The second theoretical insight is that if owners cannot sell short (i.e., sell shares borrowed from others), breadth will decrease. This is because when investors' opinions diverge, optimists will hold the stock, but pessimists will sell out. Hence, decreasing breadth forecasts a future decline in the share price. If short selling is allowed, however, pessimists would short sell until the price fell to a level at which they would be willing to hold the stock, and breadth would again increase. Therefore, differences in breadth across stocks provides information on differences in expected returns and hence the cost of capital. Our basic research question is whether reduced breadth increases the cost of capital.
An empirical study of ownership breadth and the cost of capital is especially interesting in Norway. First, the state and a small number of institutional investors hold a sizeable portion of the market portfolio; typically 40%. Second, the breadth of ownership is small by Anglo-Saxon standards. The largest investor held 29% of a listed Norwegian firm's equity in 1997, and the corresponding figure was 14% in the UK and 3% in the US. Third, short selling was illegal in Norway until 1999, and mutual funds are still not allowed to sell short. Therefore, it is interesting to examine if the relaxed short selling restriction in 1999 has affected breadth and hence a firm's cost of capital. This effect appears quite significant economically in the US market, since the estimated effect on the cost of capital of a short-selling restriction is up to 5 percentage points per year. These estimates must be treated with caution, however, as the US figures have severe limitations not shared by Norwegian data.