From dodo to phoenix

ADAM SMITH once said that “there is a great deal of ruin in a nation.” There is also a great deal of ruin in some kinds of business organisations. Management theorists have been predicting the death of conglomerates for decades. Stockmarkets apply a “conglomerate discount” to the price of their shares. Investors argue that it is better to bet on several focused companies than a single diversified one. Business writers routinely apply the adjectives “bloated” and “unwieldy” when mentioning conglomerates. And yet, almost everywhere, they continue to thrive.

The contrast between theory and practice is forcing management gurus to reconsider. The academic literature is bristling with second thoughts on conglomerates. Some articles are gung-ho: December’s Harvard Business Review explained “Why Conglomerates Thrive (Outside the US)”. Some are fence-sitting: September’s Journal of Corporate Finance asked, “Conglomerates on the Rise Again?” The Journal of Financial Economics and the Strategic Management Journal have also weighed in.

Conglomerates are at the heart of the Asian miracle: consultants at McKinsey calculate that over the past decade conglomerates made up about 80% of the largest 50 companies by revenue in South Korea; and their revenues grew on average by 11% a year. In India conglomerates constituted 90% of the top 50 companies (excluding state firms), and had average revenue growth of 23% a year. Tarun Khanna of Harvard Business School has argued that emerging-world conglomerates are transient phenomena: they have thrived because businesses need to compensate for the underdeveloped nature of the local market (or fill in “institutional voids”, as he puts it). They will have to focus as those markets develop, he says. But the opposite seems to be happening. The past decade has seen institutional voids being filled in rapidly across the emerging world. But conglomerates have outperformed their more focused rivals. South Korea and Singapore have joined the ranks of developed economies, yet their conglomerates still thrive. Emerging-world conglomerates such as the Tata group have also succeeded in the rich world.

J. Ramachandran of the Indian Institute of Management Bangalore says all this shows that conglomerates are not just a symptom of a difficult business climate; they have advantages that more streamlined firms lack. They can cross-pollinate ideas across different businesses: Tata’s Swach, a cheap water-purifier, incorporates expertise from both Tata Consulting Services and Tata Chemicals. They can also cross-subsidise risky ventures: Mahindra Group, another Indian giant, could rely on its solid tractor-making business as it took a punt on time-share properties; now Mahindra Holidays & Resorts is valued at more than $500m.

Mr Ramachandran says that, unlike the typical American conglomerate, those in the emerging world often have one person or family as the dominant owner. Despite this, their divisions have more independence than the typical Western conglomerate’s do: they often have separate boards and stockmarket listings. These groups’ parent companies vary enormously in their competence, Mr Ramachandran notes. Some are “evangelical architects” that focus on shaping the industries they enter. Others are “absentee landlords” that just extract rent. That said, the overall quality is going up. Tata’s decision to create a group executive office in 1998 to explore synergies between different businesses soon found imitators among other Indian conglomerates.

The rich world’s hostile climate for conglomerates since the 1960s has meant that only the fittest survive. Adaptability is key: GE, the T. rex of the clade, this week took the latest step in its continual reinvention by buying three medical companies. Guided by Warren Buffett’s management philosophy and financed by its profits from insurance, Berkshire Hathaway, with its roots in textiles, has moved into everything from railways to newspapers.

As in emerging economies, Western conglomerates enjoy advantages that focused businesses lack: In “The Deep-Pocket Effect of Internal Capital Markets”, Xavier Boutin of the European Commission and his co-authors demonstrate that diverse French business groups routinely use their deep pockets to dissuade competitors from entering their markets or to force their way into new markets themselves. Rich-world conglomerates did relatively well in the financial crisis: Christin Rudolph and Bernhard Schwetzler of Leipzig Graduate School of Management calculate that the conglomerate discount fell during the crisis from 12.7% to 6% in western Europe and from 10.8% to 7.2% in America. In the Asia-Pacific region conglomerates enjoy a stockmarket premium; it rose in the crisis. A world of scarce capital and volatile economies is one to which the conglomerate is well adapted.

Not all will fly

But this does not guarantee that every dodo will become a phoenix. Some conglomerates, especially in places like South-East Asia, depend heavily on their proprietors’ courting of politicians, and are thus at constant risk from regime change or pro-market reform. Many still sacrifice profits for market share, and will surely one day exhaust shareholders’ patience. A smaller conglomerate discount is still a discount.

Even so, the revisionists of conglomerate theory are performing a valuable public service. They are right to point out that not all diversified business groups are alike: Tata has a very different internal organisation from GE’s, and both are run quite differently from Berkshire Hathaway. They are right to point out that management matters enormously: most emerging-world conglomerates are far better run today than they were a decade ago. There used to be a near-consensus among management thinkers that Western-style focused companies represented business’s version of the end of history. That is becoming ever harder to argue.

^{Economist.com/blogs/schumpeter}