The Hedging Benefits of Domestic and Global Diversification: Evidence from Economic Downturns

We examine the influence of economic downturns on the relation between diversification and firm value in a large panel of U.S. firms over the period from 1984 to 2014. When markets are incomplete or there are significant frictions, diversification provides value when the fortunes of one business segment are imperfectly correlated with the fortunes of another. We test whether this hedging effect of diversification is valued by the market. We find that the hedging value of diversification during economic downturns reduces the diversification discount by 9% for domestically diversified firms and 12% for globally diversified firms. Our results are robust to controlling for endogeneity of diversification decisions. Consistent with a hedging value of diversification, we find that risk reduction as measured by the correlation of a firm’s industrial and regional operations with the state of the economy is a key channel through which diversification becomes more valuable during economic downturns. We find little evidence that the enhanced value of diversification during downturns is attributable to alternative explanations such as mitigation of overinvestment in value-reducing diversification strategies, enhanced value of internal capital markets, or more valuable debt coinsurance.