Can conglomerate stocks turn toads into princes?

Experience has taught us, and billionaire Warren Buffett, that bad acquisitions create a bad conglomerate stock. But a company can improve its chance of success by making acquisitions within its industry. Companies that acquire disparate businesses, particularly those in which they have little or no expertise, will see their conglomerate stock trading below break-up value.

ConglomerateStocksWarren Buffett, of course, became a self-made billionaire by making smart investments in the stock market. One of the secrets to his success is that he’s wary of companies that go on acquisition binges.

In his inimitable style, Mr. Buffett has written: “Many acquisition-hungry managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations.

“Initially, disappointing results only deepen their desire to round up new toads. Ultimately, even the most optimistic manager must face reality. Standing knee-deep in unresponsive toads, he then announces an enormous ‘restructuring’ change. In this corporate equivalent of a ‘Head Start’ program, the [chief executive officer] receives the education but the stockholders pay the tuition.”

Acquirers should stick to their industry

In fact, studies of mergers and acquisitions show that two-thirds of them end up badly. But some acquisitions are more likely to succeed than others. One factor is whether the acquirer sticks to its industry. The fact is, a company that buys a competitor has a better chance of success. Certainly its chances for success are better than for companies that buy businesses they know little or nothing about.

Laidlaw Inc., for example, was doing well operating school buses. But it acquired an industrial waste-management company and an ambulance service in the US—businesses it knew nothing about. This and the excessive debt it took on to make these acquisitions ultimately led to the company’s demise.

Some companies refuse to admit that they’ve made a mistake. Rather than sell a business they know little about, they keep it. Do this often enough and you end up with a conglomerate.

What’s known as the ‘conglomerate discount’ means that conglomerates often trade for less than the combined values of the underlying businesses. The solution is to break up the conglomerate and spin off the businesses to the shareholders.

These businesses need no kisses from acquirers. All they need to turn into princes is their freedom. At that point, they can make decisions that pay off for their easier-to-understand companies. There’s no need to justify these decisions since they no longer report to a higher level of management.

This is why conglomerates often trade below the value of their underlying businesses which means that you can often pick up assets at bargain prices.

As a result of this discount many companies feel pressure (particularly from large institutional investors) to raise the value of their shares by ‘de-conglomerating’. When this happens, shareholders can reap big profits.

6 successful conglomerate stocks to buy

There are, however, some successful conglomerates we like. They include these ‘buy’-rated Canadian Key stocks:

■ Atco Ltd. (TSX—ACO.X) which will recover along with Alberta’s economy. It raises its dividend every year;

■ Fortis Inc. (TSX—FTS) which is expanding profitably in the United States and raises its dividend every year;

■ Power Corporation of Canada (TSX—POW) which yields an attractive 4.8 per cent; and

■ Toromont Industries (TSX—TIH) which is a ‘buy’ for further long-term share price gains and modest, but growing, dividends;

and these ‘buy’-rated US Key stocks:

■ The Walt Disney Company (NYSE—DIS) which is a ‘buy’ for rising dividends and price gains; and

■ General Electric (NYSE—GE) which is also a ‘buy’ for rising dividends and price gains.

This is an edited version of an article that was originally published for subscribers in the August 18, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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