Impregnaciones o pre-fondos

This section considers the performance of conglomerates compared to other categories of company. In analysing conglomerate performance their use of

acquisitions as a means of growth comes to the fore and, given the poor post- deal performance of many acquisitions, has a major bearing. Acquisitions may provide a quick route to conglomeration and to turnover growth but their effect on profitability is less clear.

One of the major advantages claimed for conglomerates is their superior level of profitable growth compared to other categories of company. However, a review of the, predominantly US, literature does not provide clear evidence that conglomerates consistently outperformed other categories. Dess, Gupta, Hennart & Hill (1995) reviewed the findings of 32 papers, all except that by Grant, Jammine & Thomas (1988) into US, principally Fortune 500 or 1000, companies with the majority using Rumelt's strategy-based categorisation scheme in preference to SIC/Entropy. The studies revealed no clear picture regarding the relationship between diversity and performance with a broad range of positive, negative and neutral outcomes being observed. However, Dess, Gupta, Hennart & Hill (1995, p30) are quick to point out that, as with Rumelt's (1974) original work, many of the subsequent studies failed to control for industry effects.

Some of the earliest research into diversification was that by Weston & Mansinghka (1971) who compared conglomerates and non-conglomerates. Unsurprisingly, given their predilection to diversify by acquisition, conglomerates were found to grow more rapidly than comparative focussed companies. However, they also found that although the earnings/net worth of conglomerates was higher than for non-conglomerates the difference was not

statistically significant. By the end of their study, i.e. 1968, there were "no significant differences in earnings performance" (p925) where earnings were linked to total assets or net worth plus long term debt. It is important to note that there was a wide variation in performance across the conglomerate category with some companies performing significantly better than others inferring an industry effect and/or that the ability of management has a very direct influence on financial performance.

Rumelt (1974) used his 4-category categorisation scheme to research the performance of US conglomerates and found marked variations in average performance across diversification categories between 1949 and 1969 as the following table shows:

Table 14: Annualized Performance of Listed NYSE Companies, 1949- 1969 All Figures % Diversification Sales Growth Earnings Growth EPS

Growth ROC ROE

Single-business 7.17 4.81 3.92 10.81 13.20

Dominant-business 8.03 7.95 5.99 9.64 11.64

Related-business 9.14 9.39 7.64 11.49 13.55

Unrelated-business 14.24 13.86 7.92 9.49 11.92

Average all comps 9.01 8.72 6.57 10.52 12.64

Source: Rumelt (1974, p91)

Conglomerates did produce superior growth rates achieving the highest sales growth, 14.24% compared to the overall average of 9.01% but also the lowest return on investment, 9.49% compared to 11.49% for related diversifiers and 10.52% overall. Of the other categories, single-business and related business companies produced better than overall returns implying that companies focusing on core activities rather than pursuing conglomeration produce better

Salter & Weinhold (1979, p24) note that, in response to criticisms regarding failure to control for industry, Rumelt refined his analysis adjusting for industry effects by comparing each company's performance to a weighted average 'synthetic' profit calculated for each company according to the proportions of its total investment in various business segments. Rumelt also sub-divided some of his original categories with related being split into constrained and linked and unrelated split into multi-business and unrelated.

The following table compares the performance, in terms of return on capital, of each of Rumelt's extended categories against weighted 'average' expected performance. The notes explain the new categories.

Table 15: Performance Differences Among Rumelt's Strategic Categories (Weighted for Industry Affiliation), 1962-1971

All figures % Category Actual ROC Expected ROCa Residual Single Business 11.45 9.94 1.51* Dominant - Constrainedb 12.09 11.01 1.08 Related - Constrainedb 12.28 11.67 0.61 Related Linkedb 10.53 10.83 (0.30) Multibusinessc 8.30 10.13 (1.83)* Unrelated Portfolioc 8.80 10.46 (1.66)*

Average for all companies 11.00 10.89 0.11

Notes:

a _{Average return on capital over the period for all the companies in each strategic}

category if they were average performers in the industries in which they participated.

b _{Rumelt's "constrained" categories closely correspond to related-complementary}

diversification while his "linked" categories closely correspond to related- supplementary diversification.

c _{Rumelt expanded his original unrelated category into a multibusiness segment, or}

companies with 2-4 relatively balanced though unrelated businesses, and an unrelated portfolio segment, or companies with numerous unrelated businesses. * Significant at the 5% level.

Sources: Salter & Weinhold (1979, p24). Original source - Richard Rumelt, “Diversity and Profitability”, University of California at Los Angeles Working Paper MGL-51, 1977.

Using average return on capital, the best performers are single business companies which produced returns 1.51% higher than the average with the worst being the multi-business and unrelated portfolio business categories, i.e. conglomerates, whose returns were 1.83% and 1.66% lower than the average respectively. These results support those of Rumelt‟s (1974) earlier work.

Rumelt (1982) continued to research into the profitability of the increasingly common conglomeration strategies of US companies finding further support for his earlier results that "corporate profitability differed significantly across groups of firms following different 'strategies' of diversification" and that "the lowest levels were those of vertically integrated businesses and firms

following strategies of diversification into unrelated businesses" (p359).

Holzmann, Copeland & Hayya (1975) also compared the financial performance of US conglomerates and non-conglomerates starting with the premise that: "the growth of conglomerate corporations is often justified on the grounds that conglomerate mergers are likely to lead to superior risk-return

performance, the customary rationale underlying portfolio diversification"

(p74). They categorised 349 companies using definitions developed by Forbes (1965) and Weston & Mansinghka (1971) as either conglomerate or non-conglomerate and used four performance measures; two asset-based (operating income/total gross assets and operating income/book value of equity) and two equity-based (net income after tax/stockholders' equity and net income available for common equity) to assess the performance of both

groups. They did not try to link conglomerate performance to share price performance. Data covering the period 1951-1970 was analysed and, for asset-based measures, conglomerates produced lower but less variable returns. However, for equity-based measures the picture was less clear; non- conglomerates achieved higher mean returns but they also experienced greater mean variances suggesting greater volatility.

Holzmann, Copeland & Hayya (1975) noted that their findings were consistent with earlier research by Reid (1968) who asserted that conglomerates were size rather than profit maximisers and by Weston & Mansinghka (1971) who showed that conglomerates diversified defensively to reduce risk and increase stability of returns. In summary, Holzmann, Copeland & Hayya (1975, p76) said that ”….on the basis of our findings it is possible to speculate that

conglomerate managers were more concerned with overall firm performance

and growth than with returns to equity holders". Holzmann, Copeland & Hayya (1975) also referenced consistent findings from research by Berle & Means (1968), Mason (1959), Penrose (1959), Marris (1964), Galbraith (1971) and Herendeen (1974).

Research by Mason & Goudzwaard (1976) found that, compared to randomly selected portfolios, conglomerates did not produce superior returns. They questioned why conglomerates need to exist if individual investors can achieve the same or better results. Another paper along the same lines is that of Melicher & Rush (1973) who compared the financial performance (ratio based) of 45 conglomerates against 45 non-conglomerates with the

constituents of both groups having been in the same basic industry in 1960. The financial performance of both groups was found to be similar: "the irony of our findings is that the conglomerates were shown to be no better or worse off

than those firms that remained in the basic industries that the conglomerates

abandoned" (p388).

Salter & Weinhold (1979) produced data showing that, on average, conglomerates perform worse than the market in general as represented by the average of companies comprising the All Industry Composite. Their results are summarised in the following table:

Table 16: Business Week Survey of Business Profitsa

Conglomeratesb All Industry Composite

Year Average Return On Equity Average Price- Earnings Ratioc Average Return On Equity Average Price- Earnings Ratioc 1973 11.3 6 14.0 11 1974 11.8 5 14.0 9 1975 11.3 8 11.8 12 1976 13.2 8 14.0 10 1977 12.9 7 14.1 9 1978 13.5 6 15.1 8 Notes:

a _{Based on Business Week's Quarterly Survey of Business Profits.}

b _{The composition of Business Week's conglomerate category is Teledyne,}

Northwest Industries, Textron, Avco, Studebaker-Worthington, Southdown, Martin Marietta, Signal, Colt Industries, Whittaker, Bliss & Laughlin Industries, Tenneco, Chromalloy American, Gulf + Western Industries, Fuqua Industries, Kidde (Walter), City Investing, IU International, U.S. Industries, IC Industries, Litton Industries, LTV.

c _{Based on price-earnings ratio in effect on evaluation date.}

Source: Salter & Weinhold (1979, p27)

In each year both the average return on equity and the average price earnings ratio of conglomerates was substantially below that of the all industry composite. Salter & Weinhold (1979) also quote statistics of relative economic

performance between 1965 and 1978 showing the S&P index of 10 conglomerates underperformed the S&P 400 index of industrial companies and the S&P index of major companies by a substantial margin. As with Rumelt's (1974) early work, Salter & Weinhold (1979) did not control for industry effects. Furthermore, their conglomerate population, the Business Week Conglomerates, comprised a small group of only 32 companies limiting the robustness of their research.

According to Bettis & Hall (1982) industry effects can have a significant bearing on conglomerate performance. Acknowledging that diversification can be into either related or unrelated activities, they noted conglomerates should have an advantage saying, “….unrelated diversification strategies would seem

to have an advantage because they permit a wider choice of industries in

which to participate" (p255). Notwithstanding the need for diverse companies to match business strategies to their activities if overall performance is to be optimised ("high performing diversified firms may be those firms that are able to develop and pursue appropriate strategies in their constituent businesses"

(p256)) Bettis & Hall (1982) note that the success of conglomerate strategies remains heavily dependent on the business activities into which the company diversifies. Their research showed the best performers were those with businesses in pharmaceuticals, a high growth/high profit industry. A key finding from Bettis & Hall (1982, p262) is that "…the researchers are led to

conjecture that selection of industry or industries in which to participate may

be more important than a related or unrelated diversification strategy....further

the effects of diversification strategy and to determine whether the two interact

in some manner". In effect, corporate investors are faced with the same industry choices as private investors; both can see the relative industry performance and can make choices based on that information. The inference is that the success of a conglomerate is heavily dependent on the portfolio choices made by management.

Looking at the performance issue from a value perspective, there is a substantial body of evidence supporting the view that diversified firms are consistently valued less than 'pure play' firms. Lang & Stulz (1994) researched the Tobin's q ratios for US firms through the 1980s finding that "Tobin's q and firm diversification are negatively related throughout the 1980s. This negative

relation holds for different diversification measures and when we control for

other known determinants of q [for example, R & D]. Further, diversified firms

have lower q's than comparable portfolios of pure play firms" (p1248). This finding was consistent with that of Servaes (1996) into performance in the 1960s and 1970s.

Berger & Ofek (1995) also considered the effect on a firm's value of its diversification activities. They found that during the period 1986-1991, when compared to focused companies, diversified companies lost 13-15% of their value. Berger & Ofek (1995) recognised the potential benefits of diversification, notably the acquisition of imperfectly correlated (counter- cyclical) profit generators, better management and resource allocation. However, they also believed that loss-making companies lose more when part

of a conglomerate than they would as independent companies as they will be cross-subsidised by other profitable operations reducing pressures to improve.

The very limited UK literature on conglomerate performance should be considered in light of the foregoing US research. Grant & Jammine (1988) conclude that, overall, UK research, limited though it is, has failed to “shed

appreciable light on the relationship between diversification strategy and performance” (p335). Their opinion is supported by the conflicting findings of Grinyer, Yasai-Ardekani & Al-Bazzaz (1980) who found in favour of dominant business firms, Hill (1983) who found volatility but little difference in mean profitability and Luffman & Reed (1982) who found conglomerates performed better than related diversifiers. However, Grant & Jammine (1988) do note that research in this area has not been consistent with differences in profitability measures having a major influence.

Finally, it should be remembered that much of the extant literature relates to the 1960s and 1970s, a period when conglomeration and conglomerates were enjoying growth rather than contraction. Haynes, Thompson & Wright (2002, p173) covered a more recent period – 1985 to 1993 – and reported a

„positive, significant and substantial‟ relationship between divestment and performance suggesting the refocusing activities undertaken by conglomerates improved their financial performance. However, research by Montgomery & Wilson (1986) into the subsequent divestment of large acquisitions made by US public companies between 1967 and 1969, the

height of the diversification boom, found no significant difference between the number of related and unrelated business divested.

Reliability of Financial Data

When assessing performance it is important to recognise that the reliability of financial performance data has, over recent years, increasingly been called into question. The lack of transparency of financial information adds to a general mistrust of conglomerates. In the UK, Smith (1996) wrote a best seller in which he claimed to be "stripping the camouflage from company accounts"

to highlight how performance may be manipulated. Whilst Smith (1996) did not confine his analyses and criticism to conglomerates, they were well represented in his book which drew attention to a number of the 'creative' accounting practices that were in widespread use and looked at how many leading public companies adopted them strongly inferring that, in doing so, they were manipulating their accounts and to some degree misleading investors as to their financial performance. Biographies of some leading businessmen, e.g. Lord Hanson at Hanson (Brummer & Cowe, 1994), have, by questioning the financial performance of the companies they ran, provided support to Smith (1996).

The practices highlighted by Smith (1996) were, at the time, all legal and within the range of accounting treatments acceptable under accounting standards. However, several have since been restricted or eliminated by new/revised standards issued by the Accounting Standards Board (ASB) and its successors the Accounting Standards Committee (ASC) and the Financial

Reporting Council (FRC). While the ASB, ACS and FRC have closed some loopholes, many still remain. Interestingly Smith (1996, p162) notes that US generally accepted accounting practices are more prescriptive than their UK equivalents reducing, but not entirely eliminating, scope for interpretation and therefore, manipulation. Where companies have dual US and UK reporting requirements, e.g. those with a US stock market listing, Smith (1996) advocates using accounts prepared under US rather than UK GAAP when undertaking analyses.

The book was first published in 1992 and in the second edition Smith (1996) defends his record noting that several of the companies he originally criticised for questionable accounting practices had, by 1996, experienced difficulties. The following table lists the criticised companies and their subsequent problems and note in parentheses the number (out of 12) of dubious practices adopted by each company:

Table 17: Companies Using the Most Dubious Accounting Practices

Company Problems

Tiphook (4) In talks with banks, debts soar Queens Moat (6) Financial reconstruction underway

Trafalgar House (8) Auditors, chairman and chief executive depart; huge losses, two rights issues

Albert Fisher (7) Losses, chairman departs British Aerospace (7) Record losses, rights issue

Ratners (7) Founder departs, huge losses

Lonrho (6) Huge changes in way group is run

GrandMet (9) Shares underperform

Bass (6) Shares underperform

Ladbroke (8) Chairman steps down

Source: Smith (1996, p7)

While it is easy to suggest cause and effect between dubious accounting practice and subsequent problems, it must be remembered that many other

factors may have been influential, e.g. Ratners‟ problems were primarily due to extremely ill-advised comments by its CEO Gerald Ratner who, in a high- profile speech, described some of its products as 'total crap'!

A company singled out by Smith (1996) is the conglomerate BTR. Smith (1996) points to the 'misuse' - aggressive but not illegal - of provisions during the company's acquisition of Hawker Siddeley in 1990. According to Smith (1996), BTR acquired Hawker Siddeley, which had net assets of £748 million, for £1,513 million and then created provisions, primarily to adjust book asset values to fair values, of £445 million (£285 million in 1991 and £160 million in 1992). These 'fair value' adjustments - made under the rules of SSAP22 (revised) - represented 59.5% of the net asset value and 29.4% of the purchase consideration. Smith's (1996) point is that the judicious reversal of these provisions, and others relating to other acquisitions and activities, without the matching costs being incurred, helped BTR maintain its historically high margins in subsequent years 'confusing' markets into believing that it was continuing to trade very profitably when, in reality, it was not. BTR released provisions totalling £305m in 1992 (28.1% of the reported profit of £1,085 million) and £81 million in the first half of 1993 (13.5% of the reported profit of £602 million). With its provisions largely exhausted by mid-1993, BTR's true underlying profitability became apparent. After stagnating in 1994 and 1995, profits fell sharply in 1996 as did the share price and City confidence in the company. The second half of the 1990s saw a series of disposals as the company attempted, unsuccessfully, to restore its profitability through

focussing its operations and to raise cash to repay the substantial debts incurred in its acquisitive years.

BTR‟s experience suggests that the underlying profitability of other conglomerates may have been declining long before they undertook strategic reviews that led to the adoption of divestment strategies and re-focussing.