Abstract
A long-short strategy based on sorting firms on gross profitability has been shown to generate substantial excess returns relative to the traditional Fama and French factors. While those excess returns are also robust to the inclusion of a momentum factor, I show that they are to a large degree driven by operating leverage. High profitability firms have large fixed costs that substantially exceed those of low profitability firms. This difference in operating leverage is highly persistent over time and across firms. Operating leverage affects expected stock returns by increasing the risk of profits. I also provide novel evidence that operating leverage does not explain the value premium: value firms do not have a higher degree of operating leverage than growth firms.
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