Conglomerates have become an important part of the United States economy. A conglomerate usually starts with a small company that does well. When the small company builds into a large one with plenty of free cash flow and looks to expand, it purchases other companies. Soon enough, the once-small company becomes a massive corporation with several subsidiary companies working underneath it.
Over the past few decades, the world has become digitized. In light of this technological revolution, there’s a new type of conglomerate — and it’s proving to be more valuable than any other class of conglomerates in history.
These are digital conglomerates. Naturally, with the emergence of these titans, investing dollars are flooding into them.
Although there are definitely perks to investing in digital conglomerates, every investment comes with risk, and the risk-vs.-reward profile should be carefully considered before investing your hard-earned money.
What Are Digital Conglomerates?
Digital conglomerates are just like any other conglomerate in the sense that they generally start as small companies that work their way to becoming massive companies through both organic growth and acquisitions. The difference between digital conglomerates and the conglomerates of yesterday is technology.
Digital conglomerates start with one piece of cutting-edge technology, living and breathing around the perfection of that technology. Once the technology is perfected and a proven success, the company begins to grow, driving new revenues, profits, and eventually free cash flow.
Instead of paying this free cash flow out in the form of dividends, a growing technology company will sometimes make the decision to use its free cash flow to purchase smaller companies with complementary or competing technologies that the acquiring company can work to integrate or perfect.
In this way, over time, the small digital company with a great idea can become a massive digital conglomerate with several subsidiary companies under its belt.
Digital Conglomerate Example: Alphabet
Alphabet started as Google, a company founded by Larry Page and Sergey Brin in late 1988. The goal of the company was to create a digital directory that put a massive database of information at the fingertips of the average consumer.
The plan worked.
When people want to know the name of an actor they can’t quite place the name of, a new recipe for a pound cake, or where to get the cheapest gas, the common solution since the 1990s has been to Google it. Google started as a brand surrounding an innovative technology and has today become a verb.
As Google began to accumulate massive amounts of free cash flow, the company decided to start purchasing smaller companies in technology and biotechnology. By August 2015, the company had revenue coming in from so many different subsidiaries that the name Google simply didn’t make sense anymore.
As a result, the company changed its name to Alphabet. The company not only owns the world’s largest search engine and advertising platform, but also owns robotics companies, cloud computing companies, and companies across various areas of the digital world.
COVID-19 Greatly Accelerated the Emergence of Digital Conglomerates
Google and Amazon.com were already digital conglomerates well before the COVID-19 pandemic took hold around the world. However, COVID-19 has greatly sped up many corners of the digital revolution, and it has sped up the emergence of digital conglomerates.
Due to COVID-19, consumers around the world have been told to stay home and stay safe. Stepping foot into a crowded restaurant, department store, or convention could be dangerous. As a result, people are staying home.
Staying home changes the way you do things.
While younger generations were already visiting doctors, buying goods, and managing their finances online, there’s a large older population who liked doing these activities the traditional way, face to face. This is the same population that is at the highest risk of severe medical events as a result of COVID-19.
Because of this, the consumers who were previously the least eager to shop, bank, and visit their doctors online are now embracing the opportunity to do so. Due to social distancing measures, the company Zoom — a brand that offers online conferencing capabilities — may quickly grow to become a digital conglomerate. Like Google before it, its name is becoming a verb.
These rapid, large-scale changes in consumer behavior may prove to be good or bad for digital conglomerates — unless you can see into the future, it’s impossible to know.
When the economy reopens completely and life goes back to normal, digital conglomerates are likely to continue to benefit from online users who tried these new technologies, but the real question is how many users will go back to more traditional services once the option is available to them again.
That question is impossible to answer until the economy fully reopens, and it represents an increased level of risk when considering an investment in one of today’s emerging digital conglomerates.
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Digital Conglomerates Stocks Pros and Cons
No matter what type of investment you’re considering, it’s important to dive into the pros and cons before risking your hard-earned dollars.
Digital conglomerate stocks, as with any other type of stock, come with their own list of pros and cons that should be carefully considered before deciding to invest in the space. Without taking the time to do so, you’re not investing, you’re gambling with your money.
Pros of Digital Conglomerates Stocks
Digital conglomerates are massive, well-known companies that come with a sense of stability not seen with up-and-comers.
As a result, there are several benefits that come with investing in these types of stocks. Some of the most significant of these benefits include:
1. Digital Conglomerates Are Established Companies
Any company that has become a conglomerate has been around for a while and has seen incredible success. Think of the digital conglomerates that have already emerged. Alphabet paved the way with Google, and now has its fingers in nearly every area of the technology industry.
Amazon is another great example. The company revolutionized the way Americans shop by bringing great prices on one of the world’s largest catalogs of items to your computer, simplifying shopping and achieving great success in the process.
Today, Amazon owns Amazon Web Services, Audible, Zappos, and a long list of other digital shopping, media, and entertainment companies.
There are several traits these two massive digital conglomerates have in common, but the most important to consider are:
- They’re Popular. Could you imagine a world without Google or Amazon? Neither could most people. These companies are popular companies that have become household names.
- They’re Profitable. Both of these companies also have a strong history of generating free cash flow for their investors.
- They’re Established. Combining a history of strong popularity among consumers and profitability tells you that Amazon and Google are well-established companies.
Investing in companies that are well established greatly reduces the risk associated with your investment.
2. The Digital Revolution Will Continue
At the end of the COVID-19 pandemic, the impressive growth in the digital revolution may slow, but it will not stop. The move to a digital world is one that surrounds simplicity.
Human instinct is to follow the path of least resistance. Digitizing the world simply creates a path with less resistance for the end consumer to do something valuable.
For example, when a salesperson rang your doorbell in the past, you would have to stop what you were doing, go to the door, and tell them you’re not interested. Today, Nest — an Alphabet subsidiary — provides a doorbell with a camera and a speaker, allowing consumers to answer someone at the door from their phones, simplifying the process. This is great in a time of social distancing, but also convenient during normal times too.
As long as human beings follow their instinct to take the path of least resistance, the technological revolution will continue. So, opportunities in the emerging digital conglomerates space will continue as well.
3. Gain Ownership In Companies You’re Already Familiar With
If you’re like most Americans, you have an intimate knowledge of Google, Amazon, and other digital conglomerates. Unless you live under a rock, the names at least ring a bell.
The most successful investors invest in what they know best. The idea is that the more you know about a company you’re considering investing in, the better your chances are of understanding the true long-term value that the company has to provide.
So, there’s significant value in familiarity when you’re considering an investment.
Because digital conglomerates are massive, well-known companies, you likely already know a great deal about the underlying story of the company you’re considering investing in and have a sense of its potential to yield long-term value.
Cons of Digital Conglomerates Stocks
Digital conglomerates are great investment vehicles for some. However, there is no such thing as a one-size-fits-all investment vehicle.
As with any rose, digital conglomerates come with a few thorns that investors should be aware of before they dive in headfirst.
1. Valuations Suggest a Bubble in Some Digital Conglomerates
Due to the COVID-19 pandemic, interest in digital conglomerates has been overwhelmingly high. In the stock market, high demand for a stock or a class of stocks results in increased prices, the result of the law of supply and demand.
With the COVID-19 pandemic in mind, investors are looking for opportunities to achieve monumental growth in their portfolios through the stocks that benefit from the crisis. This has led to tremendously high valuations.
According to Investopedia, the average price-to-earnings ratio across the S&P 500 ranges between 13 and 15. Moreover, traditionally a price-to-book value of somewhere between 1 and 3 is considered to be an acceptable average range.
Now look at these key valuation metrics for the stocks of digital conglomerates Alphabet and Amazon as of September 2020:
- Price-to-Earnings Ratio. Alphabet currently trades with a price-to-earnings ratio of 34.05.
- Price-to-Sales Ratio. Alphabet currently trades with a price-to-sales ratio of 7.09.
- Price-to-Earnings Ratio. Amazon currently trades with a price-to-earnings ratio of 119.78.
- Price-to-Sales Ratio. The stock also has a price-to-sales ratio of 4.94.
As you can see from the valuations above, Alphabet and Amazon shares currently trade at around double what their average valuation should be according to these traditional valuation metrics. These high valuations suggest that a bubble may be taking place in the space.
Should this be the case, at some point the bubble could burst and substantial losses may be the result.
2. Significant Growth Has Already Taken Place
When you invest in a conglomerate — digital or otherwise — you’re accepting the fact that the stock you’re investing in has already undergone significant growth.
The fact of the matter is that as a company gets bigger, it becomes harder to grow. Think of it this way:
A young company with a cutting-edge product that nobody knows about yet has plenty of room for growth. For example, a young Google in the early ‘90s had the world to capture. However, when a company has saturated its market to the extent that Amazon and Alphabet have, there is far less of a pool from which to grab new customers.
As a result, growth tends to slow and, in some cases, plateau. As a result, an investment in digital conglomerates isn’t the best option for those looking for more momentous growth opportunities in the stock market.
3. Diversification Is Difficult
Digital conglomerates fill some big shoes:
- They have a massive following.
- They’ve achieved a position of market leadership.
- They generate incredible revenues.
- They own a significant number of subsidiaries.
In other words, these companies have achieved a level of success that few companies ever do. That’s a great thing, but it also creates a problem for investors.
The most successful long-term portfolios tend to be well-diversified portfolios. Diversification is a great way to shield your portfolio from significant losses.
When investing in a class of stocks in which there are very few options, proper diversification becomes difficult. After all, the 5% rule suggests that you should never invest more than 5% of your portfolio in a single stock, no matter how little perceived risk it comes with.
That means to invest only in digital conglomerates, you would have to find 20 compelling opportunities. That’s nearly impossible to do.
Pro tip: Before you add any digital conglomerate stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
How Much Should You Invest in Digital Conglomerates?
No single sector, asset class, or stock should encompass your entire investing portfolio. But how do you decide how much of your portfolio should be invested into digital conglomerates?
Here are a few tips that will help you decide:
Consider Your Appetite for Risk
There are some serious risks to consider when investing in digital conglomerates as the world seeks solutions to the COVID-19 pandemic.
There’s a chance that the vast majority of people who have been reluctantly introduced to online services will continue to go digital. There’s also a chance that the opposite will happen when it becomes safe to venture away from home.
Should the economy reopen and revenues among digital conglomerates suggest that market valuations have gone too high too fast, significant losses may be the result.
As such, at least until a few months following the end of the COVID-19 pandemic, an investment in digital conglomerates should be considered a medium-risk investment at best, and potentially a high-risk play.
Therefore, if you have a weak stomach and are not a fan of high-risk, high-reward opportunities, digital conglomerates may not be the place for you to be right now.
However, with the chance that consumers will continue to veer toward digital options post-pandemic, there’s also the opportunity for significant growth. If you have a healthy appetite for risk, you could scratch your itch by adding digital conglomerates as a relatively small (10% or less) portion of your portfolio.
Think About Your Goals
Digital conglomerates are hard to fit into most investing goals as they stand. Although these stocks have achieved tremendous growth in recent years, most growth investors look for opportunities for continued growth ahead.
With more questions than answers about the potential for continued growth without a correction post-pandemic, this space may not be the choice for growth investors.
At the same time, valuations are incredibly high among most digital conglomerates. As a result, value investors who are looking for a discount on the future potential of the company won’t find what they’re looking for here either.
Finally, at this stage of the game, most digital conglomerates are going through an expensive growth phase in which they are acquiring other brands. As a result, there’s not much cash left for dividends, making it a tough play for dividend investors too.
Nonetheless, digital conglomerate stocks do have their place. Again, these are large, highly successful companies, most of which have a strong history of growth. So, although there are definitely risks to consider, there’s a possibility that growth will continue in the space and make all the risks mentioned above moot.
Investors often make great returns banking on unorthodox moves like this. For example, Amazon has been overvalued from a traditional valuation perspective since the stock hit the market. Investors justified the overvaluation by looking at the company’s potential to revolutionize shopping. That bet paid off, and Amazon stock has seen tremendous gains.
Now, the company is working to revolutionize cloud computing, biotechnology, transportation, and much more. So, the high valuations can be justified by its work to revolutionize these industries and the potential profits that could come from success.
Yes, it’s a risky play. But for the speculative investor who enjoys risk from time to time, digital conglomerate stocks could become a big win. Again, just keep investments in these stocks to a minimum, with the combined total investment in the space not exceeding 10% of your portfolio, given current market conditions.
A Variation on the 5% Rule
The 5% rule is one of the most important general rules for beginner investors to follow. It is a method of diversification that protects your portfolio from significant losses, should one of your investments take a turn for the worst.
The rule suggests that you should never invest more than 5% of your portfolio into a single security and no more than a total of 5% high-risk securities.
Digital conglomerates come with serious risks to consider and fall in the gray area between low- and high-risk stocks. You don’t want to limit yourself to 5% on all digital conglomerates as you would with high-risk stocks, but you also don’t want to overallocate to this category because there are some added risks.
As such, it’s best to keep exposure to a minimum or no more than 10% of your portfolio’s total value. This means that if you have $10,000 to invest, no more than $1,000 of your portfolio should be invested in digital conglomerates.
You might also cap your investment in each digital conglomerate stock a little more conservatively than you would other individual investments.
For example, let’s say that you are interested in Alphabet, Amazon, and Apple. Because of their high valuations and concentration in the tech sector, you should invest no more than 2.5% of your portfolio value into any single option listed.
In this example, let’s say that you believe Alphabet has great potential, Amazon has medium potential, and Apple is a long shot but worth consideration. In this case, you might invest 2.5% of your portfolio value in Alphabet, 1.25% of your portfolio in Amazon, and 0.5% of your portfolio in Apple.
That works out to a $250 investment in Alphabet, a $125 investment in Amazon, and a $50 investment in Apple.
Digital conglomerates have quickly become some of the largest companies in the world. With strong investor interest leading the charge, it seems like there’s nowhere for these stocks to go but up. However, the harsh reality is that there’s always a possibility of declines.
While high valuations and COVID-19-related risks may be red flags for many investors to stay away, savvy investors with a healthy appetite for risk and a belief that digital conglomerates will continue to fly may be in for strong rewards ahead if all the cards are dealt just right.
Nonetheless, given current valuations and market conditions, if you decide to invest in digital conglomerates, it’s important to limit your positions and heavily diversify to protect yourself from the potential for significant declines ahead should things go in the wrong direction.