The conventional wisdom suggests that by spreading your investments across a wide range of assets, you can mitigate risk and achieve greater long returns. In this article, we will explore the diversification benefits of conglomerate stocks and why they can be valuable additions to a stock portfolio.
Diversification has long been heralded as a fundamental principle of investing. However when the investment horizon is long (5-10 years) and the risk constraints are rather lax a counterintuitive alternative of concentrating one’s portfolio in a select group of stocks tents to achieve better results. In this article, we delve into the intriguing debate between investing in the market index versus embracing the potential of a concentrated portfolio of conglomerate stocks.
Conglomerate stocks benefits
- Exposure to multiple sectors: Conglomerate stocks provide exposure to a wide range of industries and sectors within a single investment.
- Stable revenues: Conglomerates tend to have diverse revenue streams, as they operate in multiple industries. This diversification helps to mitigate the impact of any adverse events or economic downturns that may affect a specific sector.
- Resilient returns: Conglomerate stocks often exhibit greater stability and resilience during market fluctuations compared to companies focused solely on a single industry.
- Synergistic Opportunities: Conglomerates can leverage synergistic opportunities between their various business divisions. The diverse operations of conglomerates can lead to cross-selling opportunities, shared resources, and cost savings.
It is important to note that conglomerates encompass a wide range of companies with different business models, strategies, and industry exposures. Therefore, their performance can vary significantly from one conglomerate to another. Some conglomerates may excel in capital allocation, operational efficiency, and strategic decision-making, leading to outperformance. However, others may face challenges related to managing diverse operations and may struggle to generate consistent growth and profitability.
Valuing diversified companies poses a difficult task as requires analyzing the specific factors affecting each business unit. Considering the financial health, industry dynamics, competitive landscape, and overall market conditions for its business unit or subsidiary requires the contribution of many industry analysts to get the fair value of the company.
For the purpose of this backtest our investment universe is comprised of the 25 biggest US conglomerates (in market cap terms as of 2012). The investment universe contains the 2-3 biggest conglomerates per sector at the time. We tested 4 equally weighted portfolios and compared their performance against the S&P 500 index. For the first 3 we selected 10 random stocks and for the forth we use all 25 stocks.
As we see most stocks have high beta so the portfolio beta is expected to be close to 1. Also the sector correlation is high as their weight in the sector is quite high. In the following scatter plots we see how they measure against the sector SPDR ETFs and the S&P 500 index in terms of return and risk.
Nearly half of the selected stocks have annualized returns lower than the market but at least 1 of them outperforms their respective sector ETF. In terms of volatility the majority of the stocks have more volatility than the market and their sector except for 2 of the 3 Energy stocks.
Of course when our investment horizon is long we should pay more attention to drawdowns and holding period returns.
From the graph below we see that most stocks have experience drawdowns greater than the market’s and 10 out of the 25 stocks fail to beat the market during the simulation period. However there are 11 stocks that deliver far greater accumulated returns than the market.
All portfolios outperformed the market and had better sharpe and sortino ratios, although they experienced greater drawdowns.
Of course this is a simple backtest, so the universe construction and the conglomerate identification method used are rather unsophisticated. Thus we have certain bias that impact ex post results and make any ex-ante return expectations less trustworthy.
- Survivorship bias: We tested only companies that were public during the whole simulation period. (Companies that had divestitures like Dow Chemicals were excluded.)
- Selection bias: We selected companies based on the starting year and included only the bigger names per sector.
- Size bias: By definition conglomerate stocks are large cap companies.
If you are looking for a passive long term investment strategy a carefully constructed portfolio of a dozen diversified companies can potentially deliver far greater performance than an index fund.