Investment strategy: “Breaking Up Is Hard To Do”

The 10 conglomerates followed by The Investment Reporter have out-performed the market recently. But they can suffer from some of the drawbacks outlined below. Often strategic investment planning for ‘De-conglomeration’ can deliver rewards to shareholders. (Sorry, Neil Sedaka, but your girlfriend got it right.)

Conglomerates (which own companies in different industries) have fallen out of favour for years. Here are disadvantages conglomerates can face.

First, it’s hard for management to intimately know many industries. As a result, there’s a risk that a lack of deep knowledge by management will lead to poor performance. Especially if a bureaucratic structure prevents each company from moving as fast as its independent competitors. More important, even if management knows each industry well, the demands of running many businesses can spread management too thinly across the conglomerate.

A company whose strategic investment objectives lead it to make acquisitions outside of its industry is often headed for disaster. Think of real estate developer Robert Campeau. When he bought U.S. retail firms (an industry he didn’t fully understand) in the late 1980s, Campeau Corp. collapsed.

Conglomerates rarely fire on all cylinders

Second, different companies, of course, face different prospects. This means that troubled companies can hurt the performance of the conglomerate.

Consider, for instance, General Electric Company (NYSE─GE). During the last financial crisis, GE’s enormous capital division hurt its overall earnings. In 2007, for instance, GE earned $2.20 a share. In 2008, by contrast, its earnings fell by 19.1 per cent, to $1.78 a share. In 2009, its earnings plunged by more than 42 per cent, to $1.03 a share. It was only in 2010 that the company started to recover. In 2009, it slashed its dividend due to its deteriorating earnings. This marred GE’s formerly excellent record of raising its dividend each year for decades.

Spin-off investment strategy added value

Third, conglomerates often fail to reap the anticipated ‘synergies’. That is, their businesses do not always fit well together. Even where synergies do exist, it’s not always to the benefit of the company’s strategic investment objectives.

A case in point is PepsiCo Inc. (NYSE─PEP). PepsiCo used to own Pizza Hut, Kentucky Fried Chicken and Taco Bell. This, of course, gave it outlets for its soft drinks. But some restaurant chains punished PepsiCo—whom they saw as a competitor—by offering Coke’s drinks instead. Potential conflicts of interest disappeared after PepsiCo spun off the restaurants as Tricon Global Restaurants (now Yum! Brands). These restaurants have also improved their own performance since becoming independent.

Fourth, investors can diversify as they see fit by investing in “pure plays” (where a company operates in one industry). Today, for example, you can gain exposure to the beer industry by buying Molson Coors Brewing (NYSE—TAP). In the past, buying Molson would have forced you to have exposure to many companies—including specialty chemical company Diversey (which suffered heavy losses). Molson’s decision to return to its roots in brewing beer likely explains why its share price keeps rising.

“Breaking up is hard to do”—but very profitable

These disadvantages may explain why many conglomerates trade at a discount to the value of their underlying businesses. Just keep in mind that what we call ‘deconglomeration’ can present profitable opportunities. This means that you can often make a strategic investment in assets at deep-discount, 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.

The shares of the parent companies can rise, such as Molson Coors Brewing. Second, spinoffs can unlock value, as with Toromont Industries’ distribution of Enerflex.

Canadian conglomerates we like include Atco Ltd. (TSX─ACO.X), Fortis Inc. (TSX─FTS), Power Corporation of Canada (TSX─POW), Power Financial Corporations (TSX─PWF) and Toromont Industries (TSX─TIH). 

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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