Stocks and Strategy

The Rise of Conglomerates

• Large, diversified companies with many subsidiaries
• Examples: widgets, financial services, food business, jet engines, etc.
• Managers compensated by:
• Sales growth
• Asset growth
• Issue: High sales, low profits
• No focus on profitability
• CEOs and managers doing well, but shareholders frustrated

The Problem with Conglomerates

• Difficult to manage multiple unrelated businesses
• Extraordinary skill required to excel in all sectors
• Managers reduce risk but:
• Lack of focus on profitability
• Low performance despite growth
• Risk-averse CEOs:
• Focus on sales and asset growth, not profits
• Managers focused on risk minimization, not long-term performance

The 1980s Solution: The Breakup of Conglomerates

• Shift: Breakup of conglomerates for more focus and profitability
• Why?: Companies were worth more broken up than as a whole
• Objective: Improve efficiency and profitability
• Hostile takeovers:
• Buy companies, break them apart, sell pieces for more
• Motivated by: Profits for shareholders
• CEO’s comfort was the barrier

Hostile Takeovers and Regulatory Impact

• 1968 Law: Limits on hostile takeovers
• Requirement: Inform public once you own 10% of a company
• Public Tender: Once a company’s stake reaches a threshold, offer a public price to buy the company
• Corporate defense tactics:
• Poison pills, legal strategies to avoid takeovers
• Resistance from current CEOs who were comfortable
• 1980s Corporate Battles: Managers vs. takeover artists

Key Figures in the Takeover Era

• Michael Milken:
• Junk bonds (high-risk, high-return) funded many takeovers
• Created massive capital for the restructuring of American industry
• Instrumental in the development of fiber optics and cellular networks
• Carl Icahn:
• Takeover artist: Bought companies, broke them apart
• Focused on improving efficiency and productivity of companies

The Role of Stock Markets

• Stock Market Function: Provides a way for businesses to raise capital and change control
• Hostile Takeovers:
• Ability to replace bad managers with better ones
• Companies get more focused and efficient under new leadership
• Regulatory Impact:
• Laws make it harder to execute hostile takeovers today
• Efficiency loss: Some large companies remain inefficient due to regulatory barriers

Stock Market’s Role in Efficiency

• Managers & Shareholders:
• The best way to maximize shareholder wealth: Make managers shareholders
• Align the interests of managers with the owners
• Board of Directors:
• Problem today: Boards are often filled with outsiders (e.g., politicians, academics)
• Best practice: Boards should consist of shareholders who are incentivized to maximize wealth

Regulations and Their Effect on Capital Markets

• Stock Market Regulations:
• Regulations have distorted incentives and created inefficiencies
• Stock buybacks: Companies return capital to shareholders when they can’t find better investments
• Stock options: Managers incentivized with stock ownership to align their interests with shareholders
• Insider Trading:
• Controversial topic: Should insiders be allowed to trade based on private info?
• Argument: Let markets decide through contracts, not government regulation

Conclusion: The Role of Stock Markets in the Economy

• Stock Markets:
• Provide a mechanism for businesses to raise capital
• Offer a way to change control and replace poor management
• Efficient markets: Price reflects available information
• Market Efficiency:
• Speculators: Crucial for making markets efficient by embedding information in stock prices
• Bubbles: Caused by cheap money and easy credit
• Stock prices reflect the future, not just short-term gains

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