Tech Companies Aren’t Immune to ‘Deworsification’

By ,

More is always better.

Or maybe it isn’t.

It’s not always easy to keep up with the likes and dislikes of investors. Investment fads change almost from year-to-year.

In 2000, investors were crazy about wireless and network companies.

But after the fall in tech stocks, 2001 was the year for old economy, defensive stocks.

Fast forward to 2013, and investors were piling into businesses that were buying their own shares.

2014 was the year to be in the US stocks.

The only reliable thing about these fads is that they come and go.

But some are more persistent than others. And in the 1960s, there was one fad that lasted for almost a decade.

Investors couldn’t get enough of conglomerates.

And, once again, investors today seem to be prizing huge tech conglomerates over anything else.

Conglomerate boom and bust

Conglomerates are those with multiple unrelated businesses under the one umbrella.

Warren Buffett’s Berkshire Hathaway Inc. [NYSE:BRK] is one such business.

Berkshire owns insurance, energy, candy and even a jet business.

General Electric Co. [NYSE:GE] is another example. Under GE’s hood is energy, computing and insurance.

In the 60s, these kinds of businesses were all the rage.

To understand why, you need to understand the time.

Growth was extremely hard to come by. Interest rates were low. And the market swinged widely from year-to-year.

Investors were looking for something safe. But they also wanted to buy companies that were growing earnings.

Sounds reasonable right?

Well, savvy managers caught on.

Why not grow earnings by buying other companies, they thought.

Because the market was volatile, they could potentially buy other businesses for cheap. Low interest rates helped finance these takeovers.

But importantly, buying more businesses would boost earnings and diversify their revenue stream.

It was a bulletproof plan.

That’s why conglomerates were popping up all over the place. As long as earnings were going up, investors happily bought in.

This chart shows how conglomerates diverged from the wider market:

Conglomerate Index vs S&P 500 Index 28-02-18

Source: JHL Capital Group

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Unpleasant Facts writes:

From 1965 through 1969, the market was obsessed with rising earnings and investors didn’t seem to care if the earnings came from new business or from buying other business. As long as earnings growth was up the company would keep its high valuation multiple,

But rather than only buying high growth businesses, managers bought just about anything. Compounding the problem were irrational investors, focusing solely on growth.

Unpleasant Facts continues:

The basic formula was that a fast growing company valued favourably by the market would use their stock to purchase low growth companies – and the earnings of the combined company would have the same multiple as the fast growing company.

Investors didn’t seem to realize that the low growth company’s earnings wouldn’t magically start growing just because it was bought by a company with a high multiple.

So when interest rates started to rise, highly leveraged conglomerates were caught with their pants down.

Losses were massive. 

Droves of investors piled out of conglomerates, causing them to collectively fall by 79%.

Here’s the chart again, a few years later:

Conglomerate Index vs S&P 500 Index 28-02-18

Source: JHL Capital Group

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Could the same happen now to the world’s largest tech companies?

Look out for ‘deworsification’

I should say, all conglomerates aren’t bad investments.

Berkshire is a wonderful company. And with hindsight, who wouldn’t have bought that stock a decade ago?

You could say the same about, Inc. [NASDAQ:AMZN].

Each year they increase their scope, adding more businesses to complement their ecommerce business.

They also make the occasional purchase that leaves investors scratching their heads. Whole Foods, an American upscale supermarket, was one of those.

What does Whole Foods have to do with online retailing?

Not a whole lot. But it could bring in a whole lot more revenue dollars for the company.

Alibaba Group Holdings [NYSE:BABA] is another example of a tech company slowing growing into a conglomerate.

If you’re unfamiliar with the name, they’re China’s Amazon, minus the inventory.

Along the way they too have added a few businesses that have nothing to do with online retailing.

Like Amazon, Alibaba has also recently jumped into the food industry. Days ago, the tech giant bought the remaining stakes in food delivery business,

Along with food, Alibaba also dabbles in loans, movies and even maps.

Take a look at the number of businesses Alibaba has bought since 2014.

Alibaba Acquisitions & Investments Over Time 28-02-18

Source: Bloomberg

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But if these acquisitions increase earnings, why not blot them on?

I’d be hesitant to say we’re looking at a 1960s situation. However, it’s important that you’re aware of what you’re paying for.

Growth via acquisition is a common method. If these are acquisitions just for the sake of having acquisitions, then it should raise some red flags.

Legendary fund manager, Peter Lynch use to call this ‘deworsification’. Meaning companies would diversify their business, but get worse at the same time.

Make sure you look out for these deworsifiers.

Kind regards,

Härje Ronngard,
Editor, Money Morning

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