Enterprise group: cash cow or company chaos?

A corporate group is a company that partially or fully owns many other companies. Not long ago, huge corporate groups were a distinctive feature of the corporate landscape. Huge empires, such as General Electric and Berkshire Hathaway, have been established over the years, with interests ranging from jet engine technology to jewelry.

Enterprise groups pride themselves on providing investors with long-term stable income and dividend (or cash payment) flow. They provide diversified products and services aimed at avoiding market fluctuations or turbulence. In some cases, corporate groups have generated considerable long-term shareholder returns.

However, corporate group investors do not always perform well. Investors should understand the pros and cons of investing in corporate groups.

Key points

  • A corporate group is a company that partially or fully owns many other companies.
  • Enterprise groups provide diversification, and if one subsidiary suffers losses, it can be offset by another subsidiary.
  • Companies owned and managed by corporate groups can usually obtain financing through the parent company.
  • The financial reports of corporate groups may be difficult to understand and obscure the performance of various departments.
  • If departments within the group perform poorly, group discounts can be applied.

How corporate groups work

A corporate group is a company that conducts business in multiple industries by owning multiple companies. A corporate group can be a multinational company that has subsidiaries that are managed independently of other companies. However, the management team of each business reports to the senior management of the parent company.

Enterprise groups span various industries around the world, including food, retail, manufacturing, and media. For example, a conglomerate may start as a manufacturer, and as its business grows, it acquires a financial services company to provide customers with credit cards to facilitate the purchase of its finished products. If a manufacturer ultimately needs software, it may acquire companies in the technology or electronics industries.

For example, a media group may initially own several newspapers, but has acquired a radio station and a digital media company over the years to help offset the impact of the decline in newspaper revenue. One of the main goals of business groups is to diversify their sources of income so that they can generate income in any type of economic environment.

Advantages of corporate groups

Enterprise groups can provide investors with advantages and ultimately bring better returns on their investments.

diversification

The case of corporate groups can be summed up in one word: diversification. According to financial theory, because the business cycle affects the industry in different ways, diversification leads to a reduction in investment risk. For example, the downturn of a subsidiary can be offset by the stability or even expansion of another company.

Warren Buffet’s Berkshire Hathaway can be considered a conglomerate with a majority stake in more than 50 companies, including real estate, banks, and aircraft manufacturing companies. Investors benefit from diversification, because if Berkshire Hathaway’s bank holdings perform poorly, the losses may be offset by the good years of its real estate business.

Profitable acquisition

Successful corporate groups can show sustained profit growth by acquiring companies whose stock ratings are lower than their own. In fact, both General Electric and Berkshire Hathaway have promised and achieved double-digit revenue growth through the application of this investment growth strategy.

Financing channels

Companies owned and managed by conglomerates can often obtain financing through the parent company and thus be able to invest in long-term growth. Smaller companies may not be able to obtain favorable credit facilities from banks and capital markets because their revenue and profit performance may be intermittent or uneven. The parent company can step in and provide more favorable terms than the market may provide to the subsidiary alone—for example, lower interest rates.

Disadvantages of corporate groups

Although some enterprise groups provide considerable returns in the long term, investing in them also has disadvantages, because not all enterprise groups are created equal.

Economic risks still exist

The remarkable success of conglomerates such as General Electric (GE) does not prove that conglomerates are always a good idea. There are many reasons to think twice when investing in these stocks. As explained in 2009, when General Electric suffered losses due to the economic recession, this proved that scale did not make the company foolproof. As management continues to divest businesses to repay debts, GE has been working hard to create stable income, and the current scale is only a small part of the past.

Spread too thin

Investment guru Peter Lynch uses the term “diversification” to describe companies that diversify investments in areas other than their core competitiveness. A corporate group is usually an inefficient and chaotic company. No matter how good the management team is, its energy and resources will be dispersed among many businesses, and these businesses may or may not produce synergy.

financial report

For investors, corporate groups can be very difficult to understand, and it can be a challenge to put these companies into a category or investment theme. Therefore, even managers often find it difficult to explain their investment philosophy to shareholders. In addition, the accounting of enterprise groups may have many shortcomings and may obscure the performance of various departments of the enterprise group. Investors’ inability to understand the corporate group’s philosophy, direction, goals, and performance may ultimately lead to poor stock performance.

Although the countercyclical argument is established, there is also the risk that management will hold companies with poor performance in order to take advantage of the trend. Ultimately, lower-value companies will prevent the value of high-value companies from being fully realized in stock prices.

A better way to diversify

Enterprise groups do not always provide investors with diversified advantages. If investors want to diversify their risks, they can do it themselves and invest in several focused companies instead of putting all their money in a single corporate group. Investors can do this cheaper and more efficiently than the most greedy conglomerates.

Comprehensive discount

Enterprise group discount refers to the lower value or discount given by investors to the enterprise group due to the poor performance of the internal departments of the enterprise group. The discount is due to the partial sum valuation, which is applicable to corporate groups compared to companies that focus on their core products or capabilities.

In other words, the market can deduct the value of the partial sum. Of course, some corporate groups demand premiums, but generally speaking, the market will consider them to be discounts, allowing investors to get a good understanding of the market’s valuation of the total value of its various parts. The deep discount indicates that if the company is dissolved, its divisions will operate as independent companies and stocks, and shareholders will benefit from it.

Example Comprehensive discount

Let’s use a fictitious conglomerate called DiversiCo to calculate the discount for the conglomerate, which consists of two unrelated businesses: the beverage department and the biotechnology department.

DiversiCo’s stock market is valued at US$2 billion and total debt is US$750 million. The balance sheet assets of its beverage division are US$1 billion, while the assets of its biotechnology division are US$765 million.

For example, suppose that a company that focuses on the beverage industry has a median price-to-book ratio of 2.5, while a purely biotech company has a price-to-book ratio of 2. DiversiCo’s division is quite a typical company in its industry. Based on this information, we can calculate discounts for corporate groups:

DiversiCo total market capitalization

  • Equity + debt
  • USD 2 billion (equity) + USD 750 million (debt)
  • Market value = US$2.75 billion

Use the estimated value of the sum of the parts

  • Value of Biotechnology Division + Value of Beverage Division
  • (US$750 million X 2) + (US$1 billion X 2.5)
  • US$1.5 billion + US$2.5 billion
  • Total value of parts = 4 billion USD

Comprehensive discount

  • (US$4 billion-US$2.75 billion) / US$4 billion
  • = 31.25%

DiversiCo’s 31.25% corporate group discount shows a significant discount, and its share price does not reflect the value of its various divisions. Investors may push to spin off its beverage and biotechnology divisions to create more value, because if the company is split into independent companies, its value may be higher.

Bottom line

The corporate group discount suggests that investing in corporate groups may not be wise. However, investing in conglomerates that are split into independent companies through divestitures and spin-offs can provide investors with added value because conglomerate discounts disappear.

On the other hand, some conglomerates require valuation premiums or at least discounts for smaller conglomerates. These are very well-run companies with excellent management teams and clear departmental goals. Successful corporate groups usually sell underperforming companies and don’t overpay for acquisitions. In addition, the premium corporate groups associated with them often have good financial, strategic, and operational goals.

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