Katzin, Jerome S.

English

St. John's University School of Law

St. John's Law Review Volume 44 Number 5 Volume 44, Spring 1970, Special Edition Article 57 December 2012 The Conglomerate as an Investment Vehicle Jerome S. Katzin Follow this and additional works at: https://scholarship.law.stjohns.edu/lawreview Recommended Citation Katzin, Jerome S. (1970) "The Conglomerate as an Investment Vehicle," St. John's Law Review: Vol. 44 : No. 5 , Article 57. Available at: https://scholarship.law.stjohns.edu/lawreview/vol44/iss5/57 This Symposium is brought to you for free and open access by the Journals at St. John's Law Scholarship Repository. It has been accepted for inclusion in St. John's Law Review by an authorized editor of St. John's Law Scholarship Repository. For more information, please contact selbyc@stjohns.edu. THE CONGLOMERATE AS ANINVESTMENT VEHICLEJEROME S. KATZIN*Regardless of any possible correlation between the level of stock marketprices and women's skirts, it is readily demonstrable that there are fashionsin investment. So pronounced is the herding impulse among investors, thata more appropriate symbol of Wall Street might well be a sheep instead ofthe embattled bull and bear.The transiency of investment popularity is well illustrated by the riseand decline of the "conglomerate" as an investment vehicle. Over the lastdecade, this group attained separate identification, was accorded a highmarket multiple as a reflection of wide popularity and expectation, and thenfell into disrepute when these expectations began to meet disappointment.The coveted conglomerate (or mini-conglomerate) label was quickly aban-doned. Management either took full-page ads in financial journals to explainto analysts why their particular company should have a different classifica-tion, or tried to demonstrate by speech and testimony what made them dis-tinguishable from all the others.Although the conglomerate label is a recent invention, the multi-facetedcompany is not. Many of the largest industrial concerns engage in a widerange of activities, some of which are quite unrelated to the main area ofcorporate identification. What characterizes the modern conglomerate isthat its primary impetus for growth comes from the acquisition of othercompanies, usually bearing no operating relationship or industrial connec-tion with each other.A number of circumstances joined to produce the modern conglom-erate. Not least in importance has been the antitrust laws which severelylimit acquisitions within the same industry, either horizontally or vertically.Generally, growth into a new area of endeavor can be accomplished morecheaply and safely through acquisition of a going concern than by startingafresh. The difficulties of breaking into a new line, of gathering and provingmanagement, of achieving market acceptance, of attaining profitable levels,and of successfully overcoming all the known and unknown hazards of anew business are avoided if an existing business can be acquired. Not onlycan companies rapidly and securely change the direction of their businessthrough carefully selected acquisitions, but revenues and profits per sharecan also be made to increase dramatically. The prestige and other emol-uments of size can thereby be achieved with a minimum of peril and in0 A.B., University of Chicago, 1939; J.D., University of Chicago, 1941. Member of theinvestment banking firm of Kuhn, Loeb & Company; Formerly Director of Public Utilities,Securities and Exchange Commission, 1941-1953.801ST. JOHN'S LAW REVIEWfairly rapid fashion through a series of acquisitions. When the law prohibitsthe joining of companies with a natural affinity, there will be pressure toacquire those without.The market, during this period, has been particularly receptive to newmodes of investment. As the depression-tempered generation passed fromresponsibility for money management, they were replaced by a new breedof investors who emphasized market performance over stability, earningsover asset value, and capital gain rather than yield. This concentrationon market performance created, instead of long-term values, a demand forstocks of companies which were active performers in the market. A companyon a dynamic acquisition program commands attention, gives opportunityfor quick profit in the premium customarily paid for the acquired company,and the promise of rapid earnings improvement justifies not only higherstock prices but higher multiples as well.There is, in fact, a good deal of difference in the management andphilosophy of companies in the conglomerate group. Some seek to acquirecompanies with some operating relationship which common ownership canmake more efficient, the so-called "synergy." Some get extensively involvedin the management of the operating divisions and subsidiaries. Othersausterely limit themselves to a small, highly proficient money managementand supervisory team, leaving the divisions relative autonomy except formoney decisions, budgeting, and insistance on meeting performance goals.But, regardless of style, market acceptance and popularity can evaporatequite suddenly if performance falters. A problem division which fails tomeet its earnings goals immediately has repercussions, and if the difficulty isdeep and lasting, the stock market proves an inconstant corroborator. A lossperiod, a levelling of the rate of growth, a subsidiary in difficulty, andmarket deflation follows promptly, affecting not only the particular com-pany, but casting a shadow on the entire group.The continued prosperity of the conglomerate, of course, depends uponits ability to maintain a high market multiple for its shares, so that its securi-ties can be used as the medium for acquiring companies with a lower marketearnings multiple. This permits the acquirer to pay a premium for thoseearnings, and, at the same time, to augment its own earnings per share, evenafter allowance for the additional dilution.This smooth system of escalating the value of earnings through incor-poration into the more highly regarded conglomerate comes apart when themarket ceases to accord a higher multiple to the combination. This willoccur when the inherent inadequacies of any of the acquired companiesappear. There is generally a reason for the original lower market valuationof the acquisition. This may be temporarily obscured when the cofiglomeratetakes over. The new management can give the enterprise an improved image.Operations will be closely scrutinized; excess working capital will beCONGLOMERATE AS INVESTMENT VEHICLEsqueezed out and put to work earning maximum yield; loss operations will,'be pared; personnel cut; there may be accounting changes; and a moreaggressive and modern stance will replace the accustomed ways. But if thecompany is in a mature or troubled industry, its future rate of growth willremain limited. It may require extensive plant modernization and heavycapital expenditures to stay competitive. Unrevealed weaknesses may sud-denly emerge. The market's original appraisal of the company is vindicated.After all, a marginal steel company with an 8 times multiple does not by asimple transfer of ownership suddenly become a glamour company entitledto 20 times plus. Doubts arise about the sagacity and miracle-working powersof the conglomerate's management. As there is a falling off in the valuationof the conglomerate, the smooth process of compounding growth and multi-ple goes into rapid reverse. With a lowered market multiple, opportunitiesfor growth through acquisition diminish; this reduces the rate of growth,and, in turn, the multiple is further lowered. The conglomerate must turninto itself to produce growth and improved earnings. This may provedifficult.Another factor contributing to the functioning of the conglomerate hasbeen the availability of different accounting conventions. Pooling has per-mitted acquisitions at a substantial premium over underlying book value ofassets without requiring amortization of that premium against subsequentearnings. On the other hand, where assets are acquired at less than bookvalue, the merger can take the form of purchase which permits the discountto be amortized in a fashion that increases reported earnings, although, infact, there has been no change in profitability. Until recent changes in re-porting for convertible securities and common stock equivalents, it was possi-ble to delay the full dilution effect of an acquisition and temporarily give afurther lift to per share earnings.The conglomerate's emphasis on rising per share earnings as the mea-sure of accomplishment has also created pressures to maximize leverage inits capitalization. As acquisition premiums rise in the competition for com-panies, the tax-free exchange (using common, preferred, or convertible pre-ferred shares) becomes less crucial and the use of debt, sometimes withconvertibility or warrants as a sweetener, becomes feasible. High federalcorporate income tax rates with deductibility of interest enables a full returnto be paid on the debt, and with the narrower equity base, to report betterearnings per share. This becomes even more attractive if an installmentpurchase, using debt, defers the taxable event until cash is actually received.These devices have now been limited by the Tax Reform Act of 1969, whilehigh interest rates have further discouraged the use of debt securities. Theaddition of tiers of corporations, each leveraged with debt, and controlled,but not wholly-owned is another aspect of the modern conglomerate whichrequires examination and clarification. These multiple-level companies804 ST. JOHN'S LAW REVIEWbring to mind the public utility holding companies of the 1920's whichproduced the corrective restraints of the Public Utility Holding CompanyAct of 1935.There is a place in our economy for the diversified corporation. Modemmanagement has proven that it can handle large and diverse operations effi-ciently and profitably. The dynamics of our economic system will alwaysreward managers capable of producing growth and utilizing assets moreprofitably. The door should not be closed to mergers and consolidations.They serve an essential purpose in our economy, bringing revitalization toinefficient or backward companies, and offering a home to the small com-pany, the family-owned business, or the undercapitalized venture which canno longer make it alone. Improved reporting, the breaking out of divisionalfigures, more uniform accounting, and the development of better financialanalytical techniques, will assure that with longer experience each company,whether called conglomerate or diversified, will be judged on its individualmerit, as it properly should, and not by some vague categorization or thedictates of fashion.

The Conglomerate as an Investment Vehicle

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The Conglomerate as an Investment Vehicle

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