Buffett champions conglomerates, don't believe him

5 min read

Warren Buffett telling the rest of us about the advantages of conglomerates is like Willie Mays arguing for the no-look-over-the-shoulder catch while running full speed.

It can happen, and those who do it will command a premium, but your wealth or retirement should not depend upon it.

So when Buffett, the man behind Berkshire Hathaway, the world’s most successful conglomeration of companies and investments, starts singing their praises, you should do what he does when an investment banker starts talking about enhancing shareholder value: hold on to your wallet.

While first acknowledging the deservedly lousy reputation conglomerates have with investors, Buffett in his annual letter to shareholders goes on to make a full-throated defence, at least of his version.

“If the conglomerate form is used judiciously, it is an ideal structure for maximizing long-term capital growth,” Buffett writes.

The astonishing, and very possibly true, basis for his argument boils down to the idea that Buffett does capitalism better than everyone else. Better than the securities markets, with its long-running mispricings and occasional manias. Better than companies with self-serving executives aided by even worse investment bankers. Better than individual shareholders, who get trapped into paying taxes or stand befuddled and at the mercy of the fund managers and other intermediaries upon whom they rely.

“In contrast, a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Of course, form itself is no guarantee of success: We have made plenty of mistakes, and we will make more. Our structural advantages, however, are formidable,” Buffett writes.

He simply believes that he is better at allocating capital and that the conglomerate structure gives him the ability to do this more efficiently. Capital is reallocated from slowing sectors to ones with better prospects. Further, Berkshire can buy shares of businesses when they are available at attractive prices. Finally Buffett sees his company as the home of choice for owners who want to sell out but who want their firms to escape the tender mercies of private equity chieftains and cost-slashing trade sale buyers.

It is hard to argue with Buffett’s track record. Berkshire Hathaway owns more than 80 companies, eight and a half (this being its partial share of Heinz) of which are big enough to merit inclusion in the S&P 500. And his conglomerate trades at a price 40% over book value, as against a typical discount for most conglomerates.

Better capitalism or just exceptionalism?

But putting Berkshire aside for a moment, let’s look at conglomerates as a group. The sector trades at what has to be considered a structural discount to intrinsic value. This phenomenon has gone on so long it even has a name, the ‘conglomerate discount’. This discount in 2012 stood at about 10%, according to Boston Consulting, a bit less than the 14% or so average since 1990.

Conglomerates trade at a discount for a complex set of reasons. Firstly, they are often veritable playgrounds of corporate self-dealing, with executives in charge bent on empire building rather than value extraction. Empire building is a great way to justify a larger pay packet, but not always a path to lasting value.

In short, conglomerates have a track record of sub-par capital allocation, be it for venal reasons or just because most people have a bias towards what they already own and are loath to cut when it is merited.

And, as Buffett points out, conglomerates have a history of issuing too much equity to fund acquisitions, not to mention a fair amount of creative accounting along the way.

Then finally there is the fact that conglomerates are, by definition, a mismatch with the desires of everyone other than the people who built them. Investors want insurance companies, or they may want ice-cream shops, but they rarely want both together. Getting them to buy the package requires a discount.

All of these issues are essentially about abuses of power and position by incumbents, something which is possible in every corporate structure but which perhaps is given more scope in large combinations of otherwise unrelated companies.

Indeed Buffett’s deserved arrogance is a strength. He does not get seduced by Wall Street and start issuing shares and buying things willy-nilly when he is offered a silly price to do so. He plays the long game.

But this is just the point. Buffett is a hugely exceptional person, someone possessed of great judgement, great patience and a huge ability to put off very large current rewards for even bigger future ones. He’s also straight as the proverbial die.

So, invest in conglomerates, but first find your angel.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

James Saft