Synergism

Synergism

In the 19th century, by the mid-sixties, creative entrepreneurs had discovered that growth was a word and the word was synergism.

Synergism in the quality of having 2 plus 2 equal 5. Thus, it seemed quite plausible that two separate companies with an earning power of $2 million each might produce combined earnings of $5 million if the business were consolidated. This magical, mystical, surefire profitable new creation was called a conglomerate.

Part of the genius of the financial market is that if a product in demanded, it is produced. The product that all investors desire is expected growth in earning per share; and if growth isn’t to be found in a name, it is only to be expected that someone would find another way to produce it. The market always shakes off its losses and settles down to ponder its next move, which is not too long in coming.

In the U.S., while antitrust laws keep large companies from purchasing firms in the same industry, it is possible to purchase firms in other industries without interference from the Justice Department. These consolidations are carried out in the name of synergism. Ostensibly, mergers would allow the conglomerate to achieve greater financial strength (and thus greater borrowing capabilities at lower rates); to enhance marketing capabilities through the distribution of complementary product lines; to giver greater scope to superior managerial talents; and to consolidate, and thus make more efficient, operating services such as personnel and accounting departments. All this led to synergism – a stimulation of sales and earnings for the combined operation that would have been impossible for the independent entities alone.

Synergism. Photo d'Elena.

In fact, the major impetus for the conglomerate wave of the 1960s, for example, was that the acquisition process itself could be made to produce growth in earnings per share. Indeed, the managers of conglomerates tended to possess financial expertise rather than the operating skills required to improve the profitability of the acquired companies. By an easy bit of legerdemain they could put together a group of companies with no basic potential impulse.

The trick that make the game work is the ability of the company to swap its high-multiple stock for the stock of another company with a lower multiple. For example, a type-writer company can only “sell” its earnings at a multiple of 10. But when these earnings are packaged with the electronics company, the total earnings (including those from selling type-writers) could be sold at a multiple of 20. And the more acquisitions a synergetic company can make the faster earnings per share will grow and thus the more attractive the stock will look to justify its high multiple.

The whole thing is like a chain letter – no one would get hurt as long as the growth of acquisitions proceed exponentially. Of course the process can not continue for long, but the possibilities are mind-boggling for those who get in at the start. It seems difficult t believe that Wall Street professionals could be so myopic as to fall for the conglomerate con came, but accept it they did for a period of several years. Or perhaps as subscribers to the caste-in-the-air theory, they only believed that other people would fall for it.

There were a lot of monkey-shines practiced in the 60s, that could be described as the standard conglomerate earnings “growth” gambit. Convertible bonds (or convertible preferred stocks) are often used as a substitute for shares in paying for acquisitions. A convertible bond is an IOU of the company, paying a fixed interest rate, that is convertible at the option of the holder into shares of the firm’s common stock. As long as the earnings of the newly acquired subsidiary were greater than the relatively low interest rate that was placed on the convertible bond, it was possible to show even more sharply rising earnings per share. This is because no new common stocks at all had to be issued to consummate the merger, and thus the combined earnings could be divided by a smaller number of shares.

It is hard to believe that investors did not count the dilution potential of the new common stock that would be issued if the bondholders of preferred stockholders were too convert their securities into common stock. Indeed, as a result of such manipulations, corporations are now required to report their earnings on a “fully diluted” basis, to account for the new common shares that must be set aside for potential conversions. But most investors in the second half of the 20th century ignored such niceties and were satisfied only to see steadily and rapidly rising earnings.

(Based on A Random Walk Down Wall Street, including a life-cycle guide to personal investing, by Burton G. Malkiel, 1973. W.W. Norton & Company, Inc.)