Monday, May 12, 2008 5/12/08-Conglomerate Boom and Bust

In today's excerpt--the anatomy of an investment boom and bust of the type that inevitably occurs in U.S. financial markets once or twice per decade. In this case, it is the conglomerate boom of the 1960s--as described by George Soros:

"[The conglomerate boom] started when the managements of some high-technology companies specializing in defense recognized that the prevailing growth rate their companies enjoyed could not be sustained in the aftermath of the Vietnam War. Companies such as Textron, LTV, and Teledyne started using their relatively high-priced stock to acquire more mundane companies, and, as their per-share earnings growth accelerated, their price-earnings multiples, instead of contracting, expanded. ... The success of these companies attracted imitators; later on, even the most humdrum company could attain a higher multiple simply by going on an acquisition spree. Eventually, a company could achieve a higher multiple just by promising to put it to good use by making acquisitions. Managements developed special accounting techniques that enhanced the beneficial impact of acquisitions. ...

"Investors responded like pigs at the trough. At first, the record of each company was judged on its own merit, but gradually conglomerates became recognized as a group. A new breed of investors emerged: the early hedge fund managers, or
gunslingers. ...

"The misconception on which the conglomerate boom rested was the belief that companies should be valued according to the growth of their per-share earnings no matter how the growth was achieved. The misconception was exploited by managers who used their overvalued stock to buy companies on advantageous terms, thereby inflating the value of their stock even further. ... Multiples expanded, and eventually reality could not sustain expectations. More and more people became aware of the misconception on which the boom rested even as they continued to play the same game. To maintain the momentum of earnings growth, acquisitions had to be larger and larger, and eventually conglomerates ran into the limits of size. ...

"When stock prices started to fall, the decline fed on itself. As the overvaluation diminished, it became impractical to make new acquisitions. The internal problems that had been swept under the carpet during the period of rapid external growth began to surface. ... The situation was aggravated by a recession, and many of the high-flying conglomerates literally disintegrated. ... The surviving companies, often under new management, slowly worked themselves out from under the debris."

George Soros, The New Paradigm for Financial Markets, Perseus, Copyright 2008 by George Soros, pp. 59-61.


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