Why conglomerates break themselves up

Three giant conglomerates announced their breakups in the past week. All of them are seeking to put their recent past behind them.

Why it matters: GE, Johnson & Johnson, and Toshiba weren't the last of the conglomerates. Giants both old and new remain. (Think 3M, or Softbank.) In today's financially-optimized stock market, however, the arguments for internal diversification have mostly lost the day.

Driving the news: GE is splitting into three parts; J&J is splitting into two; Toshiba is splitting into three. In each case, the newly-independent businesses are going to be a lot easier to describe than the sprawling corporate octopi from which they descended.

The big picture: When a company underperforms on the stock market, there are often calls to break it up. (See Shell for a recent example.) Financial analysts look at how much each of the component parts would be worth as standalone companies, and calculate that the current whole is worth much less than the sum of the parts.

• Senior managers generally resist such moves, but an extended period of disappointing stock returns will weaken their position.
• In the era of index funds, investors can get diversification easily from ETFs; they don't need corporate managers to do that for them.

How it works: Companies like GE, J&J, and Toshiba generally had four broad arguments for the conglomerate model.

• Management: The idea was that the breadth of businesses allowed managers to learn from the best in a variety of different companies and countries, giving the company a managerial edge.
• R&D: The bigger the company, the bigger the research and development budget, and the more opportunities for profit that might come from innovation. If GE came up with an improvement on making a machine spin more accurately, for instance, that could conceivably benefit its turbine business and its jet-engine business and its MRI machine business.
• Brand: A strong global brand could engender trust across businesses. If you trust Toshiba's disk drives, you might well apply that same level of trust to its semiconductors.

• Finances: An internally diversified company tends to have stronger and more predictable cashflows, and therefore a higher credit rating and a lower cost of funds. That in turn can allow it to make investments out of the reach of smaller competitors.

Reality check: Large conglomerates often become bloated and sclerotic, with central offices taking up an ever-increasing proportion of total overhead while producing no revenues. They can also become too big to manage — a syndrome that can often result in massive scandals and lawsuits.

• GE and J&J have both had to pay billions of dollars in fines for corporate malfeasance. Toshiba became a poster child for bad corporate governance. None of which was good for the overarching brand, at any of the companies.

The bottom line: That which financial engineering brings together, financial engineering can just as easily put asunder.