Remembering the Conglomerates
by Michael S. Rozeff
by Michael S. Rozeff
The first stock market new era that I lived through and traded in was the go-go sixties. A major glamour group in those days was the conglomerates. Originating in the fifties, these were companies like International Telephone and Telegraph (ITT), Ling-Temco-Vought (LTV), and Textron that built themselves up by acquisitions of unrelated companies. Swift and Company, the old meat packer, at one point owned International Playtex and Avis. LTV, which began as an airplane manufacturer, acquired Okonite Copper Company and Jones and Laughlin Steel among others. These conglomerates often owned 30—40 or more separate companies operating in all sorts of markets and industries. After awhile, they would change their names to a nondescript entity. Swift became Esmark, Philip Morris (cigarettes) became Altria Group, Michigan Plating and Stamping became Gulf and Western Industries. The latter owned Paramount Pictures, Simon and Schuster publishing, plus companies in auto parts, zinc mining, cigars, sugar, etc. Conglomerates would buy out other conglomerates. Norton Simon bought Avis (it had been part of ITT), then Esmark bought Norton Simon, then Beatrice bought Esmark.
Conceptually, the conglomerates became somewhat like closed-end mutual funds, but with a greater hand in running the companies in their portfolios. Closed-end funds usually sell at close to book value or slightly less. But the conglomerates sold at premiums in the sixties. Furthermore, their operations were not especially profitable or safe, and they also carried more debt than average. They seemed overvalued. They were glamourous. Security analysts, who usually specialize in a few industries, were incapable of analyzing the operations of these diversified firms. Similarly, they could not decipher balance sheets that featured a bewildering list of securities arising from all the different acquisitions. Meanwhile, the heads of these companies became industrial heroes, although their names (Charles Bludhorn, James Ling, Harold Geneen) raise no eyebrows today.
For quite a few years, the conglomerate stocks rose and rose, and to this day I don't think anyone knows exactly why. What tempted investor psychology appears to be that the mother company seemed to promise new types of economies of scale, called synergies in those days. The conglomerate was said to borrow at lower cost than the companies it purchased. It was reputed to spread its operational knowhow to its benighted purchases. It would efficiently allocate capital internally among them, investors were told. It could bring name recognition through a corporate brand. It could purchase large amounts of advertising more cheaply. Sometimes the head of the company was thought to be a genius, a new King Midas, who could turn a zinc smelter into a household name. These were the hopes and dreams. They made some sense as all such stories do. How much sense, no one knew. There was, as is usual, uncertainty. But the market was a bull, and uncertainties evaporated before the winds of optimism.
Meanwhile there were realities. The conglomerates were paying big premiums over market value when they bought out companies. If there were to be economies, the selling company shareholders of the target firms were getting the lion's share. The sellers were receiving handsome premiums up front because the conglomerates were operating in competitive buyout markets. They bought companies at auction. Buyers bid up prices at auctions. Most of the gains, if they were real, were going to the target companies that were selling themselves to the conglomerates.
How one company could create value for its shareholders by paying a big premium over market value to buy another company in an unrelated industry was a mystery, then and now. When the conglomerate sold at a price/earnings ratio of 20 and bought a company with a price/earnings ratio of 10, the combination seemed to fetch a price/earnings ratio of 20! This financial legerdemain (or was it ledger-demain?) created value, for a while. It was not permanent. By 1970 the days of reckoning arrived and the conglomerates crashed along with many other stocks.
The company heads were empire-building. They were being paid according to the revenues they managed, so they grew revenues by acquisition. If Wall Street made their paper (stock) worth a lot of money, it made good sense, they thought, to issue more of it and buy real assets. It made sense for the managers who made more money. It made less sense for the shareholders who saw companies overpay for acquisitions. For awhile the roller coaster rolled upwards before reaching the crest and speeding downwards.
The conglomerates and financial writers manufactured rationales for their success, which seemed to be plainly evident in the rising stock prices. The companies had to be doing something right, or so it seemed. What was it? This was a new business phenomenon. Some of the rationales seemed real. Others were strained or implausible. In the heat of the moment, it was hard to tell one from another.
It seemed that small companies had higher borrowing costs, whereas the conglomerates could borrow at the best rates from large banks. If the bought-out firms had little debt, the mother company would borrow more against the new assets. The new money could then be used to buy out yet more companies. An added incentive for doing this was that the interest on the debt was tax-deductible. Tax code peculiarities encouraged conglomeration, which became a money pump.
The purchase accounting standards of the time, then as now paternally blessed by the SEC, allowed companies to increase their earnings on steady growth paths. Wall Street loves consistent earnings growth. It bespeaks lower risk, and lower risk bespeaks higher stock prices. Seeing through the accounting for dozens of acquisitions was exceedingly difficult. Most didn't try. Eventually, Abraham Briloff single-handedly exposed the accounting peculiarities in a series of articles in Barron's. He punctured the balloon and conglomerate stocks began to underperform the market.
The conglomerates advertised that they brought management expertise to the companies they purchased. They pruned them and ran them more efficiently. This made them worth higher price/earnings multiples, they argued. But it didn't make sense that executives knew how to run 40 different companies efficiently. The head of a conglomerate who knew the meat-packing business had no idea how to run a chewing gum company.
The idea was spread that the top management of the conglomerate ran an internal capital market. They were like a bank or a stock market, but smarter and better. They evaluated their children and decided who should get the larger allowances. They'd allocate capital to the individual companies efficiently. That was the theory. In practice, this had many problems. They couldn't keep track of the activities of all their acquisitions. They had problems melding 50 different accounting systems. When new managers and new groups of employees came on board, somehow internal politics, not economic efficiency, influenced the allocation of capital. The companies making more money (the cash cows) gave up money to the weaker sisters whose leaders specialized in political savvy rather than making money. It was hard to devise workable rules or criteria that governed capital allocation, and sometimes the top managers chose incorrect rules that fed money to the wrong enterprises in their fold. Without a stock market for each internal firm, it was hard to know the cost of capital for each of them; and allocating capital using the mother company's cost of capital gave too much capital to high-risk subsidiaries and not enough to low-risk subsidiaries. Maybe the internal allocation of capital wasn't so savvy after all as compared with separate firms.
Another theory was that the company was safer because it operated in so many different industries. This rationale overlooked the fact that any investor could far more easily diversify by buying the stocks than by having the conglomerate absorb the actual companies. No investor will pay a conglomerate premium for diversification when a mutual fund offers far more diversification for far less cost. When recessions arrived or even when they didn't, the strange thing was that this rationale failed to work anyway. One poorly operating segment could drag the entire company down! Occasionally, the conglomerate would discover that the prince it had purchased with high hopes was really a toad and no amount of kissing could transform it. If it were really a sturdy prince (a crown jewel), the winner's curse assured that they had paid top dollar for it.
As for the debt-capacity rationale, the idea that the conglomerate had a better shot at borrowing more money and borrowing it on better terms than the smaller companies it acquired — this was more plausible. But it was implausible that the financial synergies, such as they were, could possibly justify or account for the market value increases of these stocks. Anyway, was borrowing a lot of money a sound practice? What would happen if the economy should turn sour, which sooner or later it always did? Earnings would plunge. If the conglomerates were all that profitable, they should have been generating excess cash flow. They should have been paying down debt. Furthermore, merging many companies into one meant that the survivor would have a single ratio of debt to equity. Could this be optimal when different industries typically display different debt/equity ratios that are chosen in accordance with a variety of industry-specific factors?
Alternatively, if the conglomerates generated more cash flow than what they knew to do with, they should have returned it to the shareholders in the form of dividends or stock repurchases. This was the long-run way to create shareholder value. Unfortunately, the government's higher taxes on dividends and lower taxes on capital gains encouraged the companies to retain the cash flows and invest them as the conglomerates did. Indeed, some of the conglomerates had begun as mature companies with excess cash flow that they did not want to distribute so as to avoid taxes. Repurchases were not used as much in those days for fear that they would violate the government's rules that excessive stock repurchases were a disguised form of cash dividends. This fear vanished in the 1990's and companies began repurchasing far more stock.
There were other problems. The internal accounting and budgeting systems couldn't get a good handle on allocating costs across all the companies, and the central managers actually could not accurately tell the profits of the various divisions and subsidiaries. They were running little socialist economies in which they could not solve the calculation problems that befell the big socialist countries. They ran into incentive problems like those faced by socialist countries. They didn't know how to incentivize their internal managers or how to provide different incentives for managers of different sorts of companies. A well-run company folded into a conglomerate soon lost its initiative and drive. The conglomerates had problems integrating many different accounting systems and many different corporate cultures. Last but not least, when a company was merged, its stock disappeared. The company then lost one of the clearest signals of its success, its stock price.
Fortunately, the worst was not all that bad. The conglomerates always held the companies they had bought. There was hidden value in the portfolio always waiting to be unlocked. The time would come when it would be unlocked.
All along it made no sense for a conglomerate to pay a huge premium over market value to buy up another company. It was a big penalty to overcome via economies of scale. Often it couldn't be done. The shareholders of the conglomerate were lucky to break even on such a deal. Such buyouts couldn't create value for the buyers unless the stock market had mispriced the target firm and the buyer got it at a bargain price.
Eventually Wall Street marked conglomerate prices down along with other stocks. They did not withstand the bearish tide. The new era ended. Bear markets proliferated and turned into a secular bear market that lasted for 16 years. The period from 1966 to 1982 was rough sledding. Meanwhile academic finance came along. Having arrived after the conglomerate era, it did not pay as much attention to it as it merited. But it paid some. The research showed that, after the glamour period, conglomerates came to sell at a discount to what their pieces will bring if they are sold off in the open market. Like a closed-end fund, the whole was worth less put together than if taken apart. The joint operations and melding of disparate companies produced losses in shareholder value as compared with the values of the separate operations. This is still true today for companies like Time-Warner, but others like Berkshire-Hathaway, up to now, defy this property by holding a portfolio of highly profitable and motivated companies and operating them with little interference.
The conglomerates of the fifties and sixties got new management in the seventies, and the managers realized that they could make money simply by de-conglomerating. Thus began an era of breaking up companies into pieces that extended into the seventies and eighties. The conglomerate era began to run in reverse. The goal became to create sharply focused businesses. The old conglomerates sold and spun off units with abandon. They created value by doing so. New, stand-alone companies suddenly acquired the will to innovate and prosper when the managers could reap more of the benefits of good decisions and see less of it taxed away by central management. De-centralization worked. Buying spinoffs became a good investment strategy. The de-conglomerators were stanching the ongoing value-losses arising from too much conglomeration of operations. They were creating value and their stock prices rose apace. Esmark sold off company after company and its stock price rose and rose from its depressed depths. Even when companies that seemed only to be in one industry, like General Dynamics in the defense business, began to de-conglomerate, their stock prices rose dramatically. Business gurus noticed something they had missed before. Businesses that seem close together, like publishing books and publishing magazines, can be quite different. They frequently can be managed better by separating them. Conglomeration is a minefield of problems. The fact that conglomerate stocks that slimmed down and restructured went up so much in price suggested that a good deal of conglomeration had been destructive of value.
Are there lessons here?
Whenever a company begins to acquire others, let the investor beware. The first issue is whether real economies of scale or other benefits can be realized or not. The chances of this happening are much greater if the acquisitions are directly and closely related to the buyer's business. This is not that easy to judge. If a luxury hotel chain begins to acquire moderate hotels, are these closely-related? It takes different skills and cultures to run these two kinds of operations. They may not mesh as easily as surface indications suggest. If Time-Warner, already a media conglomerate, buys AOL, it's easier to understand that it's a flawed endeavor that will end up destroying shareholder value. This brings up the second issue, which is the price paid for an acquisition. It's very easy for managers to overpay in the heat of bids and counter-bids or even in private market deals. The third issue is that acquisitions are hard to digest. Costs crop up. In general, investors should be skeptical of firms that acquire other firms, unless the benefits are identifiable. If this is how the buyer intends to dispose of its free cash flow, the odds are not in favor of the buying company. Empire-building does not benefit shareholders. Far better to be invested in a target firm.
On the other hand, after the inefficiencies of conglomeration result in the stock price being beaten down, an investment opportunity arises. There is value waiting to be unlocked in such a company. If new managers or even the old managers switch gears and start a policy of selling off companies, this will create value. The stock price will rise. If the company seeks out an investment banker and formulates a plan for realizing the company's hidden value, this is a positive signal. Look for signs of a change in company strategy toward de-conglomeration. If there are no such signs or if the company continues to speak of acquisitions, the odds are the investor should stay away.
Markets make mistakes, that is, individuals who transact can err. Markets have to learn. They do learn. Sometimes the mistakes take a few years to become evident. Markets are not perfect. They don't know everything. As in the case of Enron, penetrating complex accounting can be worthwhile as Briloff showed.
Sometimes, more often than we may realize, large economic trends are induced or influenced by government rules and policies. If interest is tax-deductible and dividends are not, this may induce companies to borrow rather than pay dividends, and that may make it harder for investors to determine if a company's reported earnings are meaningful. If government or the Federal Reserve regulates bank loans, banks may be more willing to lend to larger firms; and this may induce large firm conglomeration. If government regulates broadcast media licensing, it may influence the costs of advertising to smaller companies. If capital gains taxes are relatively high, they may cause stockholders to defer realizing capital gains and stocks may rise too much. If tax rules allow tax-free exchanges in acquisitions, small companies in which owners have capital gains may have an incentive to sell out to larger firms. How much of conglomeration was driven by arcane tax laws rather than operational factors? How much economic activity today is driven by tax law and by arcane rules and regulations? It is hard to know, but we know that the effects can be enormous. The tax deductibility of company-supplied medical care insurance has ended up distorting the entire medical system of the U.S.
Human beings are adept at rationalizing all sorts of things they observe. The number of explanations of why conglomerate prices rose was large, and many of them had surface plausibility. Upon reflection, the order of magnitude of the proposed synergies could not reasonably account for the stock price increases. Some of the explanations did not make that much theoretical sense. But sober and orderly reflection was inundated by the sheer number of stories, the publicity, and the fact of rising earnings and rising stock prices in a bull market. Let the investor beware of being carried away. This is hard to learn. A simple rule of deferring any purchase one is anxious to make will help. A rule of weighing the prospective gains against the losses will help. Most of all, if one cannot understand the reasons for investing and if those reasons do not make sense, then don't invest. Warren Buffet always stresses the latter, which suggests that it is a very difficult rule to implement.
There are parallels between conglomerate companies and states. Both have rather small top management groups (like Congressional committees) that oversee diverse and unrelated programs. Just as conglomeration stifles value creation of the component companies, so do states stifle society's value creation. Just as de-conglomeration unlocked significant value, so will de-conglomeration of states do the same.
De-conglomeration in the modern era continues in new ways. It means creating businesses in which even the basic functions that used to be housed under one roof are separated. A business may farm out its accounting, its cash management, its production, its marketing, etc., or even sub-functions of these, in order to achieve efficiencies. The conglomerate idea has been tried and found wanting for the most part. Coordinated decentralization has the upper hand at the moment. Contrary thinking warns us that this too can be overdone.
The Austrian approach has merit. It suggests that nothing in business is a slam-dunk. How to lower costs will never be reduced to a formula found in a book. How to create incentives that motivate managers and employees to work together is an open book. The opportunities to finance enterprises in the internet world will produce many innovations. The ways in which companies produce and market products will evolve in unexpected ways. Entrepreneurs will continue to experiment with organizational forms in order to find the most efficient forms. The issue of how to organize human business activity will remain very subtle, involving information, valuation, agency costs, business operations, etc. What is inside a firm and what is outside a firm, where market prices stop and where they start are open matters. One wonders what a firm is. However firms evolve, those of us who made our first forays into the stock market in the sixties will fondly remember the almost daily excitement of a new conglomerate acquisition.
August 8, 2006
Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.
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