In a corporate landscape littered with failed mergers and acquisitions, it's getting hard to argue the advantages of operating in diverse lines of business. Even if you pull it off, numerous academic studies conducted over the past decade suggest you'll pay a penalty in the stock market--a so-called diversification discount relative to more highly focused companies. No wonder countless firms have sought to "unlock" the value of important subsidiaries by spinning them off as separately traded entities, leaving both parent and child to operate with a more narrow focus.
Yet diversification continues to exert an alluring appeal. Why? Done well, it can help to smooth financial results for companies in cyclical industries. More broadly, it can allow firms in mature markets to grow their revenues far more rapidly than they could by hewing to their existing lines of business. For companies with excess financial and management capabilities, it may offer the only practical avenue for growth if there are no good opportunities to invest close to home.
And there is some evidence that conglomerates don't necessarily suffer a stock-price discount after all. Larry Shulman, a senior partner in the Chicago office of Boston Consulting Group, has studied the performance of the companies in the Standard & Poor's 500 stock index for the 10 years ended December 31, 1997. When he compared the total shareholder return generated by the diversified companies with that of the more focused companies, he found that, on average, the diversified companies performed in line with the S&P 500, earning 18.6 percent per year versus 17.6 percent for the index.
What's more, Shulman was able to identify a subset of 50 conglomerates--companies with at least four SIC codes--that substantially outperformed the S&P 500 over that 10-year period, with an average annualized return of 27 percent.
How can Shulman's research be at such odds with the academic literature? Most previous inquiries have taken one of two approaches, he explains. One uses price-to-earnings multiples to discern a bias against conglomerates. The other calculates the intrinsic value of a conglomerate's diverse businesses as if they were stand-alone companies, in order to arrive at a figure greater than the conglomerate's market capitalization.
The problem with the former approach, says Shulman, is that investors in the real world buy and sell stocks, not P/E ratios. As for the second approach, he notes that until somebody actually ponies up the cash to buy part of a diversified company, any guess as to what that part is worth is just that--a guess.
Shulman isn't suggesting that conglomerates are ipso facto better investments than focused companies, and therefore embody a better business model. In his 1999 study "Management Lessons of Premium Conglomerates," he also found a subset of 50 conglomerates that consistently underperformed the S&P 500 during the 10-year period in question. Still, his work suggests that companies that automatically shy away from diversification opportunities may be shortchanging themselves and their investors--especially if they are led by executives who are proficient in strategic thinking and capital allocation, and emphasize performance and accountability.
"If, in a nondiversified company, you routinely make decisions to back some product lines and move away from others, to put more capital over here and less over there, and to hold the managers of plants or products to absolutely rigorous performance standards, you have the discipline to run a diversified company," Shulman says flatly. "The single most important factor is being able to make the decision to put more and more capital behind your winners, and basically shut down or get rid of your losers."
THROWING GOOD MONEY AFTER BAD
Raghuram Rajan, the Joseph L. Gidwitz Professor of Finance at the University of Chicago's Graduate School of Business, says Shulman's findings dovetail in many ways with recent academic inquiries concluding that the diversification discount may be much smaller on average--perhaps 5 percent--than the 10 percent to 12 percent that previous studies had suggested. "That said, interest has now shifted to the variations in the discount," Rajan observes. "Why do some diversified firms trade at a huge discount, and others at a huge premium?"
Rajan says his own and others' studies into the phenomenon have backed the notion that poor capital-allocation decisions are a major culprit. "Diversified companies often allocate investment dollars to keep poorly performing divisions alive," he says. "The market would cut them off, but in a diversified firm, good money is thrown after bad."
More specifically, Rajan says, companies whose competing divisions have the greatest diversity of opportunity, in terms of industry growth prospects, tend to do the worst job of allocating resources internally. In other words, a company with one division operating in a high-growth industry and another in a low-growth industry will generally do a worse job of allocating capital than one with two divisions operating in industries with comparable growth prospects.
"Corporations tend to have an in-built sense of intrafirm equity," says Rajan. "They don't let any unit suffer overly relative to others, nor do they let any unit benefit too much relative to the others. If the firm has to tighten its belt because it suffers a big loss of value in one division, that tightening will usually spread throughout the firm, even though for sound economic reasons it should be focused on the division that is doing badly."
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