For quite a few years, the conglomerate stocks rose and rose, and to this day I donâ€™t think anyone knows exactly why. What tempted investor psychology appears to be that the mother company seemed to promise new types of economies of scale, called synergies in those days. The conglomerate was said to borrow at lower cost than the companies it purchased. It was reputed to spread its operational knowhow to its benighted purchases. It would efficiently allocate capital internally among them, investors were told. It could bring name recognition through a corporate brand. It could purchase large amounts of advertising more cheaply. Sometimes the head of the company was thought to be a genius, a new King Midas, who could turn a zinc smelter into a household name. These were the hopes and dreams. They made some sense as all such stories do. How much sense, no one knew. There was, as is usual, uncertainty. But the market was a bull, and uncertainties evaporated before the winds of optimism.
Meanwhile there were realities. The conglomerates were paying big premiums over market value when they bought out companies. If there were to be economies, the selling company shareholders of the target firms were getting the lionâ€™s share. The sellers were receiving handsome premiums up front because the conglomerates were operating in competitive buyout markets. They bought companies at auction. Buyers bid up prices at auctions. Most of the gains, if they were real, were going to the target companies that were selling themselves to the conglomerates.
How one company could create value for its shareholders by paying a big premium over market value to buy another company in an unrelated industry was a mystery, then and now. When the conglomerate sold at a price/earnings ratio of 20 and bought a company with a price/earnings ratio of 10, the combination seemed to fetch a price/earnings ratio of 20! This financial legerdemain (or was it ledger-demain?) created value, for a while. It was not permanent. By 1970 the days of reckoning arrived and the conglomerates crashed along with many other stocks.
Full article here: http://www.lewrockwell.com/rozeff/rozeff89.html
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Tip comes from Going Private