15/03/2007
Conglomerates – Discounting Diversity
Conglomerates generally find little favour with equity fund managers. However, their form is still relevant - especially in emerging markets. In our recent Global Insight research publication, we examined the justification for such a stance and how a business structure that has adapted to a range of markets and business cycles has performed.
In one sense the term 'conglomerate' is a flag of convenience, a way of lumping together diverse groupings of business irrespective of their origins or the way in which they conduct their business. We believe that this is a flawed approach – distinctions should be drawn between conglomerates that have grown organically and those which expand through serial acquisitions and between the different control models.
The case supporting conglomerate structures is often presented as a simple choice offering a spread of risk and diversified revenues. There are also arguments in management synergies, better support for research and development, and efficient use of capital. In addition, conglomerates are in a position to exploit funding sources from cash-generative parts of their portfolio to pursue value or new opportunities.
Our analysis indicates that within the business cycle the optimum structure of trading conglomerates waxes and wanes with interest rates. Divestments, spin-offs and restructuring are more likely when growth and earnings are slowing, while a recovery in fortunes may see conglomerates buying back subsidiaries that they had previously spun off. This pattern may also be sparked off by the subsidiary eclipsing the parent or posing a competitive threat to the core business.
Conglomerates often trade at a discount, which marks down functional rather than geographical diversification and can reflect the absence of a takeover premium. Mega caps or companies with stable strategic shareholders offer a comparable case in the lack of takeover potential, many exhibit conglomerate characteristics. However, for corporate bond investors the arguments for discounts are turned around. Conglomerates tend to be well-rated as the diversified income streams feed into more favourable credit risk profiles than 'pure' plays which face concentrated risks. If the conglomerate is large enough to deter takeovers, this adds to the appeal for corporate bond investors.
Conglomerate performance in Asia and the emerging markets surpasses that of developed market vehicles and of their own markets. This outperformance is linked to superior access to capital and favourable relationships with governments. Family/founder control, the dominant conglomerate model in emerging markets, seems to lend longevity compared with the 'professionally' managed or government-linked conglomerates.
For some Japanese and European conglomerates, further unwinding of cross shareholdings is seen as key to unlocking value. The trend to more active management and trading of portfolio companies is welcomed more by equity fund managers than by corporate bond managers for whom the conglomerate form is an attractive one.
Frances Hudson, Global Thematic Strategist, Standard Life Investments
First published in Pensions Management in March 2007
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