Information Production, Analyst Following and Diversification Discount: A Market Microstructure Approach

Abstract

This paper offers an information-based explanation for the well-documented diversification discount. While explicitly assuming that the stock prices convey valuable information to the management, our model shows that the value loss from diversification is due to the insufficient information production. If more investors are willing to follow and actively trade a certain stock, more information will be transmitted to the managers and the corresponding value loss tends to decline. Thus, our model provides a rationale for the existence and cross-sectional variation in diversification discount. Using the analyst coverage as the proxy for information production, we find empirical evidence, which supports our model implications: holding firm characteristics fixed, the analyst converge explains a significant portion of the cross-sectional variation in diversification discount during the period 1985-1999.