Conglomerates or companies engaged in a variety of industries and businesses have the potential to grow their earnings at a brisk pace. However, budding investors should realize that there are also sizable risks that go along with investing in a conglomerate. Read on to learn the risks involved in investing in these complicated giants.

Acquiring Problems
By having its hands in multiple businesses, a conglomerate may increase its potential to generate income for its shareholders, and in some cases reduce its overall earnings cyclicality. However, sometimes conglomerates become involved in so many businesses - each involving multiple disciplines, making it difficult for management to get its arms around all of the companies it has under its umbrella. (For more insight, see The Ups And Downs Of Investing In Cyclical Stocks.)

It may also be hard for a centralized management team to get a handle on what drives each business in terms of preferred suppliers, operating costs, the dynamics of that industry, and so on. By extension, that can be a problem because in order to maximize growth of the overall conglomerate and ultimately build shareholder value, management must have a good grasp on each segment and the ability to be "hands on".

This is not to say that conglomerates are destined to be failures. To the contrary, there are many conglomerate firms that have fared well throughout the years, such as General Electric Co. (NYSE:GE), which operates in areas including medical devices, industrial generators, engines and solar panels.

However, even respected firms that are known for their due diligence and integration successes have become entrenched in businesses that they couldn't quite integrate successfully. (For related reading, see Introduction To Diversification and The Dangers Of Over-Diversification.)

Staffing Problems
An organization's most precious resource is usually its human capital - the people that make the products, sell the services and ultimately help bring revenue in the door. In fact, that is why companies, more specifically human resources, will do their utmost to make sure that the ranks are always well staffed.

However, with multiple companies and operating segments, staffing at conglomerates isn't so easy. It may become even more difficult if an acquisition-hungry conglomerate develops a reputation for firing swaths of people after closing a deal. In fact, it's not uncommon for some workers to jump ship once they know a conglomerate has its sights on their company.

This issue isn't just related to human resources. Keep in mind that recruiting, hiring and training individuals can cost a great deal in terms of an organization's overall time and its money.

Accounting Issues
Every company has its own way of recognizing revenues and booking expenses. That said, it can be extremely hard to blend those accounting methods together and can make it difficult for Wall Street analysts that follow conglomerate-type companies to understand all of the methods being used.

But even beyond the problems associated with multiple accounting methods is the question of security and oversight. In other words, when an organization has numerous locations throughout the country or throughout the world, it is hard to ensure that the individuals that maintain each segment's books are being honest and are using proper accounting methods.

Even when looking at GE, analysts have often criticized management's ability to clearly state the operating results of the company's myriad of businesses. It simply becomes a time-consuming effort to evaluate each business segment on its own merits, compare it to relevant peers in the industry and determine whether managers are allocating resources in that division in the most optimal way for shareholder growth.

Hard To Be the Best
Being a "jack of all trades" isn't necessarily a bad thing. Again, when an organization has its hands in multiple businesses, it has the potential to reduce the cyclicality of its net earnings.

However, when an organization has several businesses under its belt, it can be hard for management to concentrate on building out one particular business. By extension, this may prevent the company from becoming (or remaining) the best in any one business.

Investors tend to flock to companies that are best in class, not secondary or tertiary players.

Hard to Evaluate
On Wall Street, analysts are trained and charged with following a certain sector or industry. For example, some analysts follow automakers, while others follow steel makers.

Because analysts tend to specialize in such ways, few are permitted to follow conglomerates.

For example, some businesses are valued on a price-to-sales or a price-to-book value basis, such as retailers. Other businesses, such as gaming and entertainment companies use the popular price-to-cash flow metric. But what happens if the conglomerate has many different types of businesses under its umbrella? What's the best method to use for the overall company? And how do you compare its value with that of other conglomerates?

Again, this can be a major stumbling block in terms of garnering Wall Street sponsorship, but on the positive side, the sheer size and deal-making ability of conglomerates usually keeps the investment banks eager to render their services.

True Value May Be Realized by a Breakup
Because it can be hard for a conglomerate to gain analyst sponsorship, and/or to ever have the full value of its assets realized by the investment community, it may have little choice but to split apart, and let each segment trade as a separate entity.

This can be a positive experience for shareholders, but it often takes years for management to appreciate this strategy and fully act it out.

Bottom Line
Conglomerates have the potential to generate large sums of money for their shareholders, but along with that opportunity comes risks that all prospective investors should consider.

For more insight on this subject, see Conglomerates: Cash Cows Or Corporate Chaos?

Related Articles
  1. Stock Analysis

    From Shampoo to Soup, Unilever Has it Covered (UL)

    Open your fridge, your pantry, your bathroom cabinet and you'll find the Unilever logo. Here's how the company got so enormous.
  2. Investing

    How to Attend Berkshire Hathaway's Annual Meeting (BRK.A, BRK.B)

    An overview of what is required to go to the Berkshire Hathaway Annual General Meeting.
  3. Investing

    6 Wholly Owned Subsidiaries of Berkshire Hathaway (BRK.A, BRK.B)

    A look at some of the more than 50 privately held companies completely owned by Berkshire Hathaway.
  4. Investing News

    How Disney (DIS) Continues to Deliver

    The Walt Disney Co. is only an animation studio in the same way that Johnson & Johnson is only a baby powder manufacturer.
  5. Stock Analysis

    General Electric Stock: A Dividend Analysis

    Read a detailed analysis of the dividend policy of General Electric Company, and explore a comparison of the dividend policies of its competitors.
  6. Stock Analysis

    What's Behind GE's $32 Billion Deal With Wells Fargo

    GE is a 123-year-old blue chip mainstay, with some radical plans for the future--as evidenced by Wells Fargo's $32 billion purchase of several of GE's finance-related businesses.
  7. Stock Analysis

    How Dow Chemical (DOW) Makes its Money

    An in depth look at how Dow has made itself vital to so many industries in its 118 year history.
  8. Economics

    What's a Conglomerate?

    A conglomerate is a corporation that’s comprised of several different independent businesses.
  9. Investing

    Charles Koch Biography

    Charles de Ganahl Koch is the CEO and co-owner of Koch Industries, an oil and industrial conglomerate that ranks as one of the largest privately held companies in America. While he and his company ...
  10. Investing

    Is Alphabet the Next Berkshire Hathaway?

    Google has made headlines for self-driving cars and biotech products, but the most profitable part of the business remains the advertising connected with its search engine.
  1. What is the difference between a green field and a brown field investment?

    Green-field and brown-field investments are two different types of foreign direct investment, or FDI. Green-field investments ... Read Full Answer >>
  2. Why is the 1982 AT&T breakup considered one of the most successful spinoffs in history?

    AT&T had a history reaching back to 1885 and, as a government-supported monopoly, was a highly profitable company. Colloquially ... Read Full Answer >>
  3. What are the differences between affiliate, associate and subsidiary companies?

    All three of these terms refer to the degree of ownership that a parent company holds in another company. In most cases, ... Read Full Answer >>
  4. How do businesses decide whether to do FDI via green field investments or acquisitions?

    When businesses decide to expand their operations to another country, one of the more important dilemmas they can face is ... Read Full Answer >>
  5. Are domestic and foreign subsidiaries included on a company's financial statements?

    A subsidiary is a company that is controlled by another 'parent' company. The subsidiary acts and operates like its own entity ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center