Returns to Scale, Operating Profits, and Operating Leverage

Asset pricing literature shows that higher operating leverage relates to higher expected stock returns (e.g. Novy-Marx (2011)). We show that higher OL explains higher expected stock returns only when returns to scale are high. This finding is new. When returns to scale are high, OL is positive and highly significant in explaining the cross-section of expected stock returns. However, when returns to scale are low the economic and statistical significance are negligible. We provide an analysis of the theory and empirical findings to support it. A more advanced essay based on this working paper is published in the Eurasian Business Review and the title is: Returns to Scale, Operating Leverage, and Expected Stock Returns, by Roi D. Taussig and Sagi Akron.