Conglomerates tend to come and go out of fashion like flared jeans. But what happens to be in vogue or popular should not influence the way that we invest.
Our reasons for buying shares in any company should be governed by whether we think that they will be able to deliver a good return over the long term. Whether the market likes them is irrelevant.
Benjamin Graham, often referred to as the father of value investing, said we are neither right nor wrong because the market agrees with us. We are right because our reasoning is correct.
What is a conglomerate?
Quite simply, it is company that is made up of apparently unrelated businesses, in which it might own significant stakes. The key is that these subsidiaries should operate independently.
That said, the parent company – often because of its considerable ownership in them – will probably want to have some say into how they should be run.
Conglomerates were all the rage once, especially in the West. In those days, big was beautiful.
They are still popular in the East. In Korea they are known as chaebols; in Japan they are called keiretsus, while in Hong Kong they are referred to as hongs.
There was another attraction about conglomerates. The businesses that they controlled would often operate in very different industries. Consequently, they could be exposed to different economic cycles, which meant that the risk of one industry doing badly could be offset by another that was performing well….
…. It’s like an ice cream seller who also sells umbrellas. The tills could ring, come rain or shine.
There was something else that was appealing about conglomerates. They could access capital, even when credit conditions might be tight.
A well-run conglomerate could, for instance, deploy cash generated from one part of the group to another that might be able to generate an even better return. Consequently, conglomerates like to retain a significant proportion of their profits.
The average retention ratio for conglomerates is around 70%. Berkshire Hathaway (NYSE: BRK-A), Warren Buffett’s investment vehicle, doesn’t even pay a dividend.
Buffett believes that he is the best allocator of capital for the benefit of shareholders. He has a point. Over the last decade, Berkshire Hathaway has delivered an annual total return of around 10%. In other words, every $1,000 invested in Berkshire Hathaway would have almost trebled to $2,722, after ten years.
The key to Berkshire’s success has been its high return on equity. This is the profit that a company makes on every dollar of shareholder capital. Over the last decade, it has generated, on average, $9 of bottom-line profit for every $100 of shareholder equity.
It is not alone. The Philippine’s San Miguel Corporation, whose interests span beer production and finance, Malaysia’s Sime Darby (KLSE: 4197.KL) and Singapore’s Jardine Matheson (SGX: J36) have all delivered near double-digit return on equity.
What’s interesting is that there appears to be a tacit correlation between the return on equity and the total return that conglomerates have delivered. Companies that have achieved a high return on equity tend to also deliver high total returns for shareholders.
But the return on equity should not be the only way that we look at. Admittedly, it can be a useful measure of how efficiently a business uses the money at its disposal.
But it can be distorted by excessive debt, which is why it is important to look at other measures of a company’s performance also.
Too much debt could boost a conglomerate’s return on equity. But it could also make it vulnerable when interest rates are rising.
Thankfully, conglomerates are, in the main, quite conservatively leveraged. The median leverage ratio over the last decade has been around two.
But there are notable exceptions, especially amongst some Japanese keiretsu that have almost as much total assets as liabilities. But then, Japanese interest rates are ridiculously low. So, why look a gift horse in the mouth.
Sweat those assets
The asset turnover, which is a measure of the amount of revenue generated on every dollar of asset employed in the business, is another way to assess a conglomerate’s efficiency. On average, conglomerates generated about $5 of revenue on every $10 of assets at their disposal.
But some are much more efficient. Singapore’s Jardine Cycle & Carriage (SGX: C07), which also owns a big chunk of Indonesia’s PT Astra, generates around a dollar of revenue on every dollar of asset.
From an investor’s perspective, conglomerates could be an interesting way to achieve diversification through just one company. Income investors might want to focus on those conglomerates with a high retention ratio plus a high return on equity.
Together the two ratios could combine to deliver faster dividend growth. That could be a good place to start looking, especially if we are not overpaying for every dollar of the conglomerate’s asset.
A version of this article appeared in The Business Times.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo owns shares in Jardine Matheson, Jardine Strategic, Jardine Cycle & Carriage and Wharf Holdings.