Corporate diversification, information asymmetry and insider trading

Abstract

The literature suggests that corporate diversification destroys firm value. This value destruction is usually considered to be a consequence of managers' pursuing diversification strategies to benefit themselves rather than to increase firm value. This paper provides evidence that casts doubt on this agency theory-based explanation for corporate diversification. Evidence based on insider trading suggests that managers themselves consider their diversification strategies to be value-increasing. Specifically, it is documented that corporate insiders (directors) purchase more of their firms' shares in the open market when corporate diversification is high. Moreover, insiders purchase more when the level of diversification discount is high, suggesting that they disagree with outside investors' undervaluation due to diversification. It is also found that the market reaction to insiders' purchases is positively related to corporate diversification. This result suggests that outsiders consider the amount of favourable information contained in insiders' purchases to increase with the extent of corporate diversification.