Returns to scale, operating leverage, and expected stock returns

The asset pricing literature demonstrates a positive association between operating leverage and expected stock returns. We uniquely examine the predictive power of operating leverage on expected stock returns, in light of the industry returns to scale. Our inspection starts with a theoretical illustration of this facet, demonstrating higher sensitivity of operating profits to production inputs along higher level of production returns to scale. We then empirically examine 83,415 firm-year observations in the US manufacturing industry between 1963 and 2011. We find that the positive and significant relation between operating leverage and the cross-section expected stock returns appears only when the production returns to scale are high. Low returns to scale, however, alleviates both the economic and statistical significance positive effect.