Conglomerates are companies that either partially or fully own a number of other companies. Not long ago, sprawling conglomerates were a prominent feature of the corporate landscape. Vast empires, such as General Electric and Berkshire Hathaway, were built up over many years with interests ranging from jet engine technology to jewelry.

Corporate hodgepodges like these pride themselves on their ability to avoid bumpy markets. In some cases, they have produced impressive long-term shareholder returns, but this doesn't mean corporate conglomerates are always a good thing for investors. If you're interested in investing in these behemoths, there are a few things you should know.

The Case for Conglomerates

The case for conglomerates can be summed up in one word: diversification. According to financial theory, because the business cycle affects industries in different ways, diversification results in reduced investment risk. A downturn suffered by one subsidiary, for instance, can be counterbalanced by stability, or even expansion, in another venture. In other words, if Berkshire Hathaway's brick-making division has a bad year, the loss might be offset by a good year in its insurance business.

At the same time, a successful conglomerate can show consistent earnings growth by acquiring companies whose shares are rated lower than its own. In fact, GE and Berkshire Hathaway have both promised—and delivered—double-digit earnings growth by applying this investment growth strategy.

The Case Against Conglomerates

However, the prominent success of conglomerates such as GE and Berkshire Hathaway is hardly proof that conglomeration is always a good idea. There are plenty of reasons to think twice about investing in these stocks, as illustrated in 2009, when both GE and Berkshire suffered as a result of the economic downturn, proving that size does not make a company infallible.

Investment guru Peter Lynch uses the phrase diworsification to describe companies that diversify into areas beyond their core competencies. A conglomerate can often be an inefficient, jumbled affair. No matter how good the management team, its energies and resources will be split over numerous businesses, which may or may not be synergistic.

For investors, conglomerates can be awfully hard to understand, and it can be a challenge to pigeonhole these companies into one category or investment theme. This means even managers often have a hard time explaining their investment philosophy to shareholders. Furthermore, a conglomerate's accounting can leave a lot to be desired and can obscure the performance of the conglomerate's separate divisions. Investors' inability to understand a conglomerate's philosophy, direction, goals and performance can eventually lead to share underperformance.

While the counter-cyclical argument holds, there is also the risk that management will keep hold of businesses with poor performance, hoping to ride the cycle. Ultimately, lower-valued businesses prevent the value of higher-valued businesses from being fully realized in the share price.

What's more, conglomerates do not always offer investors an advantage in diversification. If investors want to diversify risk, they can do so by themselves, by investing in a few focused companies rather than putting all of their money into a single conglomerate. Investors can do this far more cheaply and efficiently than even the most acquisitive conglomerate.

The Conglomerate Discount

The case against conglomerates is a strong one. Consequently, the market usually applies a haircut to the sum-of-parts value, which it frequently values conglomerates at a discount to more focused companies. This is known as the conglomerate discount. Of course, some conglomerates command a premium but, in general, the market ascribes a discount, giving investors a good idea of how the market values the conglomerate as compared to the sum value of its various parts. A deep discount signals that shareholders would benefit if the company were dismantled and its divisions left to run as separate stocks.

Let's calculate the conglomerate discount using a simple example. We'll use a fictional conglomerate called DiversiCo, which consists of two unrelated businesses: a beverage division and a biotechnology division.

DiversiCo has a $2 billion stock market valuation and $0.75 billion in total debt. Its beverage division has balance sheet assets of $1 billion, while its biotechnology division has $0.765 billion worth of assets. Focused companies in the beverage industry have median market-to-book values of 2.5, while pure play biotech firms have market-to-book values of 2. DiversiCo's divisions are fairly typical companies in their industries. From this information, we can calculate the conglomerate discount:

An Example of Calculating the Conglomerate Discount

Total Market Value DiversiCo:
= Equity + Debt
= $2 billion + $0.75 billion
= $2.75 billion
Estimated Value Sum of the Parts:
= Value of Biotech Division + Value of Beverage Division
= ($0.75 billion X 2) + ($1 billion X 2.5)
= $1.5 billion + $2.5 billion
= $4.0 billion
So, the conglomerate discount amounts to:
= ($4.0 billion - $2.75 billion) / $4.0 billion
= 31.25%

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 Image by Sabrina Jiang © Investopedia 2020

DiversiCo's 31.25% conglomerate discount seems unusually deep. Its share price does not reflect the true value of its separate divisions. It becomes clear that this multi-business company could be worth significantly more if it were broken up into individual businesses. Consequently, investors may push for divesting its beverage and biotech divisions to create more value. If that were to happen, DiversiCo might be worth closer examination as a buying opportunity.

The Bottom Line

The big question is whether investing in conglomerates makes sense. The conglomerate discount suggests it does not. But there may be a silver lining. If you invest in conglomerates that break up into individual pieces through divestitures and spinoffs, you could capture an increase in value as the conglomerate discount disappears. As a general rule, you stand to get greater returns when conglomerates break up than when they are built.

That said, some conglomerates do command a valuation premium, or at least a slimmer conglomerate discount. These are extremely well-run companies. They are managed aggressively, with clear targets set for divisions. Underperforming companies are quickly sold or divested. More importantly, successful conglomerates have financial rather than strategic or operating objectives, adopting strict approaches to portfolio management.

If you choose to invest in conglomerates, look for ones with financial discipline, rigorous analysis and valuation, a refusal to overpay for acquisitions and a willingness to sell off existing businesses. As with any investment decision, think before you buy and don't assume big companies always come with big returns.