by John Brooks
The immigrant from Shanghai—in his aims and aspirations the simplest and most straightforward of any of the five or six prototypical moneymen of the nineteen sixties—had, like so many Irish, Jews, Italians, and others before him, emerged from a distant foreign city in response to a glimmer on a golden shore. Yet he was already failing at his chosen calling when he got rich from it. By another strange irony, he got rich in a way that would shortly be called illegal. In June 1971, Judge Henry J. Friendly of the U.S. Court of Appeals for the Second Circuit held that any profits from sale of a mutual-fund management company belong not to the sellers of the management company but to the shareholders of the fund. The decision was a return to the traditional doctrine—from which, as we saw, Edward Johnson had benefitted in acquiring Fidelity back in 1943—that a trustee may not traffic in his trust. Had the new decision been in effect in 1968, Tsai would have been prevented from selling out.
But no matter. The Friendly decision was not retroactive; Tsai and the many other fund managers who had sold their organizations early enough were allowed to keep their gains. Tsai might now be scorned in his profession for the early loss of his investment skill, and he might even be considered in some quarters a man who had cashed in his chips just before the casino’s doors were barred. But for all that, in his heyday in 1966 the young wizard from Boston had been Wall Street’s first Oriental hero.
CHAPTER VII
The Conglomerateurs
1
The year 1966 found Wall Street slowly and reluctantly beginning to recognize itself as a marketplace for the millions rather than an élite gambling club with a limited membership list. Manuel Cohen, Cary’s activist successor as head of the S.E.C.—a Brooklyn-born lawyer, as flamboyant in manner as Cary had been reticent, whose wife engagingly characterized her husband’s job by saying, “If I were doing it, it would be called nagging”—was nagging Wall Street as vigorously as he could. That summer, his S.E.C. forced a recalcitrant New York Stock Exchange to relax slightly the ironclad monopoly implied in its cherished Rule 394, which forbade members, except in rare instances, to transact business in listed stocks off the Exchange; under the amended rule they were allowed to deal off the Exchange in cases where they could not fill an order at a fair price on it. Seeking to implement Cary’s Special Study, Cohen and his men pressed for commission discounts on large-volume stock transactions, and for an end to “give-ups,” the time-honored commission splits between brokers that were lately being used by mutual funds to reward brokers for pushing their shares, and that in some businesses less given to euphemism might have been called kickbacks. With enthusiastic S.E.C. support and approval, the Amex made the reform-minded S.E.C. veteran Ralph Saul its new president. In December, the S.E.C. came out at last with its long-awaited report to Congress on mutual funds. The report recommended strongly worded legislation to require that mutual-fund management fees be reduced to more reasonable levels; to prohibit contractual share-buying plans that involved “front-end commision loads”; and to sharply lower the limits on all mutual-fund sales charges to investors.
Funston, in the twilight of his day as Stock Exchange president, became a progressively more stubborn conservator of the status quo. The earlier Funston, who had been chiefly responsible for the arrangements that had saved the hapless customers after the Ira Haupt and Company disaster in November 1963, now began to look like a flaming liberal by contrast with the later Funston. When New York City, pressed for money like all large American cities, proposed to raise its relatively modest stock transfer tax by half, Funston threatened (as Richard Whitney had done in 1933) to move his Exchange to New Jersey. The new tax, raised 25 percent, went into effect in July, and the Stock Exchange stayed where it was—but with diminished credibility and diminished grace as an institutional citizen.
On the matter of Rule 394, Funston simply dug his heels in and said, “We cannot and will not budge on this issue”—and then, under S.E.C. and public pressure, he budged. In related areas, the mulishness of Funston and of others on Wall Sreet was more productive. The Exchange argued that give-ups and unreduced commissions on large transactions were necessary to the orderly and profitable functioning of the securities business; as things turned out, give-ups would not be abolished, and volume discounts instituted, until 1968. The ever-more-powerful mutual fund industry fought the S.E.C.’s proposals to Congress for dear life—and fought them so effectively that the decade would run out four years later with Congress still dithering and mutual-fund reform bills still tied up in committee.
And Funston, increasingly isolated as champion of the rear guard, announced his resignation, to take effect in September 1967.
All this happened while the market, as measured by the hoary but still standard Dow industrials, was having its worst year, in terms of net January-through-December percentage loss, since 1937. The problem was chiefly a shortage of money. Back in December 1965, in the face of mounting inflationary pressures, the Federal Reserve had applied the monetary screws in classic fashion by raising the discount rate from 4 to 4 ½ percent, and over the succeeding months it had conducted its operations in a way calculated to restrain further the expansion of credit. But the medicine failed twice, effecting no cure and causing dangerous side effects. Credit continued to expand and inflation to proceed; meanwhile, the credit-dependent home-building industry collapsed, exacerbating an already existing national housing crisis; and—more important for Wall Street—money in huge quantities deserted the stock market to take advantage of the soaring interest rates on bonds that tight money had brought about. By the end of August 1966, the paper value of all issues listed on the New York Stock Exchange had declined more than $100 billion since February, and in late December—by which time the Fed had reconsidered and then reversed its ill-fated policy—the Dow, which had started the year at near 1,000, was hovering around 790.
However, this decline was not in all stocks. Certain groups of issues not among the blue chips that made up the Dow—and one such group in particular—not only resisted the downward trend but actually bucked it. Among those in the most favored group, Ling-Temco-Vought was up almost 70 percent for the year, City Investing was up about 50 percent, Litton Industries and Textron were up between 15 and 20 percent, while International Telephone and Telegraph and Gulf and Western Industries were up by smaller percentages but were poised for huge rises early in 1967. The group, of course, was the one that comprised the new corporate Wunderkinder of the stock market, the conglomerates.
2
Nobody seems to know who first applied the term “conglomerate”—which in earlier times had usually meant a kind of mineral popularly called pudding stone—to corporations given to diversifying their activities through mergers with other corporations in other lines of business. At any rate, the new usage made its popular appearance in 1964 or 1965, shortly before conglomerates became the darlings of investors. Derived from the Latin word glomus, meaning wax, the word suggests a sort of apotheosis of the old Madison Avenue cliché “a big ball of wax,” and is no doubt apt enough; but right from the start, the heads of conglomerate companies objected to it. Each of them felt that his company was a mesh of corporate and managerial genius in which diverse lines of endeavor—producing, say, ice cream, cement and flagpoles—were subtly welded together by some abstruse metaphysical principle so refined as to be invisible to the vulgar eye. Other diversified companies, each such genius acknowledged, were conglomerates; but not his own. Roy Ash of Litton Industries thought “conglomerate” implied “a mess” and pleaded for the term “multi-company industry” to describe Litton; Rupert Thompson hoped wistfully that people would speak of his Textron as engaging in “non-related diversification”; Nicolas Salgo of Bangor Punta wanted his company known as a “unique conglomerate.” In vain. Wide-based or narrow, stuck together by synergism or chewing gum, they were called conglomerates, and for a time, almost everybody made money on them.
The aversion of the conglomerateurs (as The New York Times so
cial page called their leading lights) to the term is understandable. Conglomerates, like prostitutes, had from the first a sufficiently shaky moral reputation to call for the use of euphemism. During their most flourishing years (roughly 1966–1969), they were said to represent, variously, a forward-looking form of enterprise characterized by freedom from all that is hidebound in conventional corporate practice; the latest of a long series of means by which “ruthless capitalists practice the black arts of finance to their ends”; and “a kind of business that services industry the way Bonnie and Clyde serviced banks.” Their increasing prevalence, for better or worse, is indicated by the simple fact that in 1968 about forty-five hundred mergers of U.S. corporations were effected—far more than in any previous year, and three times as many as in any given year early in the decade. Also in 1968, twenty-six of the nation’s five hundred biggest companies disappeared, permanently, into the bellies of other corporate whales through conglomerate merger, twelve of the victims being monsters with assets in excess of $250 million, and several of these same leviathans being swallowed by predators far smaller than themselves. By that time, at least ten of the nation’s two hundred biggest industrial corporations were conglomerates, and the enthusiasts were saying that this was only the beginning—eventually all but a tiny fraction of national business would be conducted by about two hundred super-conglomerates.
The movement was new and yet old. In the nineteenth century, few companies diversified their activities very widely by acquiring other companies or by any other means. There is, on the face of it, no basic reason for believing that a man who can successfully run an ice cream business should not be able to successfully run an ice-cream-and-cement business, or even an ice-cream-cement-and-flagpole business. On the other hand, there is no reason for believing that he should be able to do so. In the Puritan and craft ethic that for the most part ruled nineteenth-century America, one of the cardinal precepts was that the shoemaker should stick to his last. American companies were as specialized in their product lines as the vendors of dog collars and nutmeg graters in Victorian London; diversification was considered irresponsible if not a form of outright immorality, and when it occurred it usually did so inadvertently, as when the Western railroads found that the land they had ac quired for settlement and track right of way made them proprietors of mines, oil wells, and forests.
Early in this century, some of the biggest companies took to diversifying from within—adding new products not closely related to their old ones simply because they had the resources and the machinery to do so. General Electric and General Motors were notable examples. The tendency of companies to purchase other companies became prevalent for the first time in the boom of the nineteen twenties when many corporate treasuries were, for the first time, full of spare money. Between 1925 and 1930 du Pont, which had previously pretty well confined itself to making explosives, ate such indigestible-sounding corporate morsels as the Viscoloid Company, National Ammonia, Krebs Pigment and Chemical, and Capes-Viscose. In a limited way, it was a pioneer conglomerate. American Home Products, incorporated in 1926, had become an Ur-conglomerate by 1948, its product line by that time ranging from beauty preparations through foods to ethical and proprietary drugs. It was during a new spell of general affluence in the nineteen fifties that the phenomenon of really uninhibited diversification first appeared. During that decade, National Power and Light, as a result of its purchase of another company, found itself chiefly engaged in peddling soft drinks; Borg-Warner, formerly a maker of automotive parts, got into refrigerators, other consumer products, and electrical wares; and companies like Penn-Texas and Merritt Chapman and Scott, under the leadership of corporate wild men like David Karr and Louis E. Wolfson, took to ingesting whatever companies swam within reach. The results were the first genuine late-model conglomerates—but nobody had yet wrapped up the new packages in a catchy name. Among the first companies to be called conglomerates were Litton, which in 1958 began to augment its established electronics business with office calculators and computers and later branched out into typewriters, cash registers, packaged foods, conveyor belts, oceangoing ships, solder, teaching aids, and aircraft guidance systems, and Textron, once a placid and single-minded New England textile company, and eventually a purveyor of zippers, pens, snowmobiles, eyeglass frames, silverware, golf carts, metalwork machinery, helicopters, rocket engines, ball bearings, and gas meters.
3
Corporate affluence was only one element in the complex chemistry of the conglomerate explosion. Another was a decline of the stick-to-your-last philosophy among businessmen, parallel to a decline of the stick-to-anything philosophy among almost everyone else. Another was the rise in influence of the graduate business schools, led by imperial Harvard, which in the nineteen sixties were trying to enshrine business as a profession, and often taught that management ability was an absolute quality, not limited by the type of business being managed. Still another was the federal antitrust laws, which, as traditionally interpreted over the years, forbade most mergers between large companies in the same line of business and thus forced companies that wanted to merge at all to be, so to speak, exogamous.
But there was one more factor, less reputable and in economic terms more ominous, behind the trend. It was the fact that merging enabled a company to capitalize on its current stock-market value. The crux of the matter was that never before had a company’s reported earnings per share meant so much in terms of its stock-market price. As we have seen, the average investor of the sixties was a comparative novice, interested in just three figures concerning a company whose stock he owned or was considering buying. One was the market price of the stock. The second was the net profit per share—the famous “bottom line” of the quarterly earnings report’s financial summary (which, curiously, seldom actually appears at the bottom). Let the average nineteen-sixties investor be handed the latest annual report of his favorite company; his gaze would slide rapidly over the shiny four-color cover, over the glowing (but perhaps a bit glutinous) prose of the chairman’s report, over the pictures of happy employees and earnest, manly executives, and would fix raptly on that bottom line. (It may come as a surprise to some modern investors to learn that this was not always so. During the boom of the nineteen twenties, the big news for both brokers and investors was more commonly dividends than earnings. High taxes on ordinary income, and favored tax treatment of capital gains, were the principal factors in bringing about an historic postwar shift in public attention from dividends to earnings.)
The third figure that engaged our investor’s interest was, of course, the relationship between the other two. Called the price-to-earnings multiple, or ratio, its function was to give the investor a yardstick with which to judge whether the stock was a bargain or not. A multiple of ten was usually considered a bargain, while a multiple of forty might be (but often wasn’t) thought to be too much. In the absence of his friendly broker, the average investor had to calculate the multiple for himself, a feat he could easily accomplish provided he had the two other figures and a command of short division. Making this calculation marked the outer limit of his investment sophistication.
Unfortunately, in the case of conglomerates this degree of sophistication was inadequate. Where a series of corporate mergers is concerned, the current earnings per share of the surviving company lose much of the yardstick quality that the novice investor so trustingly assumes. The simple mathematical fact is that any time a company with a high multiple buys one with a lower multiple, a kind of magic comes into play. Earnings per share of the new, merged company in the first year of its life come out higher than those of the acquiring company in the previous year, even though neither company does any more business than before. There is an apparent growth in earnings that is entirely an optical illusion. Moreover, under accounting procedures of the late nineteen sixties, a merger could generally be recorded in either of two ways—as a purchase of one company by another, or as a simple pooling of the combined resources. In
many cases, the current earnings of the combined company came out quite differently under the two methods, and it was understandable that the company’s accountants were inclined to choose arbitrarily the method that gave the more cheerful result. Indeed, the accountant, through this choice and others at his disposal, was often able to write for the surviving company practically any current earnings figure he chose—a situation that impelled one leading investment-advisory service to issue a derisive bulletin entitled, “Accounting as a Creative Art.” All of which is to say that, without breaking the law or the rules of his profession, the accountant could mislead the naïve investor practically at will.
The conglomerate game tended to become a form of pyramiding, comparable to the public-utility holding company game that flourished in 1928, crashed in 1929, and was belatedly outlawed in the dark hangover days of 1935. The accountant evaluating the results of a conglomerate merger would apply his creative resources by writing an earnings figure that looked good to investors; they, reacting to the artistry, would buy the company’s stock, thereby forcing its market price up to a high multiple again; the company would then make the new merger, write new higher earnings, and so on. The conglomerate need neither toil nor spin—only keep buying companies and writing up earnings. It was magic, until the pyramid became top-heavy and fell.