Conglomerates vs Spinoffs - which creates more value?

[scorpioncapital]

Does anyone know if Buffett has ever weighed in on the argument of conglomerates vs spinoffs? I've seen several academic studies showing that conglomerates generally suppress maximum value (a discount) while spinoffs tend to release this value. Yet, there are still quite a few conglomerates and watching their spun-off brothers and sisters in the market go up in value more than the sum of the parts can make shareholders scratch their heads as to why conglomerates even exist. Is there a certain inertia to empire building that some managements strongly believe while other managements simply do not care if their assets are under one roof vs many independent ones?

[Palantir]

Management may simply lack the skill or attention to manage companies in different industries. Berk can get around this because WEB isn't directly involved in the underlying firms.

 

Imagine a shipbuilder and a toothpaste maker run by the same management team. In theory, it can be profitable....but would you think the management would have the skills for it?

[scorpioncapital]

I'm thinking insider ownership may have something to do with the decision to empire build vs split up. Suppose you own a large stake in a conglomerate, if you split it up, you keep a stake in each "child" co. but if you held virtually no shares, the management would just be splitting it to shareholders and possibly reducing their compensation at the parent level. On the other hand, you could make the case for the opposite scenario as well, getting a big payoff for splitting up.

[KCLarkin]

WEB and CM talk a great deal about the institutional imperative. Basically, this is just a principal-agent incentive problem. Management is rewarded (financially and emotionally) for getting bigger. Conglomerates are generally sub-optimal for shareholders.

 

There is one edge case where conglomerates create value -- when they have a skilled capital allocator. A standalone company will generally reinvest capital and cash flow into the existing business, no matter how bad the business is. The Outsiders are able to redeploy this capital to generate higher returns.

[Zorrofan]

Management may simply lack the skill or attention to manage companies in different industries. Berk can get around this because WEB isn't directly involved in the underlying firms.

 

Imagine a shipbuilder and a toothpaste maker run by the same management team. In theory, it can be profitable....but would you think the management would have the skills for it?

 

The argument for conglomerates is that segments (divisions) may be counter-cyclical to each other.....for example at a certain point in the cycle shipbuilding will generate large profits while toothpaste may be going through a low point due to competitive markets. Latter when shipbuilding takes a turn down toothpaste may be entering a more profitable part of the cycle. And why can't each division have a decentralized management team ala BRK?  Doesn't value creation have more to do with quality of management than with the number of divisions they have?

 

cheers

Zorro 

[scorpioncapital]

I'm thinking about companies like Goldman, Brookfield, Leucadia, Harbinger, Loews, Ocwen as examples. Here you have a motley crowd of varying strategies. Brookfield and Ocwen have generally spun-off large portions of their assets and kept a small interest either directly or as founding shareholders. Companies like Loews, Berkshire,  and Leucadia have generally - at best, held minority interests in public stock but for the most part have kept it all together. Goldman may be a conglomerate in financial services with asset management division, investment banking, etc...It really seems the spinoff crowd has some distinct valuation advantage in the market, perhaps with the exception of Berkshire. I can see one case where a conglomerate might work - as an incubator of growing new businesses to spin-off later.

[merkhet]

I'll quote what Marty Whitman once said to me when I asked him about conglomerate discounts. His response was "It's funny you mention that because I still remember conglomerate premiums."

 

I suspect the answer to your question has to do with a combination of the subsidiary's expected growth rate, the subsidiary's capital intensity and the abilities of the capital allocator at the helm.

[Guest longinvestor]

There is a difference between a conglomerate and a collection of businesses. Where the units are run by owner-operators just the way they always were.

 

 

[peter1234]

There is a difference between a conglomerate and a collection of businesses. Where the units are run by owner-operators just the way they always were.

 

Agreed.

 

Maybe size of headquarters gives you an indication of how lean the company is.

[intothebreach]

In theory, there should not be any difference between the two, but in practice spin-offs usually have the edge. Past a certain size, bigger actually get worst due to complexity and loss of visibility creeping in, departmental infighting, etc. Very often, you also get bigger because the people in charge either want to build an empire, or are actually compensated for growth rather than more sensible performance metrics. Sometimes conglomerates actually hide value due to a hidden assets, or even potential spin-offs.

 

Spin-offs actually have some structural advantages for investors due to forced sellers, less analyst coverage, a more focused management team that no longer have to fight for capital of departmental support, etc. (there is another thread where the benefits of spin-offs have been very well explained).

 

However, just as you have Berkshire, Singleton's Teledyne and others, some conglomerates do function well, provided they have sensible management at the helm, just as some spin-offs are doomed from their get go due to debt loads, or poor business prospects.

 

I have worked with very large Canadian and American businesses, and more often than not, bigger is unfortunately synonym with dysfunctional (dysfunctional can still be very profitable, just a far cry from what the true business potential would/should be.) In the end, it really depends on the perspective: bigger is often not a bad thing for management, but as an investor, I'll usually look first at spin-off before conglomerates.

[Guest longinvestor]

There is a difference between a conglomerate and a collection of businesses. Where the units are run by owner-operators just the way they always were.

 

Agreed.

 

Maybe size of headquarters gives you an indication of how lean the company is.

 

+1. Abdication rules.

 

What's in it for the owner-operator to become part of the collection? Iscar is a perfect example. Since coming under the Berkshire fold, they have strung together an impressive collection of businesses around the globe. Tungaloy, Taegutec, Ingersoll etc. These are the emerging powerhouses in Asia where most manufacturing happens these days. Would a standalone Iscar have been able to do this? Likely not.