Conglomerates are companies that either partially or fully own a number of other companies. Sprawling conglomerates litter the Indian landscape: from the Birlas to the Welspun Group, they have a finger in just about every pie.
The case for conglomerates can be summed up in one word: diversification. Because the business cycle affects industries in different ways, diversification results in a reduction of investment risk. A downturn suffered by one subsidiary can be counterbalanced by stability, or even expansion, in another venture.
The core of the idea came from a Harvard Business School proposition that management is management. If you could manage an oil business; you could also manage a movie studio, because the basic fundamental principles were the same. But anybody who has actually managed a business knows that success depends on understanding deeply the industry in which one operates. However, the megalomaniac allure of being everywhere and owning everything is hard to resist. After all, managers are also human, aren’t they?
The case against conglomerates can be summed up in two words: size and complexity. Bigger size slows down decision-making while complexity creates confusion. Diversified companies often allocate capital to keep poorly performing divisions alive. The market would have cut them off, but in a diversified firm, good money is thrown after bad. For investors, conglomerates can be difficult to understand – accounting can leave a lot to be desired and can obscure the performance of separate divisions. Behind every Tata company there is the unlisted and opaque Tata Sons lurking in the background.
So should we break up these behemoths and force them to be independent entities? It depends. Research shows that companies with one division operating in a high-growth industry and another in a low-growth industry will generally do a worse job of allocating capital than one with two divisions operating in industries with comparable growth prospects. It means that the Reliance of yore, the vertically integrated petrochemicals major, is an example of a “good” conglomerate. Whereas the new Reliance, the one that wants to be in every vertical possible, is an example of a “bad” conglomerate.
Forewarned is forearmed!