On Diversification, Conglomerates, and Consistently Superior Returns

I wrote this recent post reviewing a NewYork Times piece on GE and its CEO, Jeff Immelt. As I reflected on it, this passage from the Times piece struck me as all wrong (the italics are from the Times article, the quote preceding it my text),

"Immelt, according to Schwartz, argues for keeping GE intact as follows,

"In defending their stance, Mr. Immelt and other current executives don’t fall back on Mr. Welch’s no-surrender, last-man-standing rhetoric. Instead, they make a more subtle argument against breaking up the company: Not only does being a conglomerate help G.E. ride out the inevitable ups and downs of the economic cycle, it also creates those elusive synergies that most other companies only talk about." "

This is simply wrong in today's capital markets. It may have been true forty years ago, as I wrote here and here. But no longer. As I wrote in that second linked post,

"Simply put, corporate diversification for cash flow smoothing has been a discredited management approach for creating consistently superior total returns for some time. My own proprietary research, which drives my equity portfolio selection of consistently superior large-cap companies, confirms this. Back some thirty or forty years ago, when trading equities was expensive and information and innovation were in shorter supply, it may have made sense for investors to hold shares of conglomerates. And, in the day, they existed- Gulf&Western, ITT, and Litton, to name just a few. But they are gone now. ITT still exists, but in nothing like the shape it had under Harold Geneen."

And, in the later post about another recent Times article fawning over Immelt and GE, I stated,

"Thus, Immelt has actually broken the pattern of GE leadership through the ages by essentially changing virtually nothing. The firm has adapted to past eras, that is true. And this era is one of the continued de-conglomeration of American business. His sarcastic shots about Google to the contrary, Immelt's firm is too diversified to provide consistently superior returns to shareholders, because it's taxing them to feed an overgrown bureaucracy presided over by....none other than Chairman Jeff the First.

What Immelt fails to understand, in suggesting Google can't continue growing in its natural niches, is that every business undergoes a Schumpeterian life- and death- cycle. My guess is, Immelt is going to preside over GE's death.

Third, regarding Immelt's observation about investors "going through cycled where they don't like conglomerates" is a bit disingenuous.

The era of growing, permanent corporate conglomerates is over, thanks to very efficient, large and deeply liquid capital markets. Markets so liquid that private equity firms can borrow to buy ailing business units of conglomerates, fix them, and spin them back out to the public. The only apparently consistently profitable "conglomerates" these days appear to be the large, multi-operating-unit private equity shops. But they don't seem to want to hold their businesses- just increase their value and flip them back to the public."

So, in actually, Immelt isn't running GE in order to give shareholders the best chance of enjoying consistently superior (to the market, or S&P500) returns, no matter when they own the stock. Instead, he's pursuing some hoary, forty-plus-year-old goal of 'earnings smoothing' via 'diversification.'

I don't think I've seen a single diversified conglomerate among my consistently-superior, high-growth portfolio selections. Ever.

Conglomerates, as I wrote in the reposted passages above, are holdovers from a bygone era. Managing according to the theory that there is value in diversifying to "ride out the inevitable ups and downs of the economic cycle" is simply being backward in this more financially modern era of liquidity, low/negligible trading costs, and easier risk management via derivatives.

What is surprising to me is that nobody in the business press seems to call the few remaining conglomerates, especially GE, on this issue. GE has become a quasi-index, closed-ended fund, with a big management fee discount from its componet values. There is simply no way Immelt, as GE's CEO, is entitled the many tens of millions of dollars he is paid annually to essentially manage an index fund.

I would expect better coverage of this egregious waste of value in one of the nation's largest newspapers.