The vast majority of business carried out in the United States is conducted by companies that have been incorporated. This type of company formation is distinctly different from other types and has many advantages. One obvious difference is that ownership and control are separated, and the primary objective of those who control these companies is to maximize returns to investors. One potential way of maximizing returns is to form conglomerates, which are huge entities comprising many and different companies and types of businesses.
A financial adviser who wants to recommend a risk-averse approach will inevitable talk about diversity and a diverse portfolio of investments. This is because diversity reduces risk, not only for unforeseen events, such as particularly adverse conditions in one sector or unexpected bankruptcy in one company, but also in the differing effects of the business cycle on individual businesses. In the same way, one advantage of a conglomerate is that it is better equipped to retain a general position and be less affected by adverse fluctuations.
Advantages of Size
As a conglomerate grows and acquires more companies, it can increasingly take advantage of the greater flexibility it has to develop newly-bought companies and increase their size and profitability. This can be done through economies of scale and particularly economies of scope. The former says that, up to a certain point, companies will consistently lower relative costs as they grow, and the latter that advantages can be increasingly gained from complementary services available within a growing entity.
Divergence From Core Activities
Diversification can, however, have disadvantages. Perhaps the key one is that the specialist skills built up in the original company or group of companies may not be relevant in the newly-acquired entities. This means that with overall control being exercised by a management that does not fully comprehend the forces that drive success in some of its component parts, a conglomerate can become a confusing and dysfunctional entity that is not maximizing all of its potential.
Cloudy Performance Indicators
Although the acquisition of more and more companies may potentially enable better overall performance during business cycle fluctuations, this may not always be the case. A conglomerate may keep its poorly performing units for the purposes of diversification, but in doing so, these poor performers may dampen the performance of its more successful parts. Similarly, an overall return will not highlight problems that may exist in some of the component companies, which may increasingly inhibit profitability.