It is easy to make a case for investing in conglomerates, and often it can be summed up in just one word: diversification. Ask any business professor or financial guru and they will tell you that diversification reduces risk. Indeed, financial theory dictates this, based upon the fact that the economic and business cycles affect each industry differently. So, ideally, a downturn in one particular segment of the business would be offset by an upswing in another arena. In real world terms, if Honeywell International’s (HON) aerospace division is having a rough go of it and posting deficits, the turbocharger unit may be able to counterbalance these losses with big profits.
Another strong argument for buying shares of conglomerates is their ability to use financial leverage to make numerous bolt-on acquisitions. Even though this may not be the most efficient method of generating growth, the majority of the most prominent companies in the diversified space use this strategy to expand their top and bottom lines year in and year out.
It is just as easy to make a case against investing in these behemoths. Peter Lynch, an author, investment expert, and leading proponent of “investing in what you know”, coined the phrase “diworsification” to describe companies that expand beyond their core competencies or get into new businesses that make existing ones worse. Many times, no matter how seasoned the management team is, resources and energy are poorly divided up between numerous subsidiaries. For example, time, money, and other resources are often plowed into the poorest-performing or legacy segments in hopes they will spur quick turnarounds. However, it is often argued that this wherewithal should be used to bolster the resources available to better performing businesses, as that would nicely enhance the value of the conglomerate.
Conglomerates are also hard for Wall Street to understand. As we at Value Line know, it is very difficult to pigeonhole these companies into one category and compare them to their peers. The Chief Executive Officers are far from experts in every one of a diversified company’s interests, too, which makes it difficult for those in the corner offices to explain the various moving parts to investors in conference calls and press releases. Conglomerates also have muddled accounting practices. All of this confusion regarding direction, philosophy, and recent performance causes investors, whether knowingly or not, to discount conglomerates relative to more focused companies. This, phenomenon, known widely as the conglomerate discount, has been approximated to be anywhere from 5%-10% of the total asset value, and even the most well-run companies tend to trade at a slim discount. While this should lead anyone to believe that investing in conglomerates is a bad idea, there is always a silver lining. If the discount becomes too wide, investor groups may begin pushing for the divestiture or spinoff of various parts to unlock value. Moreover, if one buys a conglomerate that is discounted and business performance improves markedly, the difference between market price and asset value could disappear, netting a bigger return.
All told, investors opting to invest in shares of a diversified company should do their homework, making sure management is disciplined financially, does not overpay for acquisitions, and is willing to part with underperforming entities. Investors should also realize that they can just as easily diversify their own portfolios by investing in the stock of smaller, more-focused companies.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.