There is a famous quote by Aristotle who said that the whole is greater than the sum of its parts.
But for holding companies that are listed on the Philippine Stock Exchange, the market value of the whole is almost always lower than the sum of all its assets.
Holding companies, also known as conglomerate stocks, own equity stakes either partially or fully in one or more entities, whose combined valuation tends to exceed the market capitalization of its parent company.
Such discrepancy can be explained by comparing the market pricing between the diversified stocks represented by the holding companies and the undiversified stocks composed of single-segment firms.
For example, the median price-to-earnings (P/E) ratio of diversified stocks at current prices is only trading at 10 times as against 17 times of undiversified stocks, offering a huge discount of 41 percent.
In terms of price-to-book value (P/BV) ratios, on the other hand, diversified stocks are priced at 50-percent discount to the median P/BV multiples of single-segment stocks.
You may say this may be incidental because of the poor market sentiment, but history will show that the holding company discount has been consistent even in a good market.
When the PSE index was riding high at 8,200-level in the same period last year, the median P/E ratio of diversified stocks was already trading at 17-percent discount to single-segment stocks.
Interestingly, during the height of the bull market, the median P/BV ratios of diversified stocks were also trading at the same 50-percent discount to single-segment stocks.
Holding companies are priced lower than single-segment firms because of the perception that while diversification leads to lower risk, it also leads to lower expected returns.
A holding company that is expanding into unrelated businesses carries the risk of misallocating its capital to segments that have poor investment opportunities.
There is also the risk that management of holding companies may use its capital to support failing businesses, which could have been used to expand its stronger investments.
In other words, the more diversified the company is, the higher the possibility that it will generate lower returns, which result in a valuation discount.
Using a simple correlation analysis, the price-to-book value ratio of a holding company can be explained by its historical return on equity (ROE) in 28 percent of the time.
This means that a holding company with a lower return on equity as a result of capital expansion will most likely be priced lower by the stock market.
About 53 percent of all the holding companies in the PSE are trading below their book values and most of them have historical ROEs that fall below the industry median of 9.4 percent.
These conglomerate stocks are Lopez Holdings, which is trading at 0.32x P/BV ratio, House of Investments, 0.30x P/BV; Top Frontier, 0.68x P/BV; Alliance Global, 0.69x P/BV and Metro Pacific Investments, 0.90x P/BV.
Holding companies that have above average ROEs, on the contrary, enjoy higher P/BV ratios. Some of these stocks are Ayala Corp., which has 2.5x P/BV; Aboitiz Equity Ventures, 1.63x P/BV; DMCI Holdings, 2.0x P/BV and SM Investments, 3.2x PBV.
While diversification may seem to lower the valuation of holding companies, causing it to yield a discount compared to companies with more focused businesses, it is the expected returns that determine the growth of a stock.
Discounts are irrelevant if there are no reasons for the stock market to expect for the holding company to grow in the future.
Whether a holding company is diversifying or refocusing its business segments, it is the growth in returns on investments, as a result of efficient capital allocation, that will matter at the end of the day.