The Conglomerate Discount: Is it Justified?

After making numerous acquisitions within the textile industry and gaining enormous personal wealth, Royal Little was wrestling with a conundrum by the early 1950s. His textile business’s competitive advantages were beginning to erode and the cyclicality and capital intensity of the business meant huge swings in profitability year to year.

Little’s solution was to diversify the operations of his company, Textron. Textron’s first non-textile acquisition was of Burkart Manufacturing in 1953. It would go on to make a slew of subsequent acquisitions of businesses in a variety of industries.

As a result of Little’s diversification strategy, Textron came to be known as the “father of the conglomerate.” The 1960s and 1970s saw a boom in the number of publicly traded conglomerates, which included ITT, LeaseCo, and Teledyne. Among their stated objectives was diversification, ensuring challenges at any one business could be offset by strong results elsewhere.

As time passed, Wall Street became disenchanted with the conglomerate structure. Evidence mounted that portfolio companies in conglomerates performed no better than stand-alone firms and the value of diversification became suspect since shareholders in a conglomerate could position their individual portfolios to achieve whatever diversification they desired. The strategy revolution also played a role in the demise of conglomerates with its focus on core competencies.

By and large, Wall Street’s distaste for conglomerates persists to the present day, with most conglomerates valued less than the total value of the individual assets they hold. If this behavior is taken as rational, it must necessarily hold that the wrapper of a conglomerate is value destroying and that the sensible path for conglomerates to pursue is a complete break-up of their assets. Should they?

In attempting to answer that question, the following conclusions are drawn, which are explained more fully below.

  • Not all conglomerates are managed the same way and some structures are preferable to other ones. In general, conglomerates organized to manage wealth through multiple market cycles and to engage in a long-term philosophy are superior to those whose value proposition rests on simply being bigger or in providing superior operating management.
  • Spin-offs and parent companies of spin-offs have tended to perform well historically because of financial factors that include the closing of the conglomerate discount and the opportunity to be acquired at a premium in the future rather than because they were managed better post spin-off.
  • The conglomerate discount embedded in shares of almost all publicly traded conglomerates most likely results from the constraints it would place on an investor’s portfolio, fear of unwise future investments by management, and the loss of control given that most conglomerates are controlled by a family or individual.
  • Offsetting these disadvantages, though, are the ability of conglomerates to invest wherever an attractive opportunity arises, the long-term outlook in which investments are made, and the reassurance that a vehicle for a family’s wealth is unlikely to be overleveraged.
  • In cases where discounts to net asset value persist, the most intelligent course for managers to take is to set a threshold under which they are willing to repurchase shares, provided that such a repurchase can be made while maintaining a strong financial position.

 

Defining a Conglomerate

Before answering the question as to whether all conglomerates should break themselves into smaller pieces, it is important to precisely define what is meant by the word “conglomerate.” If the definition is stretched sufficiently, nearly every large business would qualify as a conglomerate. The Coca-Cola Company, for example, owns hundreds of brands in its portfolio such as Coca-Cola, Sprite, Fanta, and Dasani. But these brands are managed collectively using a common distribution network.

For our purposes, a conglomerate is intended to mean any company that operates multiple business lines in different industries and manages those lines independently of each other.

Businesses operating as conglomerates can come in varied forms and pursue wildly different strategies. For the sake of simplicity, we can consider four categories of conglomerates.

One type of conglomerate is the Business Group, which are most popular in developing parts of the world. Most often, Business Groups will have interlocking ownership amongst its subsidiaries. Korean chaebols are the most well-known example of this, with groups like Samsung and Hyundai covering multiple legal entities in a variety of industries. Tata is another such example in India, while Grupo Sura is one in Colombia.

Many attribute the success of the Business Group in emerging markets to the lack of capital markets and regulatory regimes as robust as those in the developed world. Being a part of larger entity can ensure access to capital when needed and a seat at the table with regulators.

A second type of conglomerate is the roll-up. Roll-ups are sometimes used within a single industry and can be effective when, for example, a fragmented market is transformed by bringing together many small entities. It has also been used as a conglomerate strategy. This was the dominant form of the conglomerate during the 1960s and 1970s in the United States. Denied the opportunity to grow vertically by anti-trust authorities, some companies went the conglomerate route to increase their absolute size, supposedly to achieve scale efficiencies with respect to capital. In practice, it became a route to financial engineering, allowing companies who were serial acquirers to buy businesses with debt or with stock valued at a higher multiple than the target company.

A third type of conglomerate can be thought of as an operational conglomerate. These conglomerates have a strategy of harnessing superior management by applying their management techniques to target companies, increasing their performance. This essentially describes companies like General Electric and United Technologies.

Finally, we have the financial conglomerate, which are vehicles designed to manage wealth. The success of the entity depends on the ability of its leaders to successfully allocate capital over time, with the advantage of having the ability to move capital to industries that are most attractive in different environments and to pool wealth together in a way that gives them influence over their portfolio companies. Berkshire Hathaway is the most famous example of a financial conglomerate, but family run publicly traded companies also usually qualify, such as Exor and Investor AB.

The Conglomerate (Dis)Advantage?

With conglomerate structures having such important distinctions, it is not possible to impose a general rule that states that conglomerates do or do not create value.

Certainly, the roll-up strategy has been the most problematic historically. Being large simply for the sake of being large and building an empire does not in any way advantage the returns delivered to shareholders.

The operational conglomerate has also not consistently proven its value, namely that an entity can develop managerial advantages that cannot be replicated elsewhere. General Electric was famous for moving its managers throughout the organization and launching heralded programs such as six sigma. But, in the end, so many of its talent went on to lead other firms – presumably taking General Electric’s management approach with them.

The story is somewhat different when it comes to the remaining two structure: the Business Group and the financial conglomerate. While the success of Business Groups is often attributed to emerging market factors that are not present in the developed world, one possible factor in their success is present. As a corporate governance scheme, interlocking ownership within a Business Group protects its members from short-term shareholder pressure and frees management to pursue longer-term objectives.

This same facet is often present in financial conglomerates. Warren Buffett’s controlling stake in Berkshire Hathaway has meant there has never been a need to worry about quarterly earnings or a hostile takeover. The same is true of a company like Exor, which is controlled by the Agnelli family or other family-run businesses around the world. That freedom can be put to good or bad use depending on the quality of management, but often with their own money on the line, management finds ways to make superior investments over time.

So, while it is possible to identify factors that make it extremely unlikely for a conglomerate to achieve excess returns, it is only possible to say that conglomerates without those qualities have a reasonably good chance of performing quite well relative to benchmarks over time.

Spin-Offs: Through the Looking Glass

Examining spin-offs is an inverted form of looking at conglomerates. Spin-offs have gained a great deal of attention for producing superior stock market returns, with Joel Greenblatt first highlighting them in his book The Little Book that Beats the Market. Value investor Mohnish Pabrai has also benefited from investing in spin-offs.

Spin-offs can be good investments, typically cited as being so because becoming a stand-alone entity can increase pressure on management to perform and allows the new company to make capital planning decisions free from centrally planned larger organizations. They also have performed extremely well because investors owning the former parent are more inclined to keep their shares in it and sell off the shares they receive in the spin-off.

Results generated because of the latter reason do not tell us much about optimal firm structure, only that cheap stocks outperform the market. But the former reasons, if present, could only be true if the previous conglomerate was a sub-optimal structure.

An interesting study by Boston College in 2003 summarized its findings as:

“Recent empirical evidence, however, goes beyond showing the positive announcement effects of spin-offs on stock price. Cusatis, Miles, and Woolridge (1993) show that, in addition to the positive abnormal stock returns for parent firms on the announcement date, both spin-offs and their parents experience significantly positive abnormal returns for up to three years beyond the spin-offs’ announcement date. Further, both spin-offs and their parents experience significantly more takeovers than do control groups of similar firms. Finally, they show that spin-off/parent combinations not reporting takeover activity within three years do not have positive long-term abnormal stock returns.”

In other words, outperformance among spin-offs can often be traced to a closing of the conglomerate discount embedded in both the parent and spin-offs initial valuation as well as the increased probability that the resulting smaller entities will be acquired at a premium in the future. Spin-offs and their former parents which are not acquired, do not show better performance than the overall market.

This is important because examining the performance of spin-offs as a kind of inverted view of conglomerates does not lead to a different conclusion than directly examining the conglomerate structure. Businesses managed within a conglomerate do not tend to be managed poorly when compared to their peers. Indeed, the outperformance in many periods of spin-offs is owed to financial reasons: a closing of a stock market discount and the ability to once again garner an acquisition premium.

For businesses that were once a part of a roll-up or an operational conglomerate, that discount may be tied to uncertainty as to whether the company may make acquisitions at inflated prices and destroy future value since the valuation of targets does not seem to play a large role in the acquisition decisions of firms with these structures. (GE’s relatively recent acquisition of Alstom is a perfect example of this.)

There is also a larger factor which explains the discount given to conglomerates. A conglomerate represents a constraint on an individual investor’s portfolio decisions. Larger investors, which may trade based on sector rotations or special situations would never be inclined to buy the shares of any conglomerate.

These reasons – fear of unwise future deal-making, unwanted portfolio constraints, as well as the fact that minority investors must give up control (usually) to a controlling family or group – seem to be the largest sources of conglomerate discounts. Holding costs would be an additional factor to consider, but many holding companies have very low expenses and the fact that these can be measured precisely make it unlikely that this is the driving reason for conglomerate discounts.

Discounts in Today’s Conglomerates

Since Berkshire Hathaway is the world’s most famous conglomerate, a look at its current valuation versus its net asset value illustrates the conglomerate discount. Interestingly, for many years Berkshire Hathaway was said to have a “Buffett premium” because of Warren Buffett’s skill in allocating capital.

We can roughly gauge Berkshire Hathaway’s net asset value by comparing its businesses with publicly traded peers. That comparison suggests that Berkshire Hathaway’s businesses are being valued at 87% of the price they would be if they were separate entities.

The gap is even larger for a company like Exor, despite the fact that Exor’s net asset value can be more precisely measured that Berkshire Hathaway’s.

Exor is the vehicle by which the Agnelli family manages its wealth and in which it owns a 51% stake. Most of Exor’s investments are publicly traded: Fiat Chrysler, CNH Industrial, and Ferrari make up nearly 70% of its gross asset value. Fully-owned insurer Partner Re makes up another 26%.

Despite the transparency with which Exor’s net asset value is composed, it currently trades at only 70% of its net asset value, a rather astonishingly high discount. Similarly, Investor AB –a vehicle for the wealth of the Wallenberg family in Sweden – trades at 73% of its estimated net asset value.

Closing the Gap

Whether or not the discount to net asset value is warranted in these companies, it has existed for decades and so is unlikely to rapidly close. What is most important to investors is that controlling shareholders continue compounding wealth at an above average rate.

Interestingly, John Elkann, head of Exor, commented on the performance of family-run conglomerates in his most recent letter to shareholders of Exor. According to Elkann’s research, businesses engaged in diversified industries have tended to outperform the overall market. At Exor’s recent investor day, Elkann again emphasized this fact and even stated that Exor was interested in developing a security to index the performance of family led businesses (which would include European companies such as Investor AB and Bollore, Asian companies including CK Hutchinson and Jardine Matheson, and the American firm Loews, owned by the Tisch family.

Elkann’s explanation of the outperformance seems eminently reasonable and it includes (in paraphrased form): the ability of these companies to invest anywhere as opportunities become available, the conservative nature of their finances which prevent over-leveraging and serious erosion in shareholder value, and the much longer time horizon given to investment planning than is typical in a large corporation.

Exor is a fascinating company to consider in the context of conglomerates and spin-offs because while Exor itself has diversified holdings, the company has been simplifying its ownership structure and spinning off companies within its holdings. Over a decade ago, Fiat was an industrial hodgepodge. Now, Fiat Chrysler is primarily engaged in building mass-market cars and luxury vehicles through Maserati; while CNH Industrial contains Fiat’s legacy capital goods businesses and Ferrari is a pure-play on the iconic sports card brand. It is expected that Magneti Marelli, an auto components supplier, will be spun out of Fiat Chrysler next.

The most obvious way for a company like Exor to close the gap between its share price and its net asset value would be to engage in large share buybacks, but this would be challenging for Exor to execute since two of their three large equity holdings do not pay a dividend and so the cash filtering up to the holding company is only a few hundred million dollars per year. The company also spends around $90 million a year paying dividends itself. Currently, it is still paying down debt from its Partner Re acquisition. Gross debt now stands at € 3.3 billion, 14% of Exor’s capital and below the company’s long-term ceiling of 20%.

The balance sheets of Exor’s large holdings have become much improved recently, paving the way for a greater amount of dividends to begin flowing to the parent. Fiat Chrysler’s net industrial debt is now only €1.3 billion and it is guiding to have net cash of €4 billion by year’s end. If Fiat Chrysler paid out 40% of its € 5 billion in income this year, Exor’s share would be almost € 600 million. Simliarly, CNH Industrial’s net industrial debt should come in below $1 billion by year-end, while the company will earn almost $900 million this year but pays no dividend. Finally, Partner Re paid its parent Exor a dividend of $145 million last year compared to net income of $218 million. But, last year was a poor one for reinsurers and Partner Re’s normalized income is closer to $450 million – $500 million per year, meaning this year Partner Re may have the capacity to double the dividend it pays Exor from last year.

While the financial strength of Exor would never be endangered by Elkann, the evolution of its portfolio to more prodigious cash producers could certainly allow it to devote several hundred million dollars to share buybacks. An intelligent system could be put in place, similar to Berkshire Hathaway, in which Exor announces a price – say 80% of net asset value – below which it is willing to engage in share repurchases.

Regardless, while a small discount to net asset value may be warranted to a portfolio holding a large amount of publicly traded investments, there is no logical reason why a discount as large as 30% continues to exist for so many vehicles such as Exor that have a great track record in compounding wealth. Investors owning its shares are likely to participate in business results that modestly exceed global stock indexes even should the discount to net asset value never close.

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