operating leverage

I derive and test implications of the operating leverage hypothesis for the cross-section of expected returns. Using a novel measure of operating leverage, I document that operating leverage predicts returns in the cross-section, and that strategies formed by sorting on operating leverage earn significant excess returns. Operating leverage also explains why the value premium is weak and nonmonotonic across industries, but strong and monotonic within industries. Intra-industry differences in book-to-market are driven by differences in operating leverage, giving rise to expected return differences. Industry differences in book-to-market are driven by differences in the capital intensity of production unrelated to returns. JEL Classification: E22, G12

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