Update! I finally passed all the CFA exams and wrote an eBook about the program. If you're interested, click here.

Conglomerate Monkeyshines

by Lumilog on August 6, 2007

Note: Please read the disclaimer. The author is not providing professional investing advice.

I’m still working my way through the latest edition of Burton Malkiel‘s classic A Random Walk Down Wall Street. He gives an interesting – no, disturbing – example of how a company’s earnings growth rate can be manipulated through the creation of a conglomerate.

Generally as earnings increase, so to does a company’s stock price. When screening for stocks, a company can look very attractive if its historical earnings show a steady annual increase. And most investors don’t so much examine absolute earnings, but rather earnings per share or EPS.

And as it turns out, it’s easy to manufacture a growth in EPS, even if earnings themselves are not growing at all, by forming conglomerates.

A Tale of Two Companies
In his book, Malkiel gives us the following example of EPS growth fabrication. We start with 2 separate companies that have the following properties:


Name Industry Shares
Outstanding
Annual
Earnings
EPS P/E
Company A
Electronics
200,000
$1 Million
$5.00
20
Company B
Candy
200,000
$1 Million
$5.00
10



So both companies have the same number of shares in circulation and both have earnings of $1M per year. However, as is often the case, the flashy technology company commands a higher price-to-earnings ratio (P/E) than the less exciting candy business.

An Offer They Can’t Refuse
Company A makes Company B an irresistible wager. It offers to absorb Company B into Company A to form a conglomerate by giving B’s shareholders 2 Company A shares for every 3 of their Company B shares.

So Company B’s shareholders will receive 133,333 shares of A for their 200,000 shares of B.

Why so irresistible?

Compare what Company B is worth according to the stock market, versus the market value of the shares that Company A is offering in exchange.


Name Shares P/E EPS Market Value
(P/E x EPS x Shares)
Company B
200,000
10
$5.00
$10 Million
Company A
133,333
20
$5.00
$13.3 Million


Which deal would you choose?

So Company A prints up 133,333 additional shares and gives them to Company B’s shareholders. The merger is complete.

Now assume that the earnings of both A and B stay exactly the same, just as they were before the merger. The conglomerate now reports earnings of the same $1M + $1M = $2M, but earnings per share has increased from $5 before the merger to $6 now…

New EPS = $2M/(200,000+133,333) = $6

Clearly this looks great to investors who, if only examining historical EPS, see a growth of 20% since last year! And next year the company can find another business to buy to continue manufacturing growth…

Seems like an easily-spotted con but these shenanigans seemed to have fooled a lot of Wall Street in the 1960’s. As an individual investor who glances at fundamentals in order to quickly screen hundreds of stocks, I probably would have been taken in as well.










{ 2 comments… read them below or add one }

PETER GRIGOROV September 19, 2007 at 8:14 pm

Crystal clear clarification of the topic. Bravo!!

I usually invest in the so-called “Fallen Angels” – companies below their 52 week low – getting to this point because of some fraud or litigation and punished by Wall Street. If the company has solid business after a while it regains its normal price. Recently I more than doubled my investment buing BCGI 18 months ago and patiently waiting for the day of the triumph when they were acquired by some company from India. Today I picked LGND at almost 6 and expecting some 30% gain in six months. Can you tell me if this strategy is popular because it’s so simple and almost never fails ?(2 years ago I used ABB as a cash cow when they had to settle some asbestos process and were slapped by the mighty Wall)

Best Regards,
P.G.

Lumilog September 23, 2007 at 9:04 pm

Sounds like we have a somewhat similar strategy, only I don’t necessarily follow financial news too closely to look for negative press or lawsuits.

Instead I first use Yahoo’s stock screener to narrow down the stock universe to only companies that have strong financials (defined by my screening constraints like ROA, ROE, etc.). Usually this returns about 250 stocks.

Then I run a second screener of my own creation that scans these 250 companies to see which ones appear vastly undervalued (which may indeed be due to recent bad news). The output of this is normally about 4 stocks and I often already own them so I only occasionally find buys.

I have had good success with this in the last 4 years but we have been in a bull market this entire time. And according to Investor’s Business Daily, when the market is going up, 3 out of 4 stocks go up and vice versa.

So perhaps any somewhat logical strategy should give good results during a bull market.

All Best,
Lumilog

Leave a Comment

{ 1 trackback }

Previous post:

Next post: