The Conglomerate's Fall From Grace: Two Tales of Diversification

By the time he had stepped down from the roles of Chairman and CEO of one of America's largest and oldest industrial companies in 2001, Jack Welch was arguably one of the country's most successful business men, a CEO superstar.  During the two decades he ran General Electric (GE), the stock rose 4000%.  Following his retirement from GE, Mr Welch was in hot demand on the public speaking circuit; many were prepared to pay handsome sums to get insights on how he had successfully managed a global, sprawling conglomerate.

GE represents an anomaly to text book theory and the trend in recent decades towards corporate focus. Long gone are the days where it was common practice for firms to undertake mergers and acquisitions in unrelated industries to boost flagging growth prospects. 

The development of Modern Portfolio Theory (MPT) through the 1950s and 1960s espoused the benefits of financial diversification; the value of corporate diversification is limited to the extent that investors can achieve diversification for themselves.  But at the time, the reality of high transaction costs was far different from the assumptions underpinning MPT; it was expensive for investors for investors to achieve home made or DIY diversification.  Corporates were all too willing through the 1960s and 1970s to help investors diversify by buying up target assets in unrelated industries.

By the 1980s, two developments had changed the conventional wisdom towards corporate diversification.  It had become apparent to investors that the conglomeration of corporate America has failed dismally.  Growth prospects for many diversified enterprises had not met expectations.  The failure stemmed from a lack of focus and the inability of internal capital markets to allocate resources efficiently across often disparate and unrelated divisions.

Second, the growing institutionalisation of the stock market had made it easier and cheaper for investors to achieve financial diversification themselves.  In particular, the launch of the world's first index funds in the 1970s by Wells Fargo and Vanguard was a game changer not only for the asset management industry but also for corporate diversification.  The ability to access low cost funds that tracked the S&P500 index meant that investors no longer had to rely on companies to undertake diversification themselves.

By the early 1990s, corporate America had undone most of the legacy of the conglomeration experiment.  Many diversified firms restructured voluntarily, selling off underperforming assets that were not central to their key competitive advantage.  And where management refused to see the writing on the wall, capital markets obliged, in the form of highly geared and aggressive private equity firms.  Some of these firms would spectacularly fail burdened by excessive levels of debt.  But investors had already delivered their verdict; corporate focus had won over corporate diversification.

The Schumpeter column in the Economist magazine suggested recently that the conglomerate might be staging a return ('From Dodo To Phoenix').  After all, the prospect of still subdued growth in nominal GDP around the world continues to undermine the corporate sector's ability to achieve meaningful revenue expansion.  Corporate diversification could help to boost flagging growth prospects and larger firms might be able to offer higher salaries than their focussed counterparts thus attracting and retaining the best minds the labour market has to offer.  The internal capital markets of conglomerates can also reduce reliance on at times fickle capital markets.

But Skeptikoi believes that a sequel to the first conglomerate wave is unlikely for three key reasons.  The costs of financial diversification have continued to decline sharply.  The advent of exchange traded funds (ETF) has revolutionised the asset management industry by increasing liquidity and transparency, as well as further reducing the costs of tracking a wider range of country and sector indices.  An S&P500 ETF typically attracts a management expense ratio of less than 10 basis points and can be traded on the market just as easily as a stock can. 

Second, a loss of investor trust since the financial crisis has meant that shareholders have little faith in CEOs to undertake value accretive acquisitions, particularly in industries unrelated to their core focus.  They are increasingly rewarding companies for returning cash or capital back to them in the form of share repurchases and higher dividend payments.  To this end, Skeptikoi expects the trend towards corporate focus to become even more entrenched; more companies are likely to break-up and sell off underperforming and unrelated assets to boost free cash flow and cater to investors' insatiable appetite for income.

Third, the financial crisis has failed to revive the fortunes of conglomerates.  If there was ever a time for conglomerates and their internal capital markets to shine, it was in the wake of the financial crisis, where external sources of funding either became prohibitively expensive or even dried up completely for smaller firms.  But if anything, their prospects have continued to deteriorate.  Emerging markets - where conglomerates are more common - have underperformed significantly in recent years.  And the great aura surrounding GE is no longer.  From the lofty heights of the credit boom where the stock typically traded at a 20% book premium to the broader market, it now trades closer to a 20% discount.  It remains to be seen what judgement history will deliver on the legacy of GE's superstar CEO.