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The Conglomerate CorporationAuthor(s): Neil H. JacobyReviewed work(s):Source: Financial Analysts Journal, Vol. 26, No. 3 (May - Jun., 1970), pp. 35-38+40-42+44-48Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4470677 .Accessed: 16/07/2012 17:13

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byNeil H. Jacoby

t T H EO G OMR T

THE past decade has witnessed he third great waveof corporate mergers in the American economy dur-ing the present century. Its dominant feature was

the burgeoning of the conglomerate corporation. During1968 more than forty-four hundred companies disap-peared by mergers (including combinations and acquisi-tions) involving an estimated forty-three billion dollars'worth of securities - an all-time record. In this tidalwave of mergers, which may now have crested andbegun to recede, conglomerate firms accounted for asubstantial or a preponderant fraction of all firms andassets involved, depending upon the definition of con-glomerate.

Why did a third merger wave peak in the nineteen-sixties and emphasize conglomeration? Is the conglom-erate a stable and efficient form of business, the heirapparent to American corporate power? Or is it afinancial fad, a source of monopoly, a threat to smallbusiness? Does it pose any new problems of publicregulation? Is it monster or model of the future?

The Conglomerate DefinedConglomerate is used herein to mean a business

corporation producing products or services of several

industries that are unrelated with respect to raw material

NEIL H. JACOBY s an Associate of the Center for the Studyof Democratic Institutions; he is also Professor in theGraduate School of Business Administration at the Uni-versity of California, Los Angeles, where he served as Deanduring 1948-68. He was Chairman of President Nixon'srecent Task Force on Economic Growth.

This article i8 adapted from material which appeared inThe Center Magazine, publication of The Center.

sources, product development, production technology,or marketing hannels. A conglomeratemerger ringstogether wo or more such enterprises ngaged n unre-lated lines of business. It is a particular mode of enter-prise growth in which the firm penetrates industriesoutside its current operations.

Many managers of diversified irms avoid use of theword, believing that it denotes lack of any inner logicand has a pejorative ing. They prefer o describe heircompanies as multi-market r multi-industry irms.However, tconglomerate as gained too wide a cur-

rency to be discarded, and it is a special kind of multi-industry irm.Modes of enterprise expansion may be classified as

follows:

(1 ) Vertical(a) Backward toward raw material ources)(b) Forward (toward consumers of final

products)(2) Horizontal (market extension within the same

industry)(3) Product extension (into additional ndustries)

(a) Producing elated products

(concentric)(b) Producing unrelated products(conglomerate)

Merger is a minor method of growth of Americanbusiness corporations, the predominant source beinginternally generated funds. Up to recent years mostmergers have been of the vertical or horizontal ypes, inwhich he surviving irms acquired ther firms within hesame industries or industrial groups. During the nine-

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 970 35



teen-sixties, however, most large mergers nvolved irmsoperating in different industries. Some encompassedfirms producing products hat were related with respectto sources of raw materials, production echnology, ormarketing channels. These have been aptly termed

concentric ompanies. Others nvolved unrelated n-terprises-the true conglomerates.

Product relationships re, of course, a matter of de-gree, and opinions may differ on whether hose withina diversified company are significant. Spokesmen ormulti-industry irms often offer tenuous heories of cen-trality to avoid the brand of conglomerate. Are suchtraditional iants as General Motors diesel locomotives,refrigerators, and air-conditioners as well as motorvehicles) and General Electric (jet engines and metal-lurgical chemicals as well as hundreds of electricalproducts) conglomerates r concentrics? Should Trans-america be classed as a concentric because its avowed

field is services '? Norton Simon, Inc., because itserves he needs of the individual s a consumer, home-maker, and person ? Bendi'x ecause t is committed o

growth hrough echnology ?Or Occidental PetroleumCorporation, which describes tself as a producer ndprocessor of natural resources ? Occidental, or exam-ple, rejects the conglomerate abel because commontechnologies re used in exploring or and producing il,natural gas, coal, sulphur, and phosphates, and all ofthese raw materials nter nto fuels, fertilizers, ndustrialchemicals, and plastics, ts major products.

On the other hand, there are many huge corporationswhose activities are so disparate hat their managements

do not even attempt o formulate a theory of centrality.Among them are Litton Industries, which makes officeequipment, builds ships, operates restaurants, ells pack-aged foods, and operates national development plans,among many other activities. Ling-Temco-Vought, n-ternational Telephone and Telegraph Company, Gulfand Western Industries, and Tenneco, Inc., are otherconglomerates whose manifold products clearly lackcommon raw materials, production echnology, or mar-keting channels. Even the names of some conglomeratesimply an all-encompassing enerality, uch as NationalEnvironment, Commonwealth United, or NationalGeneral.

Although oncentric ompanies resometimes roupedwith conglomerates, t is preferable o adopt a strict defi-nition, which focuses attention upon the managerial ndfinancial economies that distinguish he true conglom-erate corporation. The conglomerate as managerial ndfinancial ontrol over products o diverse hat negligibleeconomies of scale can be realized in performing hefunctions of product-development, urchasing, produc-tion, or marketing. Thus it differs from multi-plant,

multi-product, or multi-industry firms that do achievethese economies. It differs, on the other hand, from theinvestment company, which does acquire ownership in-terests in firms producing unrelated products but doesnot have management and financial responsibility forthem.

Lessons From the PastWe may more confidently assess the meaning of the

current wave of conglomerations, predict its duration,and forecast the economic effects and public regulationsit may produce by examining the course of past mergeractivity in the United States. Economic historians gen-erally agree that the American economy has experiencedthree major business merger episodes since the eighteen-nineties.

The first wave, in which activity rose markedly aboveits long-term trend during the five-year period of 1897 to

1902, peaked in 1899. In the peak year approximatelytwelve hundred mining and manufacturing corporationswith total capitalizations of $2.3 billion (about ten bil-lion in 1968 dollars) were involved. The major thrustof this wave was the joining of local and regional rail-roads into national systems and of one-plant manufac-turing companies into national multi-plant entities. U. S.Steel Corporation, U. S. Rubber Company, and Ameri-can Can Company were born in this epoch.

The second episode, marked by a high level of activityduring 1924-30, reached its peak in 1929. In that yearsome 1,250 mergers were reported, apparently involvingsecurities of much larger total value than in 1899. Ver-

tical and horizontal combinations of manufacturing,public utilities, and merchandising companies wereprominent in this wave.

The third period of hyperactivity began about 1965,when the graph of annual mergers broke sharply upwardfrom its long-term trend line. Mergers continued to risethrough 1968 when some twenty-five hundred miningand manufacturing companies were acquired witharound twenty billion dollars' worth of securities. Themost prominent actors in this wave were the conglom-erates.

The long-term curve of merger activity displays muchpeakedness. A four- or five-year buildup to a peak yearof activity has been followed by a year or two of swiftdecline. In view of the anti-inflationary policies of theNixon Administration and consequent leveling of stockprices, this pattern suggests that 1968 may turn out tomark the high point of the current wave, and that mergeractivity will subside during the next year or two to a

normal level. If so, thirty-nine years would separatethe second and third peaks, while thirty years separatedthe first and second peaks. Over the past seventy-five

36 FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 970



years, merger activity has risen at a rate of under fourper cent a year. Because this has been little more thanthe rate of growth of real G.N.P., merger activity doesnot appear to have become relatively more importantover the long term.

Although measures of merger activity areincomplete

and one may not generalize upon a basis of two or threewaves, the evidence supports a conjecture hat the hecticmerger activity of 1968 will not be matched again for anumber of years. The economy s probably not movingup an accelerating ecular trend of business concentra-tion through merger, and conglomeration hould not beviewed in apocalyptic erms. The forty-four hundredbusiness corporations hat disappeared y merger during1968 were a small number compared with the twelvethousand that disappeared by failure, or the two hun-dred and seven thousand new corporations ormed. Eventhe forty-three billion dollars n securities exchanged n

mergers that year was less than four per cent of themarket value of corporate ecurities.

Merger Episodes: An HypothesisWhy has American merger activity taken the histori-

cal form of a strong wave at long time intervals? Weknow that merger peaks have not corresponded loselywith peaks in production, ommodity prices, or over-allbusiness activity. Of all economic indicators, mergeractivity has been most closely related to movements nindustrial stock prices. A booming stock market hasbeen present at the crest of all merger waves. Yet a highlevel of mergers has not accompanied ll market peaks.

In the extensive iterature n mergers, hree theorieshave been advanced to explain their motivation andeconomic effects. Many observers have seen in businesscombinations only the elimination of competitors, sothat surviving irms can reap monopoly profits. Othershave stressed he dominance of promoters and bankers,who engineered mergers n order to sell securities o thepublic at inflated prices. Still others have viewed mergersas a natural esponse of businessmen o new opportuni-ties to reduce costs and expand sales and profits in acompetitive environment. We may call these the mo-nopoly, the stock promotion, and the efficiencytheories.

None, taken by itself, provides a satisfactory xplana-tion of the long periods of time that have separatedpeaks of merger activity. There is no reason why thequest of businessmen or monopoly power should mountto a climax every thirty or forty years. Stock marketcycles have been much shorter than a decade in theirduration. Population rowth and technological hanges,which father business opportunities, ake place more orless continuously.

The conjecture s made that long-term merger wavesin the United States are explained by the infrequent on-juncture of two preconditions: (1) an accumulation fperceived and unexploited profit-making pportunitiesfor enlarging he scale of enterprises, rising rom basictechnological and social changes, and (2) a buoyantcapital market with strong demand or new securities.

This Conjuncture Hypothesis, which is put forth asan interesting onjecture and not as a scientific heory,combines elements of the efficiency nd stock pro-motion theories. It asserts that, before merger hyper-activity can occur, there must be present both an un-usually large number of opportunities for enlargingprofits by combining independent firms, and strongpublic demand for the new securities created in themerger process. Because hese two preconditions o notoften coincide n time, merger hyperactivity s much lessfrequent han stock market peaks.

The Conjuncture Hypothesis reasons that the pre-dominant motives for mergers are the drive of busi-nessmen to realize larger profits by capitalizing uponnewly perceived economies of scale, and the ability ofbankers o sell new securities o the public on profitableterms. It rejects the notion that monopoly power hasbeen an important motive for corporate mergers duringthe past half century. The quest for monopoly powerapparently id play a role in the first merger wave thatpeaked in 1899, because anti-monopoly aws were thennot vigorously enforced. Since World War I, however,the Sherman Act, the Federal Trade Commission Act,and state anti-monopoly aws have generally orbiddencombinations hat threatened o create undue marketpower. The Conjuncture Hypothesis does not, of course,imply that substantial advantages of larger scale arenecessarily present n all mergers. History demonstratesthat in the hyper-enthusiasm f a stock market boommany mergers are launched that later founder on therocks of reality.

Why does a combination of a large number of per-ceived opportunities or profits rom enlarging irms andbuoyant capital markets occur infrequently? The ideathat change s the only constant n modem society is bynow a cliche. Less well understood s the distinction be-tween tactical (small, superficial) and strategic salient,structural) changes. Most tactical changes cancel oroffset each other through time. A few cumulate intostrategic shifts in the structure of technology and society.Not only do strategic changes take many years to accom-plish but there is a time-lag between their occurrenceand their general perception by people. Many strategicchanges create opportunities for profit by enlarging en-terprises. In the pervasive optimism of a stock marketboom, once-overlooked opportunities, or known oppor-




tunities previously not financeable, are acted upon. Giventhe rapidity of communication in financial markets, suchperceptions multiply and build up to a climax. WallStreet goes through a phase of merger madness.

Later, the pool of profit-making opportunities for

business combinations is drained. Concurrently, finan-cial expectations deteriorate. Merger activity falls off asquickly as it previously mounted. Many years pass be-fore structural changes in technology and society createa new pool of perceived chances for gains from enlargingthe scale of corporate operations. When a new reservoirof opportunities has been filled, and this knowledgepermeates the business and financial communities, theconjuncture of a boom in equity security prices willtrigger another merger wave.

Let us consider merger waves of the past. Certainstructural changes set the stage for the first peak in1899. One was the creation of a national railway net-

work during the eighteen-eighties by the connection ofhundreds of local and regional lines and the buildingof tens of thousands of miles of new lines. The same erawitnessed the completion of national telegraphic andtelephone communications. These facilities enormouslyreduced the cost and increased the speed of transpor-tation and communication. National markets became areality. By 1895 opportunities for profit by combiningfirms into larger units and reaping the benefits of lowercosts through economies of scale in production hadgrown immensely. Meanwhile, the nation had developeda national capital market. By 1895 rising security priceshad met the other necessary condition, and the firstmerger wave rolled on. That stock promotion gains mayhave played a significant role in this merger wave is sug-gested by the fact that a large number of the combina-tions made in that era subsequently failed.

The structural changes that undergirded the secondmerger peak in the nineteen-twenties also took place intransportation and communication. With the develop-ment of reliable mass-produced motor vehicles and thecompletion of a national network of all-weather roads,the U. S. economy was motorized after World War I.Autos and trucks gave people and goods unparalleledmobility, enlarging markets, destroying local monopo-lies, and creating new economies of scale. Concurrentlythe home radio receiver made national advertising cheapand effective, built the value of national brand names,and enhanced the advantages of national marketing.Single-unit distribution was doomed. By the mid-twen-ties, businessmen generally perceived the astonishing op-portunities for larger firms opened up by these changes.The booming stock market of 1921-29 satisfied theother precondition, and the second great merger episodewas under way. Its economic rationale focused upon

economies of scale in marketing, although it also ex-ploited production economies.

Structural Foundations of the ConglomerateMerger Wave of the Nineteen-Sixties

The Conjuncture Hypothesis is consistent with themain facts about the great merger wave still under way.Structural changes in the United States since World WarII had by the early nineteen-sixties created a pool ofperceived opportunities for profits by enlarging the scaleand diversifying corporate operations. The buoyant cap-ital market that emerged in the last half of the decadetriggered the merger boom that began about 1965 bymaking it easy to sell new securities to the public. Mostfundamental and powerful of the underlying structuralchanges was a revolution in management science. Othercontributory factors were the postwar research-and-development explosion, the rise of the service economy,

a quantum increase in taxation, and a doubling of theprice of capital.

Management Science and ComputersRadical changes occurred in the science of enterprise

management after World War 11. These changes hadtheir roots in the wartime efforts of mathematicians tosolve complex logistical and military problems by oper-ations research. Concepts and methods were then de-veloped that were later found to be equally powerful indealing with the management problems of a civilianeconomy. Intuitive judgment has been progressivelysuperseded by rational decision-making processes. Suchproblems as evaluation of investment projects, choice offinancing plans, locating facilities, scheduling productionand controlling inventories are now solved by mathe-matical and statistical methods.

The concurrent phenomenal development of elec-tronic computers has promoted and facilitated theexpansion of management science. The computer notonly does routine accounting with fantastic speed butperforms the great volume of calculations involved insolving management problems. In 1950 only a few com-puters were operating in businesses; at the end of 1968there were more than twenty thousand.

This fundamental development has created oppor-tunities for profits through mergers that remove assetsfrom the inefficient control of old-fashioned managersand place them under men schooled in the new manage-ment science. Managers are able to control effectively alarger set of activities. Being of general applicability tobusiness operations, management science makes possiblereductions in financial and managerial costs and risksthrough acquisitions of firms in diverse industries. Thesegains differ markedly from the familiar economies of




retums to investment han did the United States. Duringthe mid-sixties the difference began to shrink by amarked ise n U. S. interest rates. Today, prices of cap-ital are about equal n the world's major money-markets.

The higher price of capital has had many conse-quences. Corporations have tried to use their

capitalmore efficiently. Cash management rograms have pro-liferated. Investment projects have been screened morerigorously. The finance officer has moved to the top ofthe corporate hierarchy. Aggressive managements avelooked for merger partners aden with cash or liquifiableassets. Banks, insurance, and finance companies havebeen especially ought after as acquisitions by industrialcompanies because of their steady inflows of deposits,premiums, or loan repayments. Yet any company withliquifiable nd ow-earning ssetshas been a target. Thusthe pervasive quest for financial resources has been themotive behind many a conglomerate merger.

Private and Social Gains From ConglomerationAn exploration of the principal tructural hanges n

the U. S. economy that have fostered conglomeratemergers helps to identify the gains that may accruefrom this kind of corporate diversification. A criticaldistinction should be drawn between social gains andprivate gains. Public policies should encourage, or atleast permit, hose mergers hat have the potentiality fyielding net gains to society. It should not encouragethose that result only in transfers of wealth or incomeamong ndividuals.

The two principal kinds of private gain from mergers

are promotional profits and reductions n tax liability.While these private gains may or may not be accom-panied by social benefits, t is probable hat both resultfrom most conglomerate mergers.

Consider the extreme case of a merger whose solepurpose and effect is to generate profits for promotersand bankers, who take advantage of the optimism ofthe public during a stock market boom. The standardgambit s to have a growth ompany, whose stock isselling at a high multiple of its annual earnings, acquireanother company whose stock is evaluated at a lowmultiple of earnings, n the expectation hat after a pool-ing of interests he market will value the equity of theexpanded urvivor at the higher multiple. In the atmos-phere of a boom this expectation s often realized. Earn-ings per share of the acquiring irm will increase as aresult of the merger. The market will apply the highmultiplier nd bid up the price of the stock. This makesfurther acquisitions hrough exchange of stock attrac-tive. They are the basis of a further expansion n re-ported earnings per share and further nflation of themarket price of the stock.

The game can continue until the public recognizesthat there is no growth n the operating arnings of theacquired companies. The price of the conglomerate'sstock then plummets o a point where he price/earningsratio s normal. At this much ower price, further acqui-sitions are unattractive nd cease. Meanwhile, romoterswill probably have unloaded heir shares on less sophis-ticated investors, and bankers will have pocketed theircommissions. By assumption he mergers produce nosocial benefits, so that all that happens s a transfer ofcapital values from one to another set of individuals.Such stock promotion mergers have tended to takethe form of conglomeration n recent years, becausecourt decisions have made other large mergers difficult.

Public policy can do little to prevent such mergers,beyond enforcing Securities and Exchange Commissionregulations equiring ull disclosure of all material acts.If speculators ignore the rule caveat emptor, they suffer

the consequences. A good number of the mergers duringpast waves have subsequently ailed, implying a want ofreal social gains. Of course, their promoters may havesincerely believed hat real gains were possible, but theirhopes were disappointed. Given the dynamism nd com-plexity of business life, predictions of social gains areinevitably hazardous, and there is no feasible means ofdistinguishing promoters with honest intentions fromothers. The public is best protected by education andfull disclosure.

The second type of private gain from mergers s re-duction of tax liability. If a company with carried-overlosses is merged nto a profitable ompany, he taxes of

the survivor are reduced. Reduction n tax liability alsooccurs when a company with fully depreciated ssets isacquired n a purchase basis for a market price substan-tially n excess of net book value, thereby permitting heacquiring company to write off the acquired assetsagainst axes a second time. A further reduction arisesif the company acquired has little or no debt outstandingand the acquisition s financed argelyor entirely hroughthe issue of debt securities, he interest cost of which istax deductible. When, for any or all of these reasons,taxes are reduced, government may be obliged o imposeheavier taxes upon other firms in order to restore thepreexisting evel of revenues. There is a shift of taxburden from stockholders of the merged companies tothose of the other firms. Society will be unaffected, x-cepting for a possible deterioration n the equity of thetax system.

Public policy can do little to inhibit mergers arrangedsolely to cut taxes, given the high tax rates. Opportuni-ties for reducing axes by merger could be curtailed byradical implification f the structure f federal axationof corporate ncome. This structure s now highly dif-




ferentiated and shot through with special treatment ofparticular industries.

Several types of gains from mergers are, at leastpotentially, of value to society.

(a) Reduction of the risk/reward ratio. By defini-tion, the conglomerate firm combines operations un-related in respect to raw materials, technologies, ormarkets. The annual sales or profits of its differentoperations may be only weakly correlated. In the aggre-gate they will produce a more stable return through time.For any given rate of return on investment, risk will beless; for any given risk, expected reward will be higher.The standard gain from portfolio diversification will berealized. This benefits society as well as the conglom-erate's stockholders, because the reduction in the pre-mium for risk is equivalent to a cut in the company'scosts and, via market competition, in the prices of itsproducts.

(b) Lower capital costs and avoidance of Gambler'sRuin. Closely related to the gains of diversification arethe advantages reaped by the conglomerate of lowercapital costs and avoidance of Gambler's Ruin. Theconglomerate can raise funds on either a debt or equitybasis at lower cost than could its constituents.

In addition, having a long purse, it is in a positionto finance temporary operating losses of a subsidiarythat would bankrupt the latter if it were an independentfirm. The conglomerate is in a position to out-spend,out-dare, and out-wait smaller and financiallv lesssecure firms in its effort to win a market. This is socially

beneficial, provided that the conglomerate continues toface adequate competition in its several markets-a sub-ject to which we shall return. Of course, this sameargument can apply to any large corporation-whetherconglomerate or not.

(c) Economies of scale in performing general man-agement functions. Acquisitions can enable the con-glomerate firm to apply over a wider sales base thetalents of a skilled general management team. Generalmanagement functions are involved, and include thoseof planning, organizing, staffing, budgeting, and con-trolling-generic functions in all kinds of enterprises.While organizational structures of conglomerates differ,the central corporate management commonly delegateswide authority to each divisional management, and holdsthe latter accountable for a target rate of return onthe investment in its division. The central corporateofficers enforce a planning and controlling disciplineupon all divisional managers. They make the majordecisions on capital allocation. Characteristically, theyalso provide a kind of inside ' management consultingservice to the entire organization.

(d) A cquisition of highly specialized managementtalent. Closely related to the third factor is the possi-bility that the conglomerate, with its larger and morediverse activities, can utilize efficiently specialized ex-perts in operations analysis, computer science, behavioralscience, incentive systems, international business, andso on. The scale of operations of the smaller firms itacquires is often too small to justify their cost.

(e) Transfer of assets to more efficient management.A real social gain occurs when the assets of an enterpriseare transferred via merger into the control of a superiormanagement. Striking advances in management science,combined with great inequalities among firms in itsapplication, have opened up extensive opportunities forgains from such transfers. Through more informed de-cisions and better information systems, resources can bedeployed with greater efficiency, resulting in lower costsand product prices. While this kind of social gain can

flow from any kind of merger, it is most likely in con-glomeration. The reason is that market competitiongenerally compresses differences in the quality of man-agement of firms in the same industry to a smallerdimension than is present among firms in different in-dustries. Hence the frequency and size of such gainsfrom conglomerate mergers is probably greater.

In what proportion of conglomerate mergers aresocial gains realized, and how large are those gains?Regrettably, these questions cannot be answered in thepresent state of knowledge. Answers would require in-tensive, elongated case studies of the costs, prices,

profits, and managements of conglomerates and theirconstituents, before and after merger. Most conglom-erate corporations have had too recent a life history topermit confident conclusions. Professor J. F. Westonanalyzed the financial performance of fifty-eight multi-industry firms over the nine-year period 1958-66. Asmight be expected, their sales grew at an annual com-pound rate of 17.8 per cent a year, double that of allU. S. manufacturing firms. Earnings per share grew tenper cent a year versus 6.7 per cent for all firms in theStandard and Poor's stock index. Stock prices at eachyear's high point rose 10.5 per cent a year, against 5.4per cent for the Dow Jones Industrial Average. In 1967

conglomerates earned 12.6 per cent on their net worthcompared with 11.9 per cent for all manufacturing firms.

Prima facie, the conglomerates gave a superior per-formance. Yet, these figures do not prove that theymanaged assets more effectively than other corporations.Many of the firms in the Weston study were concentricsrather than true conglomerates. His study did not takeinto account the heavier levering of equity capital byconglomerate managements- a stratagem that is profit-




able during strong business expansion, but which canbackfire under adversity. Also, conglomerate managersnot infrequently ntroduced new accounting practicesthat inflated heir earnings. Empirical proof of the fre-quency and size of gains from conglomeration hus re-mains to be produced.

Conglomeration, Concentration, nd CompetitionThe most important ssue of public policy raised by

conglomeration s its effect upon the vigor of competi-tion. Traditionally, usiness mergers have been identi-fied with tendencies o monopoly. This is understand-able, because most mergers n past years have been ofthe horizontal or vertical types. Many have increasedindustrial concentration the percentage of the totalsales or output of an industry accounted or by its lead-ing four or eight firms. Economists generally agree thatthere s a positive but loose correlation etween he levelof concentration f an industry and the probability ofnon-competitive r oligopolistic behavior by its leadingfirms. When the preponderance f all output of an in-dustry s produced by three or four leading corporations,collusion among them is easier, or there may be a tacitmutual recognition hat all can profit from higher thancompetitive prices. As the level of industrial oncentra-tion drops, the chances of non-competitive behaviordiminish and become negligible when the number ofcompeting irms s more than twenty. Proposed mergersof important members f the same ndustry re thereforeproperly crutinized y the anti-trust uthorities or anti-competitive consequences, and are generally frownedupon. This is not to deny that there is vigorous com-petition in many highly concentrated ndustries (i.e.automobiles), and that mergers of several weak firms nsuch industries may sometimes reate a strong enterpriseable to offer sharper competition o its rivals than didits components.

A conglomerate merger nvolves a union of firms ndifferent ndustries. It necessarily eaves the ratios ofconcentration f all industries unchanged. Conglomera-tion does replace two or more smaller firms with onelarger nterprise, nd thus may ncrease macro-economicconcentration-the percentage f total industrial ctivityin the economy accounted or by the leading hundred r

two hundred non-financial orporations. Indeed, con-glomeration by large firms appears o have held indus-trial concentration n the economy about constant, whileincreasing macro-economic oncentration ince WorldWar II.

Manifestly, t is industrial concentration hat is direct-ly related o the vigor of competition. Macro-economicconcentration need not be of concern as long as thenumber of giant diversified orporations s large enough

to preclude overt or tacit collusion among them. Becauseit takes more than one hundred corporate giants toaccount for even a half of all manufacturing assets in thenation, we are far from the possibility of non-competi-tive behavior because of inadequate numbers.

In general, conglomerate mergers are likely to invig-

orate competition. By strengthening the managerial andfinancial support available to each of its constituents,the conglomerate is able to make each a more energeticcompetitor in the industry in which it operates. Eachentity can draw upon the conglomerate's pool of special-ized managerial talent, utilize its management science,obtain financial assistance, and assume a more innova-tive and risk-taking posture than it could as an independ-ent firm. Conglomeration can thus transform simplecompetition into multiple competition.

Beyond this, the conglomerate is more likely topossess the financial and other resources needed to enteradditional industries, theretofore closed to its smallerconstituents. Established firms in those industries will,as a result, tend to behave more competitively than be-fore in pricing their products in the hope of deterring thepotential competition of the conglomerate. It has beenaptly said that the conglomerate sits on the edge of anyand all markets, ready to enter, and thus keeps theEstablishment on its toes. Indeed, a German economisthas interpreted the conglomerate merger as a self-cor-recting force in American capitalism, making it morecompetitive and denying the Marxian prophecy of in-creasing monopoly. Certainly, enhanced potential as wellas actual competition can be an important social gain.

While conceding the probability that conglomerationenergizes competition, many observers contend thatlarge diversified corporations may engage in predatoryor other kinds of conduct prejudicial to small firms. Sev-eral arguments are advanced.

It is said that large conglomerate can engage in cut-throat or predatory pricing in one of its lines of busi-ness, subsidizing temporary losses from profits earnedin other lines until its smaller competitors are drivenfrom the field. In practice, instances of cross-subsidiza-tion are rare. Not only does it violate federal and stateanti-monopoly laws but it flies in the face of acceptedprinciples of management. In a multi-industry company

it is not feasible to force the manager of one division orsubsidiary to operate unprofitably when this requiresabandonment of established targets and managementincentive plans. Also, unless barriers to entry of newfirms are very high, the subsidized division cannot reapmonopoly profits once its competition has been elimi-nated, because its efforts to raise prices will attract newcompetitors and deny it an opportunity to recoup itslosses.




Somewhat related to the cross-subsidization rgu-ment is the idea that the large financial esources of theconglomerate its deep pocket ) enable t to engage nnon-predatory ut temporarily osing activities, such asexpensive product development or large-scale advertis-ing that smaller ompetitors re unable o finance, whichultimately give it the competitive edge in the market.While there may be truth to this contention, he advan-tage of the larger firm arises from superior resourcesand not from conglomeration. Unless one believes thatpublic policy should protect smaller firms at any cost,one cannot object to product and market developmentactivities which are in the consumers' interest, eventhough they are open only to enterprises with amplefinancial means.

Yet another tandard bjection o large irms, whetheror not conglomerate n nature, s that they achieve suchimportant dvantages f scale that they raise the barriersto entry into an industry. Here again there is truth inthe argument. Conglomeration s well as other modesof business diversification an enable the surviving irmto benefit rom reductions n risks or costs through en-largement f operations. By increasing he stakes n theindustrial ame they make it harder or poor players osurvive. If these economies are real, society benefits-provided hat competition emains effective and obligesthe conglomerate o pass the economies along to thepublic via lower prices or product mprovements. Fewwill defend the perpetuation of inefficient small-scalefirms at heavy cost to the public. What is important sthat a sufficientnumber of firms remains n each indus-try to discipline each other.

The possibility hat the conglomerate irm will causeits constituents o practice commercial eciprocity, o thedisadvantage of its small competitors, s usually men-tioned in assessing he effects of mergers upon competi-tion. If intradivisional ales are made on competitiveterms, here can be no complaint. s it realistic, however,to expect the manager of one division of a conglomerateto do business with another division on unfavorableterms, counting upon recouping he loss by selling theother division some of his own product at higher thancompetitive prices? The answer s negative because, aspreviously noted, it violates basic principles of man-

agement.Business reciprocity can also be practiced in pur-chases and sales among different companies in suchsubtle ways as to escape detection by anti-trust uthori-ties. However, there is not clear evidence that con-glomerates are more culpable than other large firms.Corporate systems of incentive and control normallydelegate o divisionalmanagers he authority o buy andsell in the cheapest market.

Finally, there is concern that conglomeration may bea new route to dangerous aggregations f economic andpolitical power in American society. A competitivedemocratic order manifestly requires an adequate dis-persion of power. Citizens and lawmakers must remainvigilant o stop undue concentrations f all kinds. It hasfrequently been noted that over the sixteen-year periodof 1947-63 the top two hundred orporations xpandedtheir share of total value added in American manufac-turing from thirty to forty-one per cent, and that by1963 the hundred argest irms had a greater hare thanwas held by the two hundred argest n 1947. There are,nevertheless, easons or believing hat macro-economicconcentration s not at a dangerous evel. Although re-duced, the number of large manufacturing orporationsremains o large as to preclude he possibility of oligopo-listic behavior. Levels of industrial oncentration havenot risen, and they are the relevant criteria or judgingcompetition, as the 1964 guidelines published by theAttorney General recognized.

American ourts have consistently held that large sizeis not, per se, an offense against the anti-trust aws. Ifcorporate giantism were anti-social the governmentshould long ago have proceeded o break up the largernon-conglomerate iants. In a ranking of 130 membersof the billion dollar club in descending order of their1968 sales revenues, he five largest conglomerates wereInternational Telephone and Telegraph, 14th; Ling-Temco-Vought, 30th; Tenneco, 45th; Litton, 48th; andTextron, 59th. If public policy required a dismantlingof these largest conglomerates, some fifty-four other

giants should first be broken up. Only eight conglom-erates ranked among the two hundred argest manufac-turing corporations.

Conglomeration elps to keep down industrial con-centration n manufacturing nd mining, in the face ofrising macro-economic oncentration. For any assumedlevel of macro-economic oncentration, population ofconglomerate irmswill produce ower average ndustrialconcentration han would a population f single-industryor concentric irms. This is shown by a simple hypo-thetical example: American manufacturing s classifiedby the Census Bureau upon a basis of product-line nto470 industries, which are aggregated nto twenty-one

major manufacturing roups. Let us arbitrarily-butnot entirely unrealistically-assume hat industries e-fine competitive markets n the sale of products and thateach major manufacturing roup embraces relatedproducts as the word is used herein. Assume furtherthat macro-economic oncentration ises greatly to thepoint that all manufacturing ctivity s carried on by fivehundred giant corporations. What kind of corporatestructure will minimize industrial concentration and




maximize the probability of effective competition at theindustrial level? There are three major alternatives:

(a) A single-industry structure, under which therewould be on the average about one firm in each of the470 industries.

(b) A concentric firm structure, under which therewould be on the average about twenty-four firms in eachof the twenty-one major manufacturing groups and 470industries.

(c) A conglomerate firm structure, under which allfive hundred firms could conceivably compete in everyone of the 470 industries.

Under the assumed high level of macro-economicconcentration, a single-industry structure would result inwidespread monopoly. Even a concentric firm structuremight leave some industries highly concentrated. Only aconglomerate firm structure would provide high assur-

ance of effective competition.Other Potential Effects

Corporate conglomeration can have, at least potenti-ally, important effects upon the role of internal financingof business, upon investment policies, upon the relation-ship of banking to industry, and upon the process ofallocating investment among industries.

Conglomeration tends to increase the role of internalfinancing of business enterprises by reducing the firm'sreliance for funds upon external sources. In an indus-trially diversified firm, some divisions may be expectedto have expanding needs for cash, while other less

dynamic divisions may be throwing off cash. The aggre-gate demand for external funds by the conglomerate willfluctuate less through time than will the demand of anequally large but more highly specialized firm. Otherthings being equal, conglomerates will have less recourseupon the commercial banking system for short-termfinancing.

Another likely, but still largely potential, consequenceof conglomeration is a restructuring of investment port-folios. If a rising proportion of publicly owned corpo-rations conglomerate, each incorporating the principleof portfolio diversification, managers of mutual funds,trust officers, and individual investors will find it less

necessary to diversify their portfolios. Thus an investormight achieve the same protection against extreme fluc-tuations in the value of and income from his holdings bybuying one million dollars' worth of stock in Interna-tional Everything, Inc., as by buying fifty thousand dol-lars' worth of stock of companies in each of twentyindustries.

Another potential effect of conglomeration is to bringcommercial banks and industrial corporations under

common control. Already, several industrial conglom-erates have acquired commercial banks. The more pop-ular route, however, is use of the one-bank holdingcompany to acquire financial and industrial enterprises.A one-bank holding company is created when a spon-soring commercial bank issues stock of a new holding

company to its shareholders in exchange for their presentshares. The primary motive is to acquire a corporatevehicle able to diversify into financial services not opento commercial banks, such as computer leasing, creditcards, mortgage banking, or sale of mutual investmentshares. Up to the end of 1968 some thirty-four of thenation's largest banks holding over one hundred billiondollars of deposits had formed such holding companies.Unlike chains or groups of banks controlled by bankholding companies, which are prohibited by the BankHolding Company Act of 1951 from acquiring non-financial enterprises, one-bank holding companies areunregulated and able to enter non-banking activities.

A serious potential consequence of conglomerationcould be a worsening of resource allocation in the econ-omy as a result of less accurate knowledge of returns toinvestment in different industries. Most conglomeratesreport their sales and net profits in the aggregate; theydo not publish for investors the financial results of theiroperations in each industry or industrial group. Therelative profitability of different lines being unknown,investors are unable to allocate their funds among indus-tries with as much knowledge as they would possess ina non-conglomerate world. More and larger errors arelikely to be made. Society will lose from a less efficientuse of scarce capital.

Public Policy for Conglomerates

Should new types of public regulation be introducedto assure that conglomerate mergers, and the diversifiedcorporations they create, serve the public interest? Letus briefly consider, in turn, public regulation of invest-ment, of competition, of the relation between commer-cial banking and industry, and of financial disclosure.

InvestmentDuring the current wave of conglomerate mergers un-

sound corporate marriages have been proposed, and

some have been consummated by creating capital struc-tures that are top-heavy with debt. Many of these mer-gers will fail to produce net gains. Some will ultimatelyfail. The question is naturally asked why governmentshould not proscribe them. The answer is simply thatthere is no feasible way to identify socially functionlessmergers in advance. Only time and the test of marketcompetition will tell us ex post facto. A foundationalconcept of the American economic system is that busi-




ness enterprisers should be free to try out new organi-zational patterns, management concepts, and financialstructures, as well as new products. No governmentalofficial can possibly know in advance which mergerswill, and which will not, produce real benefits. To re-quire advance decisions would be to deprive society ofpossible gains from innovation, and to substitute anautocratic judgment for a democratic decision by themarket. The prevailing theory of regulation of invest-ment properly asserts the right of each individual todeploy his funds as he wishes as long as there is fulldisclosure of all material facts necessary to an informeddecision. While this policy costs society something inmisallocated capital, the benefits are certainly worth theprice.

Analysis shows that there are valid and importantsocial gains inherent in corporate diversification of theconglomerate type. The generic principle of conglomer-

ation-a plurality of dissimilar activities within a largeorganization-finds expression in other American insti-tutions. Public policy has not sought to limit or preventthis development. An example from the field of educa-tion is the contemporary multiversity with its diverseprograms and professional schools. Labor unions alsohave conglomerated, as when District 50 of the UnitedMine Workers sought to organize workers in diverseoccupations under the aegis of a miners' union.

Conglomeration has thrust into public consciousnessknotty problems of the transference of corporate owner-ship and control. For example, are special restraintsneeded upon conglomerate acquisitions of such media

of communication as radio and television broadcastingstations or publishing companies? Are they required forsuch instrumentalities of American foreign relations asinternational airlines? More generally, how can andshould society guard against the use of multi-industrycorporations by criminal elements to expand their eco-nomic influence? There are no easy answers to suchquestions, which need further study.

Competition

Because conglomerate mergers are more likely to in-crease - less likely to reduce - competition than areother forms of business combination, they do not callfor changes in the anti-trust laws. The conglomeratecorporation is neither a monster lacking in economicand social justification, nor is it a model of the futureto which the U. S. economy will increasingly conform.Its present role in the private sector is modest, and islikely to continue so. It is an interesting new type ofcorporate structure within the vast and infinitely variedmosaic of American private enterprise. Under some cir-cumstances it can yield real values for society. Whether

these values are significant, and whether they will berealized in fact, only time will tell.

The guidelines issued by the Anti-trust Division ofthe Department of Justice in 1966 make industrial con-centration ratios the primary criterion for judging thecompetitive effect of a proposed merger. Conglomeratemergers do not change such ratios. The guidelines alsoplace emphasis upon barriers to entry into an industryas a deterrent to competition. The conglomerate tendsto strengthen the ability of its former constituents tosurmount theretofore formidable barriers to entry intonew industries. While it may also raise these barriers asagainst other small competitors, the net effect of theconglomerate is likely to be competitive. The Anti-trustDivision should continue to study the impact of con-glomeration upon competition. There is, however, noevident need for change in statutes or regulations.

Separation of CommercialBanking and Industry

The Banking Act of 1935 required American com-mercial banks to maintain an arm's length relationshipwith non-financial corporations. One purpose was toprevent banks from underwriting or holding corporatesecurities, which had contributed to the wave of bankfailures after the stock market crash of 1929-32. Amore important purpose was to maintain banking im-partiality in supplying credit to businesses. A bank con-trolled by a conglomerate could be influenced to dis-criminate in favor of its parent's industrial subsidiariesand against outside enterprises in times of tight money

and credit rationing. Member banks of the FederalReserve System are instrumentalities for the executionof national monetary policies. As such, they should beindependent of external influences that could create un-fair competition. Therefore, federal legislation shouldbe enacted to block the acquisition of commercial banksby conglomerate industrial firms. One-bank holdingcompanies should be brought under the, Bank HoldingCompany Act of 1951, prohibiting them from engagingin non-financial activities.

Financial DisclosureThe conglomerate merger movement has thrown into

bold relief preexisting faults in the current system ofbusiness accounting and financial reporting. It alsocreated new problems. These defects should be curedin order that the business information system, uponwhich investors rely in allocating resources through thenation's capital markets, shall give accurate guidance.

One serious fault is the lack of standard accountingrules and procedures. This permits opportunistic busi-nessmen to vary reported profits within wide limits. A




corporate manager, for example, interested only in play-ing a numbers game with stock price/earnings ratios forquick profits, will seek to inflate current profits at theexpense of future profits. The methods are legion. Shiftfrom accelerated to straightline depreciation, defer orstretch out maintenance expense, deplete inventoriesheld at low cost, sell assets for one-shot income. Ex-cessive flexibility in permissible accounting methodscreates opportunities for misleading changes in reportedprofits.

As custodians of the business information system, theaccounting profession should take the lead in correctingthis condition. For purposes of efficient capital alloca-tion, it is important to standardize accounting methodsso that investors can easily compare the performance offirms within and among industries, and managers cannotas easily create profit illusions. The accounting profes-sion should accord this need a top priority.

The other problem is the information gap created bythe loss of identity which acquired companies suffer inthe published financial statements of diversified com-panies. Fortunately, all publicly held business corpora-tions are now required by the Securities and ExchangeCommission to report sales and net income for eachindustry in which they are operating. Difficulties inassigning taxes, interest charges, or overheads incurredby the corporation as a whole to divisions or subsidariesin particular industries may justify a report of operatingearnings rather than of net profits. Some managers ofdiversified companies resist such reporting on the groundthat it is costly, subject to error, and benefits their com-petitors. It is a sufficient answer, however, that just asthey need this information for efficient management, sodo investors need it for efficient investment.

Regulatory authorities should also require publiclyowned companies to state their earnings per share on a

fully converted as well as a conventional basis. Theformer basis assumes that all convertible securities areconverted into common shares and that all warrants andoptions to purchase common shares are exercised. Onlythus may the investor gauge the true contingent earningsof the company. This practice is especially needed byconglomerates, in the formation of which large amountsof warrants, options, and convertible securities wereoften issued.

PerspectiveAlthough historical patterns suggest that the con-

glomerate merger wave of the nineteen-sixties may nowbe in a phase of recession, the true role of the multi-industry corporation in the American economy will notbe known for another decade. If time and trial provethat its theoretical potential for lowering risk and raising

returns on corporate capital are realizable, the conglom-erate format will spread further over the corporate land-scape. Should these values elude capture or be offset byfaults yet unseen, many of these firms will disappear in afurther restructuring of corporate power.

Viewed in a broader perspective, the great wave ofconglomeration attests to the flexibility and adaptabilityof the U. S. economy in response to underlying struc-tural changes. It demonstrates that stockholder controlof corporations continues to be a vital force. Stock-holders are not the faceless and spineless figures depictedby some theorists, and managements ignore them attheir peril. No institution of a democratic society shouldbe above challenge. Managements of great corporationsneed to confront the contingency of take-over bids as astimulus to unremitting exercise of skill, resourcefulness,and imagination. The conglomerate movement has, atleast, shaken the corporate Establishment. *

FEDERALFEDERALAPER OARDO., nc.

vj I i d\ 4:Send not ice | | Common &Preferred Dividends:The Board of Directors of Federal PaperBoard Company, Inc. has this day declaredthe following quarterly dividends:

MIDDLE SOUTH UTILITIES, INC. 25 0 per share on Common Stock.2854 per share on the 4.6%

The Board of Directors has this day declared a dividend of 24d Cumulative Preferred Stock.

per share on the Common Stock, payable April 1, 1970, to The Common Stock dividend is payable on

stockholders of record . ~~~~~~~~~~~~~~~~~~~April5, I970 to stockholders of record atstockholders of record at the close of business March 16, 1970. the close of business March 7, I970.The dividend on the 4.6% Cumulative $,5

I ANNE M. FITZGERALD par value Preferred Stock is payable onMarch 5, 1970 Secretary June i5, I970 to stockholders of record

Secretary ~~~~~~~~~~~~~May9, I970.

THE MIDDLE SOUTH UTILITIES SYSTEM QUENTIN.KE DY

Arkansas ower &LightCompany Mississippi ower&LightCompanyLouisiana ower& ightCompany New Orleans Public Service Inc. Montvale',Ne7wJersey

jacoby_ the conglomerate corporation

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