Tuesday, July 13, 2004

Do we have a new explanation of the conglomerate discount!!!!!!!

SSRN-Loyalty Based Portfolio Choice by Lauren Cohen

Are you loyal to your company? Your answer may depend on whether your company is a single division company or a conglomerate. As the University of Chicago's Lauren Cohen writes "Evidence from Social Psychology suggests that loyalty to the firm develops at the divisional level." Yeah yeah, so what does Social Psychology have to do with finance? A great deal!

For instance, Cohen suggests that if loyalty somehow shows up in investment portfolios, it is probably through overweighting shares in your own firm. (It should be noted that he acknowledges and at least partially controls for informational and transaction cost explanations.) Thus, the hypothesis that employees at "stand alone" divisions invest more in company stock than do employees at conglomerate firms. An alternative hypothesis is that because of the diversification inherent in a conglomerate risk averse employees may invest MORE (not less) in the conglomerates.

Cohen tests these hypotheses using a "unique dataset" that includes the makeup of employee's 401k retirement contributions. He finds that loyalty trumps diversification and that employee/investors who work at stand alone firms invest more heavily in their own shares than similar employees at conglomerate firms. The best evidence of this can be found at firms that were spun-off from a conglomerate. At these firms she finds a significant increase in employee investment at the now-stand-alone firm. (That deserves a wow!)

Minimally this paper is more evidence that loyalty and other seemingly non rational motives do impact investment decisions. (See also Shive and Morse's piece on Patriotism) I think this paper goes further than that however.

Not content on a merely great paper, Cohen goes on to see where else this loyalty might show up. He examines wage per employee and sure enough finds that it is lower at stand-alone firms. While he does not mention it, this could be a partial explanation of the conglomerate discount, i.e. why do conglomerate firms trade as a discount to stand alone firms (see Comment and Jarrell 1995).

Cohen, Lauren H., "Loyalty Based Portfolio Choice" (March 2004). EFA 2004 Maastricht Meetings Paper No. 5062. http://ssrn.com/abstract=557087

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