conglomerates

Conglomerates

…are collections of businesses, often with little operational connection with one another, linked together by common ownership.  Outside the US, the controlling entity typically exercises its influence by taking large minority interests in the subsidiary firms;  in the US it’s more common that the controlling entity owns its subsidiaries entirely.

The former structure allows greater reach; the latter makes it easier to dividend cash from one arm to another without incurring tax.

the conglomerate era

Looking back, it’s often strange to see investment suppositions that, to us, are patently crazy but which investors of another era held as gospel.

In particular, there was a conglomerate “era” in the US during the 1960s.  This was a time when Wall Street thought that there is such a thing as “pure” management, which could be applied by expert practitioners to all kinds of businesses, no matter what they were.   So, a management expert could run, say, a movie studio without knowing anything about entertainment, or head a department store chain without knowing anything about fashion or real estate or retailing, or a lead computer chip company without knowing anything about coding or chip fabrication or materials science.

What were these “pure” management skills?  Allocation capital was one.  Your guess is as least as good as mine about any others.

During that period–a decade before I entered the stock market, so I’ve only read about it–conglomerates traded at a premium to the sum of their parts.

Maybe 1950s-style conglomerates made some sense.  I don’t know.  But their executives soon worked out that they could use debt to make acquisitions that would give a (temporary) boost to ep that would get their firm a higher earnings multiple.  So companies like Gulf and Western, ITT, National Student Marketing and Textron turned themselves into M&A machines.  As long as investors believed in the supposed alchemy of management, the worst low-PE dross a conglomerate held its nose and acquired, the greater the gain from multiple expansion when those earnings came under the conglomerate umbrella.

This all ended in tears in the late 1960s, through a combination of higher interest rates, the dead weight of senseless acquisitions,and the inability of conglomerate managers to improve businesses they owned but didn’t know the first thing about, that caused the conglomerates to crater.

today’s view

Today’s view is that conglomerates should trade at a discount to the sum of their parts.  It has its roots–not in the companies per se–but in the idea that investors want to fashion portfolios for themselves, not buy pre-assembled packages.  Off-the-rack conglomerates should be worth less than bespoke portfolios.

One of my favorite examples of this belief (which I think is basically correct) comes from one of the old opium trading companies in Hong Kong, Swire Pacific.  At one time, Swires was a property development company + an airline.  The first component is income-oriented and buttressed by a steady stream of rental payments.  The other is a highly economically-sensitive industrial.

Income-oriented investors, the argument goes, must be compensated through a lower overall PE for having to hold the airline component of Swires they don’t really want.  Similarly, more adventurous investors have to be compensated for being stuck with an income vehicle they don’t want.

Therefore, the parts separated should be worth more than the two together.

In fact, when Swires announced it would seek a separate listing for Cathay Pacific, the stock rose by 40%.

 

Tomorrow, Disney as a conglomerate.

 

 

 

 

2 responses

  1. Funny, I was just reading about Teledyne.

    I wonder how much of the buyback he did int he 1970s was a reaction to a highly unpopular style of investing.

    Isn’t Berkshire just a conglomerate? A lot of private equity? I always read that era as the ability to borrow cheap, tax deferral and raise prices, but I guess that is more today than the 1960s.

    I did have a theory in my corporate finance class that a conglomerate would get a cheaper rate of capital, but that was just a theory.

  2. Thanks for your comment. I think it’s correct that a conglomerate can raise capital more cheaply than many, and in some cases, all, of its components. Internal allocation of cash flow is also one of the key tasks of central management of conglomerates.
    The biggest problem with the 1960s conglomerates, and the operating reason they failed, was that central management were often financiers, who had very little practical understanding of the businesses they controlled. So their ideas of which divisions should get capital were often superficial.

    Berkshire is an interesting case. It is a conglomerate, as you point out. It is marketed as being an investment company, however, managed by the “Sage of Omaha.” That’s even though there’s no adequate disclosure of Mr. Buffett’s investment performance (which my sense is has been sub-par for a long time, factoring out the use of financial leverage).
    In today’s world, investors generally want to create the portfolio themselves rather than have a corporate executive do it for them. So they tend to favor highly focused companies over more diverse ones.

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