Business diversification – a corporation being active in more than one business or industry – is currently viewed negatively.
Influenced by organizational economics and finance – agency theory (e.g. Ross, 1973; Meckling & Jensen, 1976; Fama, 1980; Fama & Jensen, 1983) and the Capital Asset Pricing Model (CAPM), respectively -, ,most stock analysts, strategy consultants and investors believe that business diversification hardly creates synergies, is costly and usually results from top management’s attempt to improve their own position, prestige and remuneration at the expense of shareholders, often by attempting to engage in revenue-smoothing (e.g. Amihud & Lev, 1981).
Further, analysts are organized by industry and thus analyzing diversified companies makes their life more complex, because they need to collaborate with other analysts in their firm (e.g. Zuckerman, 2000).
As a result, stock analysts and strategy consultants tend to call all diversified firms “conglomerates”, a label which has a negative connotation, given that conglomerates are large collections of unrelated businesses where therefore economic synergies are almost impossible.
A classical example of a conglomerate is General Electric (GE), a company which, paradoxically or contradictorily, is generally regarded as creating corporate value thanks to the role of the HQ (particularly under J. Welch) in managing managerial rotation across units and transferring innovative managerial and strategy ideas to all units, among other factors. More clear examples of conglomerates are perhaps Hanson Plc or Textron.
Even if net synergistic effects might be rare in diversified firms, analysts and consultants should try to avoid being biased and not use the term conglomerate to refer to all diversified firms.
References
Amihud Y, Lev B. 1981. Risk reduction as a managerial motive for conglomerate mergers. Bell Journal of Economics, 12(2): 605-617.
Fama EF. 1980. Agency problems and the theory of the firm. Journal of Political Economy,88(2): 288-307.
Fama EF, Jensen MC. 1983. Separation of ownership and control. Journal of Law and Economics, 26: 1-32.
Jensen MC, Meckling WH. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4): 305-360.
Ross S. 1973. The economic theory of agency: The principal’s problem. American Economic Review, 63: 134- 139.
Zuckerman EW. 2000. Focusing the corporate product: Securities analysts and de-diversification. Administrative Science Quarterly, 45(3): 591-619.