The Black Arts of Finance
Author John Brooks has observed, ‘Conglomerates, like prostitutes, had from the first a sufficiently shaky moral reputation to call for the use of euphemism.’ Chris Mayer explores this short chapter in financial history…
"On Wall Street, hindsight enhances foresight."
– James Grant, Grant’s Interest Rate Observer
The era of the conglomerates is brief but instructive. Flourishing in the roaring market of the late ’60s, it was a doomed effort at the new math. Then it was called "synergies." The term is used less today by the historically minded, because it brings to mind this somewhat neglected chapter in financial history.
Synergies are what the managers of the so-called conglomerates sought to achieve, though these enterprises rarely referred to themselves as conglomerates. They usually preferred high-minded and self-made euphemisms such as "multidisciplinary company." As author John Brooks has observed, "Conglomerates, like prostitutes, had from the first a sufficiently shaky moral reputation to call for the use of euphemism." As in politics, coining new buzzwords like these gives the illusion of newness to old tricks.
The idea behind this was fairly old. While most companies followed the respected dictum that a shoemaker should stick to his last, there were a number of exceptions by the time the 1920s rolled around. DuPont, for example, had largely confined itself to making gunpowder. But in the 1920s, it added a number of unrelated businesses, becoming a sort of pioneering conglomerate.
The History of Conglomerates: The Early Days
The early forays were more a matter of contingency than an express corporate philosophy. Ironing out that philosophy would be the work of Royal Little, often seen as the father of the conglomerate concept. Little turned American Woolen, a textile company, into Textron – a company that was engaged in selling almost everything, including golf balls, life insurance, helicopters, cement, pens and much more.
Little fleshed out his ideas for posterity in his autobiography, How to Lose $100,000,000 and Other Valuable Advice. His strategy, he thought, would help insulate companies from unpredictable business cycles by giving them a firm foundation in many unrelated businesses. He also thought it would alleviate the often ruinous temptation to expand into losing businesses. Since the management team would have different lines of business to expand into, it could pick the strongest performers.
Perhaps there was a kernel of a good idea in Little’s model. Textron would go on to have successes. In fact, in the roll call of "new age" conglomerates of that era – Gulf Western, Litton, LTV, National General, Northwest Industries, Norton Simon and others, Textron remains as one of a few survivors.
I think it was Benjamin Graham who made the paradoxical observation that it was not your bad ideas that do you in, but your good ideas – the idea being that people, especially on Wall Street, have a tendency to overdo what looks like might be a good idea. That’s exactly what happened in this case.
The History of Conglomerates: The Boom
Wall Street and investors fell in love with the conglomerate idea, and the conglomerates were rewarded with high price-earnings ratios. This fueled the boom and would ultimately carry it to its inglorious end.
The creators of conglomerates found out that they could take a business with a high price-earnings ratio and buy a business with a low price-earnings ratio, the end result being that their business retained the higher valuation. For example, in that market, Textron, with a price-earnings ratio of 30, let’s say, could buy a sleepy cement company for 10 times earnings.
Once combined, the old cement company would disappear in the belly of the conglomerate, and its earnings, once valued independently at a P/E of 10, would then assume the valuation assigned the larger conglomerate – again, because investors kept the shares of conglomerates high, even post-acquisition. They bought into the hype of "synergies." The result created a classic recipe for adding 1 and 1 and getting more than 2. Unfortunately for investors, these magical combinations would prove to be fleeting. But for a while, the idea was intoxicating.
In the year 1968 alone, 26 of America’s 500 largest companies were acquired in conglomerates mergers. Moreover, 10 of the nation’s largest 200 companies were conglomerates. The new era prophets of that day said it was only the beginning and soon super-conglomerates would dominate the business scene.
Depending on your viewpoint, the new conglomerates were either the vanguard of a new corporate structure and a well of instant wealth creation or they were "ruthless capitalists practice[ing] the black arts of finance to their own ends" and servicing "industry the way Bonnie and Clyde serviced banks" (the latter were the views of The New York Times; apparently, the Gray Lady was not amused).
The History of Conglomerates: The Decline and Fall
In the end, the holes in the conglomerate idea were too large for most to overcome. Management teams skilled in one industry had little expertise in others. The businesses under a conglomerate’s umbrella started to suffer and decline. This put more pressure on the conglomerates to do more acquisitions.
Eventually, they started to stumble. First it was Litton, one of the granddaddies, who reported earnings substantially less than expected. The selling began in earnest. Since the acquisition math depended on a conglomerate keeping its high multiple of earnings, Litton’s model for growth was finished. The stock prices of other conglomerates soon followed Litton down the proverbial drain. Then came the investigations and the exposure of faulty reporting and misleading practices – a snowball effect of bad news overwhelmed them. The conglomerate boom came crashing to a halt.
What insights does this history provide us with today? I think there are several: Relying on acquisitions for growth is usually a bad idea, for a lot of reasons. Lollapalooza-like combinations are rare and hard to achieve. Bad ideas sometimes begin life with the kernel of a good idea. Or what starts out as a good idea can be overdone. Too many transactions spoil the broth.
Finally, I think this story holds an important warning for investors in today’s market: A flurry of merger and acquisitions in an industry that has already seen its stock prices rise for an extended period of time can be a sign that sector is getting a bit overheated. Especially, I should add, if the acquisitions are being financed with stock.
for The Daily Reckoning
August 24, 2005
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is also the editor of the Fleet Street Letter.
The summer has been a disappointment. We feel like curling on the ground with the brown leaves and letting the wind blow us into the next season.
We are a sentimental, old fool; it’s true. We had hoped for so much from the soft, slow summer months – new thoughts…old friends…and the family gathered ’round for eight weeks. Imagine the work that we could get done – we would repaint all the shutters painted, we would lay up a new stone wall, maybe we could even build a gypsy wagon, which we have been planning for years. Instead, the family couldn’t sit still long enough to gather around, let alone get anything done. The children are all growing up – with agenda of their own. Practically every day there was a new train to catch. In the comings and goings, we couldn’t keep track of who had come and who had gone. We had to go around the place after midnight and check to see which rooms were occupied.
We had no new thoughts. And so our old ones – left too long on the table – turned a bit sour.
And now, here we are back in Annapolis. It was here that it all began. It was here that we were born in what seems like a very long time ago.
And in our 18th year, we set out into the big world, off to college. Then, we saw ourselves in a Norman Rockwell painting. It is a portrait of a young man and his father. They might be midwestern farmers. The older man is sitting on the running board of his pickup truck, if we recall correctly. His hands are hard. His face is sunburned and creased from years of fieldwork. He has a look on his face of pride, with a touch of sadness. His son is going off to college.
Back then, we were the son. Bright eyed…we stood up taller than we were, with an expectant smile. We did not know what would happen when we got out in the world, but we were sure it would be something good. And whatever it was, we were ready for it.
But now the world has made its tour of the sun nearly 40 times. And now we have taken a new place in the portrait. Now, we are the father.
It is at times like this that we see the merit in modern art. You can look at globs of paint or bands of color and see nothing. It is as meaningless and empty as a presidential speech. It has no more effect on us than herb tea.
Norman Rockwell spent his career painting pictures that helped people understand their own feelings…pictures that enriched their own experiences and celebrated their own lives. But the art establishment branded him an "illustrator," a sentimental one at that. Real artists, they said, were doing art for art’s sake, not for the sake of the bourgeois public. Real artists were putting swiggles, smears or daubs of paint on the canvas. They were doing "innovative" and "creative" work. If they were hideous and grotesque; well, that’s what life really is!
You can laugh at modern art. You can’t take it seriously. Rockwell, on the other hand, is almost too serious. We turn back to the painting and can barely stand to look. We see every line, every worry and every regret on the old man’s face – in our own mirror. For now, we have come to Annapolis to take our own boy to school. Today, he registers at St. Johns College.
You may wonder, dear reader, what this has to do with making money. We don’t know. Maybe nothing. We know it has something to do with spending money; have you seen a recent college tuition bill?
Maybe it has something to do with making money too. But we will have to stretch to find a connection, and we don’t have time for that this morning.
The financial news, from our team at The Rude Awakening:
Addison Wiggin, reporting from Baltimore…
"It’s hard to imagine, isn’t it…the world’s reserve currency spiraling downward, out of control. Well, think again."
Bill Bonner, back in Annapolis:
*** An interesting tidbit from our friend Jonathan Kolber…
"Do you remember the recent SARS virus scare? Worldwide health organizations scrambled to bury news of this impending epidemic as best they could. They had to, otherwise a global panic might have occurred. But the news leaked out, and the world was terrified for a few weeks.
"As it turned out, the SARS virus was contained. We dodged a monster bullet on that one. But SARS is still out there, waiting to rear its ugly head again at any time.
"Fortunately, a tiny Chinese company came to the rescue. This microcap medical biotechnology company, using an ultra-sophisticated drug development process, quickly developed a vaccine that, in preliminary tests, has crushed the SARS virus. So if SARS returns, we’ll be ready.
"But there is some bad news…and some good news.
"Scientists have recently discovered a new, ultra-contagious ‘super-flu’ that is impervious to any known treatment. No human being has a proven immunity to this disease. This nasty virus has wiped out 72% of the known human cases infected with it. Medical specialists consider this the greatest threat facing the world today. This is one bad bug!
"But this minuscule company is coming to the rescue again. It’s in a unique partnership with the Chinese CDC and is solving the problem. Potential gains? In an epidemic situation, think 6 billion people at $10 a dose."
*** We arrived yesterday from Paris. The first thing you notice is the difference in foliage. Europe is dry; trees are few. Here, trees are everywhere, big trees, densely packed together. It is a greener, richer country – at least this part of it.
We took a very long taxi ride from Dulles Airport to Annapolis. Everywhere we looked, we could see shopping malls, houses, apartments, and office buildings. If anyone is manufacturing anything in America, they aren’t doing it around here.
Annapolis used to be a working town. It was not a particularly up market place. There were oyster boats down at the harbor. Farmers came to town to buy supplies. There were a few restaurants, of course, and a few 5 and dime stores. There was a sleepy southern civility to the place. One of the most exciting events in town was the annual croquet match between the Naval Academy and St. Johns. Yesterday, walking around St. Johns campus at dusk, we saw some students practicing croquet, trying to steal a march on their Navy rivals; there is no football team at St. Johns.
We sat down at Harry Browne’s restaurant on State Circle and had its famous crab cake dinner. It’s been a long time since we ate crab cakes. Prices have gone up. A modest meal for two, with just two glasses of wine and no appetizers or dessert cost $90. We ate our first meal on State Circle more than half century ago. Our mother used to prefer the restaurant there because it was the only one that still used cloth napkins, she said. We don’t remember what we paid for dinner in the 1950s…but it was probably less than $2.
To put that in perspective, an ounce of gold back then would probably have been good for a dozen meals. Today, at $440, gold will still buy you about a dozen meals on the State Circle, if you’re careful. Two dollars, on the other hand, won’t buy much of anything.
Apart from that, everything in the area seemed more or less as we remembered it. The movie theatres have closed. There are many more shops that seem to cater to tourists. But otherwise, all was normal…including the loud noise of crickets coming from the State Capital lawn.
Down at the harbor, on the other hand, groups of tourists wander around. They wear baggy shorts and flip flops, as though they were at the beach. Many restaurants and gee-gaw shops await them. It is a good area to avoid.
"These people have no sense of style," said Jules.
We recalled our introduction to politics. Joe Alton was a master local politician. He could cry whenever he wanted. Faced with the right crowd, he would summon up tears. The next thing you know, whatever he had done had been forgiven and he was in office for another 4 years.
Before going to college, we spent a summer going around the county putting up ‘Elect Joe Alton’ signs. We don’t remember exactly what he was running for. Nor do we recall why we had any interest in his success. The man would give us wads of cash from time to time, ‘walking around money,’ he called it. But it was not enough to make the work pay. We don’t remember which political party Joe represented, or what his program was. All we remember is the tears…the best tears we ever saw on a politician. Ol’ Weepy Joe, they called him.
Now we wonder, maybe the tears were real.