Explaining the Pattern in Returns for Diversified Firms

Abstract:     
Why do returns fall when firms diversify? In this paper, I show that this and other stylized facts about the performance of diversified firms are fully consistent with optimal firm behavior. In my model, corporate diversification is driven by economies of scale, synergies and better production opportunities in other industries. By dynamically linking valuation and performance, the model suggests that diversifying firms tend to be those that have experienced persistent declines in performance and, as a consequence, their returns have been falling. However, in the model, a portfolio of diversified firms earns, as in the data, the same expected return as the well-diversified portfolio of specialized firms since both portfolios have the same exposure to the aggregate risk. Finally, the model also implies that expected returns on diversified firms vary systematically with relative value, as documented by Lamont and Polk (2001).

Keywords: Firm diversification, Tobin's Q, diversification discount, total factor productivity, stock returns

JEL Classifications: D21, G32, G34

Working Paper Series