The debate about ‘diversified’ versus ‘integrated’ or ‘pure-play’ industrial companies is still raging, with an apparent advantage for those advocating simple models over complex ones. Shareholder activists have not missed that trend as they typically highlight the opportunity to unlock value through the eradication of conglomerate discounts. The existence of such discounts tends to be justified by references to factors such as strategic confusion and poor operational performance. Yet, an important valuation driver relying on psychology may be underappreciated.
Human beings are known to fail to appropriately account for ‘tail events’, i.e. rare, high impact events, when making decisions. There are two distinct but compounding reasons for this: First, due to cognitive biases, individuals tend to overestimate the chance that rare events will occur. Second, and independently from the previous point, small probabilities are overweighted in terms of their impact on decisions because of irrational penchants: People demonstrably prefer a 1/1,000 probability of winning $5,000 over $5 which means that they are risk-seekers when it comes to low probability gains; A contrario, they prefer paying $5 over the 1/1,000 risk of losing $5,000 as they are risk-avoiders for low probability losses. The former explains why casinos or lotteries are a profitable business whilst the latter supports the existence of insurance policies.
Research demonstrates that this phenomenon plays a role in the valuation of securities. For example, it helps explain why stocks which are said to be ‘positively skewed’, i.e. deemed to offer a low probability of extreme capital gains, can be overpriced. Given their lottery-like characteristics, investors are prepared to pay a premium over the net present value of probability-adjusted cash flows to own them. Stocks at IPO often match this characteristic.
There are implications for diversified industrials too. Research shows that multi-segment firms have less skewness exposure relative to single-segment firms. Due to the diversified nature of their activities, they quite naturally offer a lower probability of extreme gains. Since they are not positively skewed, they require a comparatively higher return to attract investors, which weighs on their rating. On the other end of the spectrum, pure-plays carry a higher probability of extreme wins which tends to be distorted by the market, thereby resulting in a superior valuation. Like stocks at IPO and unlike diversified firms, pure-plays benefit from human beings’ risk-seeking preference for assets with a casino flavor.
What role should investors’ psychological representation of probabilities play in the diversified vs. integrated firm argument? None, really. What truly matters is that industrial firms implement the strategy, business model and organizational structure that allow them to outperform their competitors strategically and operationally given the specific industrial segments they operate in.
That being said, shouldn’t every equity story be positively skewed and come with a ‘kicker’, a little ‘je-ne-sais-quoi’ that enables investors to dream about winning a big prize, however low its probability?
N Barberis, ‘The Psychology or Tail Events: Progress and Challenges’, 2013
N Barberis, M Huang, ‘Stocks as Lotteries: The Implications of Probability Weighting for Security Prices’, 2008
T Mitton, K Vorkink, ‘Why Do Firms With Diversification Discounts have higher Expected Returns?’, 2006
A Tversky, D Kahneman, ‘Advances in Prospect Theory: Cumulative Representation of Uncertainty’, 1992