Short Sales Constraints and the Diversification Puzzle

Abstract

Disagreement about stock valuation, combined with short-sales constraints, can increase asset prices. We build a model showing that, so long as investor beliefs are not perfectly correlated, investors will disagree less about the value of a conglomerate than about each of its individual divisions. This generates a conglomerate discount, with disagreement and short-sales constraints being complementary in increasing its magnitude. We test these predictions empirically and find substantial support: conglomerates have lower differences of opinion and lower short-sales constraints than pure-play firms. Furthermore, greater differences of opinion and tighter short-sales constraints are significant predictors of valuation differences between conglomerates and pure plays.

Keywords: Diversification discount, short-sales constraints, differences of beliefs, equity lending, conglomerates.

JEL Classification: G10, G11, G14, G18, G28, G32