Information Production, Corporate Investment and Diversification Discount

This paper offers a market microstructure based model to explain the well-documented diversification discount. While explicitly assuming that stock price conveys valuable information to the management, our model shows that the value loss from diversification is a function of the stock price informativeness. If more investors are willing to follow and actively trade a certain stock, more information will be transmitted to the manager and the corresponding investment decision will be more efficient. As a result, the value loss due to conglomeration will decline. Thus, our model offers an information based explanation on the cross-sectional variation in the discount other than the various theories raised in prior literature. Using the analyst coverage as the proxy for information production, we find empirical evidence that supports our model implication: holding firm characteristics fixed, the analyst converge explains a significant portion of the cross-sectional variation in the diversification discount during the period from 1985 to 1999.