Wednesday, May 09, 2007

Breaking up General Electric?

The Wall Street Journal has an article today about the calls by some investors to break up GE. Some shareholders have clamored for a break-up, largely because GE shares have performed poorly since Immelt became CEO in 2001. The article points out that GE shares are down 7% since Immelt took charge, while the DJIA is up 35%. This discussion reminds us of the arguments surrounding the conglomerate discount. For years, studies have shown that unrelated diversifiers trade at a discount to their break-up value. (Note that this is true in the United States, where markets are relatively efficient, and many information intermediaries exist to facilitate the flow of products, capital, and labor. According to research by Harvard Professor Tarun Khanna, unrelated diversifiers tend to perform better in developing economies, where markets are less efficient).

The explanation for the conglomerate discount is that, in the presence of efficient capital markets, investors can diversify more effectively and inexpensively than the executives of the firm. In short, we don't need senior managers at the conglomerate to spread risk by being in a wide range of unrelated businesses; we can achieve risk mitigation much more effectively by buying a portfolio of stocks of more focused firms. Similarly, in the presence of efficient external labor markets, we would question whether a conglomerate could operate its internal labor market more effectively than the external market.

However, GE has been a famous exception to the general tendency regarding the conglomerate discount. It has performed quite well for decades, with its business units outperforming most focused competitors. Could this no longer be true? If the stock price performance continues to lag the overall market, more investors will be taking a look at the age-old question: is the whole worth more than the sum of the parts? Given GE's track record, I would tend to be cautious about breaking up the firm, but it will be interesting to watch what happens if the stock continues to lag the market.