’s the fuel cost. It’s gas, coal—a huge cost. Coal-fired stations are a massive cost. If you have a diversified utility portfolio of power stations, you’re going to have coal, nuclear, all kinds of fuels in them.

I showed them that most of these fields move in the same direction in terms of cost. When gas prices go up, coal prices generally go up. That’s not an opinion—you can model that and see it. But renewable fuel costs are free, which means it’s fixed. It’s always going to be free. That means when the price of coal goes up, the price of renewable—because it’s fixed and free—stays exactly the same. This means that the company’s cash flow at risk—the amount of cash you can lose at any time as swings in the fuel cost change—can be minimized if you add more renewables to your grid. So, it’s not about least cost. It’s not about how it will be cheaper in the future. It’s about if prices of commodities swing, commodities like coal feed the power station, if you add renewables to the grid, the swing can be smoothed out because you have renewables in the portfolio where the price doesn’t change.

That was a big insight at the time. It’s a big insight you need to think about. As you diversify, the point is not to get assets that move in opposite directions and commit half of your capital to value destruction. No. It’s about finding asset classes that are stable—they just move in one direction. Of course, the CEOs of those utilities were very, very happy with that thinking because you can think about the implications when you’re borrowing money on the capital markets and you can show investors that your cash flow at risk has been cut—whatever the percentage is. It affects credit ratings. It affects share prices. But also there is goodwill of the world finding a utility that’s investing in renewables, even though it’s not least-cost, and people saying, “Wow, you did this even though it doesn’t make any sense.” But, actually, it makes a lot of sense because there’s another benefit, and that’s diversification—but not in the way people are usually thinking about diversification.

This is an excerpt from Monday Morning 8 a.m. newsletter, issue #21. Many of you have found Monday Morning 8 a.m. so useful that you’ve asked us to release a book version of these newsletters. We’ve obliged and released a Kindle version, which you can find on Amazon under “Strategy Insights.” It contains the insights from previous Monday Morning 8 a.m. issues, edited into a bite-sized format that’s very easy to use. And you can learn about other FIRMSconsulting books here. 

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