Topic 1 - Psychological factors in Finance

We learn in the Corporate Finance course that companies that are not 'disciplined', ie stray from their own fields of expertise and ultimately fail in the end, will eventually be subjected to ‘market discipline’. This means that another company, usually a larger company with the same core business or ‘trade hawks’, will come in to acquire the entity. It will then sell off its non-core assets and then attempt a restructure, and for the ‘trade hawk’ case, sell the company in the end for a huge profit after turning around the money-losing firm in a few years time.

The case I want to discuss here is this: if it is so amazingly simple to make the formula work again, ie sell off non-performing units & return to winning ways, why can’t the wannabe conglomerate do that itself? After all, they could have done what the buying company will be doing, ie sell or spin off the non-core assets, and concentrate on the core businesses. I could come up with a few reasons here, in order of importance:

1) Management (psychological issue). Imagine if you were a passenger in the Titanic and you got dragged down to the Atlantic Ocean because of an oversight by the Captain. You survived and took the next ship to head to US and found that the same Captain that almost killed you has also been rescued and WORSE, appointed as the Captain (again) of this ship that you are taking this time. The 1 million dollar question is, would you still take this ship and be led to another disastrous journey? You might even be thinking that you would be better off just swimming off to your destination, because at least you have saved the money for the ticket! Although this scenario may not play out in reality, the psychological effect on the person is undeniable and it is more likely that you will get out and wait for the next ship that goes out.

Exactly the same situation applies to the corporate world. Once the incumbent management team is judged as not doing its job properly, shareholders would demand a change to the team, & if unsuccessful, be likely to dump their shares, getting out of the sinking ship before it meets its final doom. They would rather salvage some value out of it rather than waiting to see if the situation could be reversed. They would then be found pounding themselves when they find out later that all it takes to rescue it is just to throw off the unnecessary luggage aboard (the non-core assets) and the ship (company) will still be able to sail smoothly to its destination (meet its profit target). In the end, panic is the culprit that makes the situation looks even worse than it is, & the trust factor that has disappeared altogether when in a frenzy.

Obviously sometimes it’s not always the situation that the shareholders are just not patient enough when in a crisis. If the management could not see the point of concentrating its effort on the core assets, or that they have some other hidden motives (read: $$ incentives or promotion prospects), then it is definitely time to get rid of it and install someone who can perform the job.

2) Prestige (another psychological issue). While it is true that often the companies that succeed are the ones that stay true to their core businesses, conglomerates are the ones that are held at a higher esteem, at least in the psychological aspect, than the non-diversifying firms. They are often the ones hiring hundreds of thousands of people in their respective countries and are normally revered in their own countries, even by their own respective governments because of their enormous influence on the countries’ economies. Governments’ bailouts of struggling conglomerates have been very common in many countries, simply because of the devastating effects it would have on the economy if they collapse. Hundreds of thousands of jobs are at stake, and the country could be caught in a downward spiral if this happens because of the multiplier effect in the system. As such, these conglomerates are usually very confident in branching out of their industries, as they believe the government would come to their rescue in the case of failure. This will lead to higher confidence from the shareholders as well because the support from the government means a much higher return than other ventures, at an insignificant increase in risk.

Laying off non-performing units would then be seen as financial incapability of their parent units & reflects badly on the conglomerate as a whole. As such, conglomerates tend not to lay off units quickly and try to rescue them by injecting more funds to keep them afloat, without changing the top management of the units. More money is pumped in, but results normally don’t show because they are still run by the same ineffective people.

An example of this is the Mistubishi Corporation of Japan. It has a automobile producing unit that has been losing billions of dollars for many years, but yet has not been shut down because the conglomerate is very powerful in Japan. It keeps channeling the profits from another of its highly profitable unit, Mitsubishi Bank, one of the top four banks in Japan, to plug the deficit in the automobile unit. This results in lower profit for the group, clearly violating the mandate for the management, that is to safeguard the shareholders’ interests.

3) Trade unions. In some countries like US or Germany, trade unions are so powerful that they can hold the companies hostage if necessary. Therefore it is virtually impossible to simply lay off non-performing units and get back on track because they could be liable for hundreds of millions, or even billions, of dollars when they do that. One good recent example is the case of Siemens Mobile. Siemens is a rare conglomerate in Germany and it has ventures in almost every industry, from construction to chemical production. Its Siemens Mobile phone unit has been losing money for years and it has been unable to sell it off or even give it free to other companies because no one is willing to take the risk. In the end, BenQ of Taiwan, a much smaller mobile phone producer contacted Siemens, which at that time held a 5% share in the mobile phone market, about a possible takeover and the agreement was that Siemens had to pay BenQ in excess of US$500 millions for it to be willing to take over the ailing unit. BenQ’s plan is to slowly shift the production out from Germany to Taiwan and reduce the workforce there till it is finally fully shifted out. It could do that because it is an overseas outfit and hence would be less tied to the trade unions’ power if it tries to reduce the workforce in Germany. This will be a win-win situation for both parties.

Out of the 3 reasons above, 2 of them are psychological factors and only one has to do with the economic of the real world. So next time when you read a report on any business magazines or journals, remember that the deal is always more than what it seems. A lot of the companies depend on not just their products, but also their image to survive. Martha Stewart’s Living OmniMedia and Richard Branson’s Virgin are two very good examples, as is Donald Trump’s Trump Organization. Psychological factors feature prominently in business deals, but yet it is not given enough recognition because it can’t be measured in numbers. This has to change.