Does operating leverage explain the gross profitability premium?

PURPOSE OF THE STUDY: Empirically highly gross profitable firms have generated higher returns than firms with low gross profitability, hence implying that there exists a gross profitability premium. But the reason why such a premium exists has been unknown. Recently operating leverage has been proposed to cause the gross profitability premium. However, research has traditionally related the operating leverage to the value premium, which on the other hand has been shown to be negatively associated with gross profitability, thus resulting in an inconsistent triangle of relationships without an explanation why such contradictory results exist. As a result, the prior literature is lacking of a consistent view whether operating leverage can truly cause the gross profitability premium and how operating leverage should be linked to the value premium. The objective of this paper is to show both theoretically and empirically how operating leverage should be linked to the aforementioned premia. DATA AND METHODOLOGY: The dataset extends from January 1962 to December 2014 and comprises firms listed in NYSE, NASDAQ, and AMEX. The monthly market data for firms is obtained from Center of Research in Security Prices (CRSP) and the annual financial data is from Compustat. Several point-to-point and elasticity proxies for the degree of operating leverage (DOL) are employed, since DOL is not directly observable. To test the hypotheses, portfolio sorts are constructed by using gross profitability and different proxies for DOL, and similarly uni- and multivariate regressions are run by using both gross profitability and different DOL proxies. FINDINGS: Highly gross profitable firms have significantly higher degrees of operating leverage than their less profitable peers when employing a point-to-point proxy directly measuring the level of fixed costs for DOL. Whereas the elasticity measures of DOL are negatively linked to gross profitability as they capture the risk of low margins equivalently to book-to-market ratio. Due to the tendency to assign high DOL values for firms operating close to their break-even points, the elasticity measures of DOL can theoretically be considered as biased. Whereas a more direct proxy for operating leverage performs better in capturing the risk theoretically associated with high level of fixed costs. By using such a direct point-to-point proxy for DOL, the empirical evidence shows that DOL should be negatively linked to the value premium, hence completing the picture regarding the triangle of relationships between DOL, gross profitability, and value. Furthermore, the gross profitability premium seems to be strong within industries, but rather weak across industries