Can Operating Leverage be the Cause of the Value Premium?

Luis Garca-Feijo*
Florida Atlantic University College of Business Liberal Arts Building 2912 College Avenue Davie, FL 33314 Phone: (954) 236-1239 Fax: (954) 236-1298 E-mail: luis.garcia@fau.org

Randy D. Jorgensen
Creighton University Department of Economics & Finance College of Business Administration 2500 California Plaza Omaha, NE 68178-0308 Phone: (402) 280-5513 E-mail: rdjorgen@creighton.edu
_____________________________________________________________________________

Abstract: Recent theoretical models (Carlson, Fisher and Giammarino, 2004) predict an association between the book-to-market equity ratio (BE/ME) and operating leverage in the cross-section. Consistent with these models, we find a positive association between BE/ME and the degree of operating leverage (DOL), between DOL and stock returns, and between DOL and systematic risk. Overall, our findings provide support for a risk-based explanation for the value premium that is consistent with existing theoretical models. The evolution of systematic risk associated with firm-level investment activity, rather than financial distress, seems to be the main determinant of the value premium.
JEL classification: G12 Keywords: Expected returns; book-to-market; operating leverage; value premium; anomalies.
_____________________________________________________________________________

*Corresponding Author. We acknowledge very helpful comments of an anonymous referee, Bill Christie (the editor), Brad Jordan, and participants at the 2007 Financial Management Association meetings in Orlando.

Can Operating Leverage be the Cause of the Value Premium?

Recent theoretical models (Carlson, Fisher and Giammarino, 2004) predict an association between the book-to-market equity ratio (BE/ME) and operating leverage in the cross-section. Consistent with these models, we find a positive association between BE/ME and the degree of operating leverage (DOL), between DOL and stock returns, and between DOL and systematic risk. Overall, our findings provide support for a risk-based explanation for the value premium that is consistent with existing theoretical models. The evolution of systematic risk associated with firm-level investment activity, rather than financial distress, seems to be the main determinant of the value premium.

There is considerable evidence that stocks with high book-to-market equity ratios (henceforth BE/ME) have historically earned higher returns than stocks with low BE/ME. However, researchers disagree as to whether this value premium reflects compensation for systematic risk (Fama and French, 1996) or mispricing based on cognitive biases (Lakonishok, Shleifer, and Vishny, 1994; Daniel and Titman, 1997). Recently, a number of theoretical papers have endogenously linked the dynamics of expected returns and risk to firm-level investment decisions. In these models, BE/ME is associated with operating leverage; thus, value stocks earn higher average stock returns as they have higher levels of systematic risk (Carlson et al., 2004; Zhang, 2005; Cooper, 2006). 1 We provide broad empirical evidence regarding these theoretical models by examining the association among BE/ME, the degree of operating leverage (DOL), and the cross-section of average stock returns. Evidence of a positive correlation would be consistent with the general predictions of the models and would support a risk-based explanation for the value premium. The existing literature also debates whether the systematic risk underlying the value premium is associated with financial distress or with investment activity. Fama and French (1996) and Chen and Zhang (1998), argue that the BE/ME effect is due to priced financial distress risk. In contrast, Berk, Green, and Naik (1999) and Carlson et al. (2004), among others, suggest that the value premium is related to firm-level investment activity. In our analysis, we also include the degree of financial leverage (DFL) in an attempt to shed light on the nature of the systematic risk associated with the value premium. We report three major findings. First, we find a positive association between BE/ME and DOL, both at the firm- and the portfolio-level using sorting procedures as well as regression

Lev (1974) and Mandelker and Rhee (1984) predict and find evidence of a positive association between operating leverage and systematic risk.

analysis. Second, we find a positive relationship between DOL and beta, and between DOL and average stock returns in the cross-section. These findings offer support for the recent theoretical models of Carlson et al. (2004), Zhang (2005), and Cooper (2006). Third, we find a positive relation between size (i.e., market equity) and DFL, and a positive association between BE/ME and DFL after controlling for size. We also find a positive, but weak, relation between DFL and stock returns. Taken together, these results do not support the hypothesis that the value premium reflects compensation for financial risk, in contrast to the argument in Chen and Zhang (1998). To the extent that higher DFL is associated with greater financial distress risk, our conclusion is consistent with recent evidence (e.g., Campbell, Hilscher, and Szilagyi, 2008). While we follow the existing literature and estimate DOL and DFL using a time-series regression approach (Mandelker and Rhee, 1984), we obtain similar results when we use book measures of leverage, namely, the ratio of fixed assets divided by total assets and the ratio of total debt divided by total assets. Additionally, when we examine the evolution of other underlying fundamentals, such as profitability, sales, or capital expenditures, we find that high (low) DOL stocks display firm characteristics typically associated with value (growth) stocks. In the last section, we discuss the results of numerous robustness checks of our methods and variable definitions. The evidence we report is consistent with the results of two recent studies. Novy-Marx (2007) finds support for the hypothesis that operating leverage is related to the value premium. He reports a positive association between operating leverage and stock returns and between operating leverage and loadings on the value factor. Gulen, Xing, and Zhang (2008) find evidence that value firms are less flexible than growth firms in adjusting to worsening economic conditions. They report that value firms have higher operating leverage, higher ratios of fixed

assets to total assets, greater frequency of disinvestment, and higher financial leverage than growth firms. Overall, our findings are consistent with the broad implications of recent theoretical models and provide support for a risk-based explanation for the value premium. Furthermore, the evolution of systematic risk associated with firm-level investment activity seems to be the main determinant of the value premium. This study proceeds as follows. In Section I, we review the related literature. We describe our data and methods in Section II and provide initial results in Section III. In Section IV, we investigate the association between DOL and stock returns, and between DOL and beta while in Section V, we investigate the association between DOL and BE/ME. We discuss the results of robustness checks in Section VI and provide our conclusions in Section VII.

I. Related Literature Our investigation belongs to a long-standing line of research concerned with the real determinants of systematic risk. Researchers have long been aware that operating leverage is one of the determinants of systematic risk of common stock. In particular, building on Hamada (1972) and Rubinstein (1973), Mandelker and Rhee (1984) decompose a firms systematic risk into DOL, DFL, and business risk. DOL measures a firms reliance on fixed costs, DFL measures a firms reliance on debt, and business risk is the systematic risk of a firms basic operations. Recently, a number of theoretical papers have linked the evolution of systematic risk to firms capital investment decisions and to the value and size effects of stock returns. 2 In

The literature includes the models of Berk et al. (1999), Gomes, Kogan, and Zhang (2003), Carlson et al. (2004), Zhang (2005), Cooper (2006), Novy-Marx (2007), and Aguerrevere (2009).

particular, Carlson et al. (2004) model the optimal investment behavior of monopolistic firms facing stochastic market demand conditions. In their model, beta is linear in the ratio of fixed costs to total firm value (i.e., operating leverage) and the ratio of growth opportunities to assets in place. Intuitively, BE/ME measures invested capital levels relative to market demand and relates to risk through operating leverage; size captures the importance of finite growth opportunities relative to assets in place. Cooper (2006) develops a model in which the book-to-market ratio depicts the deviation of a firms actual capital stock from its target capital stock. This, in turn, measures the sensitivity of the return on the firm to aggregate market conditions. If capital investment is irreversible, the book value of assets of a distressed firm remains constant, but its market value falls increasing its book-to-market. A high book-to-market firm is sensitive to aggregate shocks as its extra installed capacity allows it to expand production easily without new investment providing a high payoff to equity holders. Low book-to-market firms, in contrast, would need to undertake investment providing a lower payoff. Therefore, high book-to-market stocks have greater systematic risk. Zhang (2005) examines equilibrium in competitive product markets and demonstrates that firms optimal investment, together with costly reversibility and the countercyclical price of risk, can generate the observed value premium. Specifically, he emphasizes that capital invested is riskier than growth options in economic downturns as it is difficult to disinvest. In contrast, assets in place are as risky as growth options in economic booms. Hence, value stocks are riskier than growth stocks, particularly in economic downturns when the price of risk is high. Although the mechanics of the models differ, they share the essential prediction that there is a positive relation among operating leverage, BE/ME, and stock returns in the cross-section. Intuitively, in the absence of operating leverage, growth stocks, whose value is derived primarily

from growth options, would be riskier than value stocks. We empirically examine the broad predictions of these models. As noted, two recent studies report findings closely related to ours. Novy-Marx (2007) finds support for the hypothesis that operating leverage is related to the value premium. He reports a positive relation between operating leverage and stock returns and between operating leverage and loadings on the value factor (Fama and French, 1993). This is consistent with what we find. However, he reports no association between his measure of operating leverage and BE/ME, contrary to what we observe. As we discuss below, he uses a direct measure of operating leverage that is different from the one typically used in the literature, which may explain the different results. Novy-Marx (2007) also develops an equilibrium model that does not require measuring operating leverage directly. The model predicts that if the operating leverage hypothesis holds, there should be a strong correlation between stock returns and BE/ME within industries, but a weak association across industries. He finds support for this prediction. Gulen et al. (2008) find evidence that the value premium displays countercyclical time variation. They speculate that the expected returns of value firms co-vary more with recessions than the returns of growth firms as value firms are less flexible than growth firms in adjusting to recessionary shocks. Consistent with the results of our investigation, they find a positive association between BE/ME and measures of real inflexibility including operating leverage, the ratio of fixed assets to total assets, and the frequency of disinvestment. In a recent paper, Aguerrevere (2009) extends the model of Carlson et al. (2004) to consider the effects of competitive interaction on firms investment decisions. He finds that the effect of competition on a firms systematic risk is conditional upon the level of demand for the industry output. In his model, firms in competitive industries are riskier than firms in

concentrated industries when demand is low because the value of growth options decreases with more firms in the market and operating leverage makes assets in place riskier than growth options. When demand is high, firms in competitive industries are less risky than firms in concentrated industries. Aguerrevere (2009) notes that his model is consistent with a negative association between operating leverage and BE/ME. Alternatively, we find evidence of a positive association between DOL and BE/ME. However, a proper empirical analysis of the models implications for the association between operating leverage and BE/ME would likely require the inclusion of controls for industry structure and market demand, which is beyond the scope of our investigation. In sum, the operating leverage hypothesis for the value premium predicts that DOL should be positively associated with BE/ME and stock returns. However, empirical evidence is sparse. In the sections that follow, we present new evidence regarding the operating leverage hypothesis.

II. Data and Methods In this section, we review the existing literature regarding operating and financial leverage and explain our methods for estimating DOL and DFL.

A. A Review of the Literature on Operating Leverage The impact of financial and operating leverage on a firms equity risk has been the subject of a stream of research extending over a number of years. 3 Most of the modern research in this area stems from studies utilizing a theoretical basis for testing the impact of operating

Early studies tend to proceed with limited theoretical grounds. Darrat and Mukherjee (1995) and Ryan (1997) review these early studies in the finance and accounting literature, respectively.

and/or financial leverage on beta. Much of this follows the theoretical work of Hamada (1972), Rubinstein (1973), Lev (1974), and Bowman (1979), who demonstrate analytically that there exists a positive relation between a firms operating and financial leverage and the systematic risk of its stock. As a result of this theoretical work, researchers generally agree that operating leverage and financial leverage are two real determinants of the systematic risk of common stock. Additionally, Gahlon and Gentry (1982) discuss the difficulties of estimating equity betas using return data (see also Jagannathan and Wang, 1993), and note that managers will benefit from an understanding of the real determinants of the cost of capital. Because of the theoretical and practical relevance of operating and financial leverage, introductory finance textbooks routinely contain a basic discussion of the two types of leverage and their effect on risk. The literature, however, has no unified approach to estimating the degree of operating leverage and the degree of financial leverage. Specifically, to measure DOL and DFL, the literature starts by making a series of assumptions in the classical ex ante model to conclude that DOL and DFL should be estimated as elasticity measures. 4 Then, studies proceed to use one of two approaches: 1) a time-series regression approach or 2) a point-to-point approach. The time-series regression approach was pioneered by Mandelker and Rhee (1984) and Ang and Peterson (1984), and has been used more recently by DeYoung and Roland (2001), Griffin and Dugan (2003), and Ho, Xu, and Yap (2004). This approach uses a regression of earnings before interest and taxes (EBIT) on sales to estimate DOL. The point-to-point approach

Regarding DOL, these assumptions include linear, deterministic, and independent revenue and cost functions, a stable product mix, output as the only stochastic variable, and prices determined in a perfectly competitive market for the firms product. The difficulty in classifying externally reported costs into fixed and variable components leads to the common definition of DOL as an elasticity measure of EBIT given a change in unit demand. However,

estimates DOL as a ratio of changes in earnings to changes in sales, or fixed assets to total assets (Ferri and Jones, 1979; Lord, 1998). The time-series regression estimates seem to be more appropriate theoretically (Dugan and Shriver, 1989), although both approaches suffer from similar biases (Lord, 1998) 5. As we discuss below, we use a time-series regression approach as our main empirical method, but also use a point-to-point approach as a robustness check. Our point-to-point estimate equals the ratio of net fixed assets to total assets (Ferri and Jones, 1979; Mandelker and Rhee, 1984). OBrien and Vanderheiden (1987) recommend an adjustment for growth in the timeseries regression approach before estimating DOL. In particular, they recommend detrending the series of earnings and sales to control for a spurious correlation between growth in both earnings and sales that would bias DOL estimates toward a value of one. Dugan and Shriver (1992) compare the two techniques [Mandelker and Rhee (1984) and O'Brien and Vanderheiden, (1987)] and conclude that O'Brien and Vanderheiden's (1987) estimates are more consistent with the classical ex-ante model. As we explain below, we follow O'Brien and Vanderheiden (1987) and detrend the series before estimating DOL and DFL using the time-series regression approach of Mandelker and Rhee (1984). This is also the approach followed by DeYoung and Roland (2001) and Griffin and Dugan (2003). We discuss the sensitivity of our results to the estimation methods in the last section. Furthermore, previous studies using the time-series regression approach to estimate DOL have either ignored or applied a different estimation method to firms with negative earnings (Mandelker and Rhee, 1984; Griffin and Dugan, 2003; Ho et al., 2004; Rossett, 2001). In
many firms do not report data on unit output (or manufacture multiple products), so it is common to use sales rather than output (Lord, 1998). 5 According to theory, DOL estimates should be higher than one if the firm is operating above breakeven point and could be negative if the firm is operating below breakeven. However, a very large proportion of DOL estimates take values less than one (Dugan and Shriver, 1992).

10

contrast, we use a transformation common in the accounting literature to compute logs of negative earnings (Ljungqvist and Wilhelm, 2005), and subsequently treat similarly firms with positive or negative earnings. Taken as a whole, the existing literature supports a positive association between DOL and systematic risk (Mandelker and Rhee, 1984, Lord, 1996; Ho et al., 2004). However, the majority of the existing studies suffer from limited sized samples. As noted in the previous section, a number of theoretical papers have recently put forward an operating leverage hypothesis to explain the value premium (Carlson et al., 2004). Empirically, Novy-Marx (2007) finds support for the hypothesis, but reports no association between his measure of operating leverage and BE/ME. We find a strong correlation between DOL and BE/ME. Novy-Marx (2007) measures operating leverage as operating costs (costs of goods sold plus selling, general, and administrative expenses) divided by assets, a measure that has not been used in the literature. As reviewed, we measure operating leverage (DOL) following the existing literature. Our investigation complements that of Novy-Marx (2007) in a number of ways. First, we emphasize direct tests of the operating leverage hypothesis using DOL, while he focuses on indirect tests based on the predictions of a model he puts forward. Second, we examine the fundamental characteristics of firms with different degrees of operating leverage, while he provides evidence using factor-mimicking portfolios. Third, we include a measure of financial leverage in our analysis, while he ignores financial leverage effects. Nevertheless, we both find that there is a positive relationship between operating leverage and stock returns, and, more generally, conclude that operating leverage is likely to be the cause of the value premium.

11

Furthermore, Gulen et al. (2008) report a positive correlation between their measure of operating leverage and BE/ME, and between operating leverage and stock returns. To measure operating leverage, they use the three-year moving average of the ratio of the percentage change in operating income before depreciation divided by the percentage change in sales. In contrast, we estimate operating leverage following the time-series approach of Mandelker and Rhee (1984) over a five-year rolling window. Despite the different variable definitions, however, the two studies report entirely consistent results that support the operating leverage hypothesis.

B. A Review of the Literature on Financial Leverage As noted, researchers have known since at least Hamada (1972) and Bowman (1979) that financial leverage is one of the determinants of systematic risk. Empirical evidence, however, on the association between DFL and beta is mixed. While Mandelker and Rhee (1984) find a positive relationship, Darrat and Mukherjee (1995) and Lord (1996) find no association. Similarly, evidence regarding the correlation between financial leverage and stock returns is weak, with leverage often becoming insignificant in regressions that include other firm characteristics (Fama and French, 1992). Furthermore, theoretical models and empirical studies that have considered interactions between investment and financing decisions indicate that there exists a trade off (Dotan and Ravid, 1985; Trezevant, 1992) or a U-shaped relation (Huffman, 1983; Prezas, 1987; Kale, Noe, and Ramirez, 1991) between operating and financial leverage. This literature suggests that we should include DFL as a control variable in our investigation regarding the operating leverage hypothesis.

12

Moreover, some authors (e.g., Fama and French, 1996) conjecture that the value premium reflects compensation for financial distress risk. According to this literature, financial distress is related to a state-variable risk of special concern to investors due to its negative effects on unmeasured components of wealth such as human capital. Although our focus is on financial leverage (DFL), which is different from financial distress, we would expect the two to be highly correlated. For example, the literature on financial distress costs has often used high levels of financial leverage, in combination with other variables, to measure financial distress (Opler and Titman, 1994). Thus, to the extent that financial leverage is correlated with financial distress, our study can shed additional light on the hypothesis that the value premium is associated with financial distress risk. Empirically, the literature has typically found that financially distressed stocks are associated with anomalously low returns and that financial distress risk is largely due to idiosyncratic factors. In a recent study, Campbell et al. (2008) conclude that the value premium does not reflect compensation for financial distress risk. We similarly conclude that the value premium is associated with operating leverage, rather than financial leverage. In sum, although the theoretical papers linking operating leverage and the value premium do not consider any financial leverage effects, we include a measure of DFL in our analysis to: 1) control for financial leverage following the literature on the determinants of systematic risk, and 2) shed additional light on whether the value premium is related to financial distress risk. For consistency and to facilitate comparisons with the previous literature, we estimate DFL using the time-series regression approach. As a robustness check, however, we also consider a point-topoint measure, defined as the ratio of total debt to total assets (Mandelker and Rhee, 1984).

13

C. Estimating DOL and DFL We collect data on sales, EBIT, and earnings after interest and taxes (EAIT) for all companies included in COMPUSTAT in fiscal years 1981-2002. To estimate DOL, we follow Mandelker and Rhee (1984) and O'Brien and Vanderheiden (1987) and proceed in two steps, as explained below. Because we are interested in relating DOL to BE/ME and stock returns each year, we need an estimate for DOL at the end of each year for each firm. Therefore, all of our regressions are run at five-year overlapping intervals (i.e., 1982-1986, 1983-1987, etc.) at the firm level. The choice of a five-year window is arbitrary, but it allows us to work with a relatively long sample period (1986-2002), while at the same time taking into account possible changes in a firms cost structure over time. To avoid giving the impression of data mining, we have not examined any other window length. More specifically, we first run the following regressions:

Ln EBITt = Ln EBIT0 + gebit t + t, ebit Ln Salest = Ln Sales0 + gsales t + t, sales

where EBIT0 and Sales0 are the beginning levels of EBIT and Sales, respectively. To compute logs of negative earnings, we use a transformation common in accounting research (Ljungqvist and Wilhelm, 2005), ln (1+EBIT) if EBIT 0, and ln (1-EBIT) if EBIT < 0. Second, once the t, ebit, and t, sales residual series are produced by the regressions, we estimate the following equation:

t, ebit = OL t, sales + et

14

where et is an error term. OL, the estimate of DOL, measures the average sensitivity of the percentage deviation of EBIT from its trend relative to the percentage deviation of sales from its trend. For consistency, we estimate DFL similarly. That is, we run the following two additional regressions:

Ln EAITt = Ln EAIT0 + geait t + t, eait t, eait = FL t, ebit + ut

FL, the estimate of DFL, measures the average sensitivity of the percentage deviation of EAIT from its trend relative to the percentage deviation of EBIT from its trend. Therefore, we end up with firm-level estimates of DOL and DFL from 1986-2002 (we lose the year 1981 when we detrend the series). Note that the methodology we use can result in negative values for DOL and DFL. We follow Reilly and Brown (2003) and measure DOL in absolute value. In addition, because negative DFL values are economically irrational, we do not include firms for which DFL is negative. 6 In an attempt to create a variable that combines operating and financial leverage effects, we also examine the degree of total leverage (DTL), defined as the product of DOL times DFL.

D. Sample Description

In sensitivity checks at the end of the paper, we report that the results do not materially change if we include firms with negative DFL estimates, retain the sign of the negative DOL estimates, or delete observations with negative DOL estimates or with negative earnings.

15

After estimating DOL and DFL, we obtain data on market value and stock returns from the Center for Research in Security Prices (CRSP). We compute BE/ME as the ratio of book value of equity (computed as in Fama and French, 1992) at the end of the fiscal year divided by the market value of equity at the end of the previous December from COMPUSTAT from 19862002. We compute market capitalization (ME) using market equity from CRSP at the end of June in the calendar year following the end of the fiscal year. Market capitalization and stock returns are from CRSP over the period June 1987-December 2003. To compute BE/ME, we ignore companies with negative book values. In addition, we do not include financial firms or utilities (SIC in the 6000-6900 or in the 4000-4900). Following the previous literature, we do not include firms until they are in the COMPUSTAT database for five years to reduce survival biases. In addition, to mitigate survivorship bias in returns for firms delisted from CRSP for performance reasons, we follow the prescriptions of Shumway (1997) and Shumway and Warther (1999). That is, for firms delisted for performance reasons, we use 30% as the last return for NYSE/AMEX firms and 55% as the last return for NASDAQ firms. These requirements should reduce the influence of small, young growth stocks on the results. To prevent extreme observations from influencing our results, we follow the literature (Fama and French, 1992; Dichev, 1998) and set the top 99.5% and bottom 0.5% of the DOL, DFL, BE/ME, and monthly stock returns distributions equal to the 99.5% and 0.5% percentiles. The resulting sample data is summarized in Table I. The descriptive statistics in the table are similar to those in Dichevs (1998) over a similar period, despite the fact that we do not include firms without valid estimates of DOL and DFL. Thus, our results are unlikely to be driven by the sample selection.

16

Insert Table I about here.

As a first step in analyzing the data, we compute the correlations between the variables. As demonstrated in Table I, Panel B, DOL and DFL are negatively correlated. In addition, BE/ME is positively associated with DTL and DOL, and negatively associated with DFL. In contrast, ME is positively related to DTL and DFL, and negatively related to DOL.

III. Initial Results In this section, we present preliminary results on the cross-sectional association between BE/ME, size, and DOL and DFL. In Table II, we report equally-weighted monthly stock returns, and mean DOL, DFL, and DTL estimates for 25 portfolios based on BE/ME and ME, as in Fama and French (1993).

Insert Table II about here.

High BE/ME stocks have consistently outperformed low BE/ME stocks over the sample period. For example, average monthly stock returns are 1.38% for the highest and 0.65% for the lowest BE/ME quintile across all firms, 1.39% and 0.25%, respectively, within small firms, and 1.22% and 1.09% within large firms. In contrast, there does not seem to be an association between size and returns in our sample. For instance, average monthly stock returns are 1.11% for the smallest and 1.01% for the largest quintile across all firms, 0.25% and 1.09%, respectively, within the low-BE/ME quintile,

17

and 1.39% and 1.22% within the high-BE/ME quintile. The disappearance of the small-size effect has also been reported by the literature (Dichev, 1998; Schwert, 2003). In Table II, and graphically in Figure I, we also report DOL estimates by BE/ME and size groups. Consistent with the theoretical models, there is a clear positive association between DOL and BE/ME. 7 Unconditionally, DOL estimates increase monotonically from 2.86 to 5.20 as BE/ME increases from the lowest to the highest quintile. Conditioning on market value, DOL estimates increase monotonically from 2.76 to 4.98 across BE/ME quintiles within small stocks, and from 2.34 to 7.09 across BE/ME quintiles within large stocks. However, there does not seem to be an association between DOL and size.

Insert Table II and Figure I about here.

In Table II, and graphically in Figure II, there is evidence of a positive association between DFL and size. DFL estimates increase monotonically from 1.04 to 1.98 as size increases. Conditionally, DFL estimates increase from 0.96 to 1.55 within the low-BE/ME quintile, and from 1.08 to 3.79 within the high-BE/ME quintile.

Insert Figure II about here.

The relation between DFL and BE/ME is more complicated. Unconditionally, there does not seem to be an association between DFL and BE/ME. DFL estimates increase from 1.17 to 1.31 as BE/ME increases from the first to the third quintile, but then decrease to 1.19 in the fifth

The associations among BE/ME, size, DOL, and DFL are similar when we examine medians rather than the reported means.

18

quintile. Conditionally, however, DFL estimates appear to be positively associated with BE/ME. For example, DFL estimates increase monotonically from 0.96 for low BE/ME to 1.08 for high BE/ME stocks within the smallest market value quintile, and from 1.55 to 3.79 within the largest market value quintile. When we combine operating and financial leverage into a total leverage measure, DTL, we find there is a positive relation between DTL and BE/ME and between DTL and size. These initial findings are consistent with a risk-based explanation for the value effect. As a sensitivity check, we consider a point-to-point measure of operating leverage, book DOL, defined as net fixed assets divided by total assets; and a point-to-point measure of financial leverage, book DFL, defined as total debt divided by total assets. As demonstrated in Table II, the general associations reported previously for DOL and DFL can also be observed for their book value estimates. That is, there is evidence of a positive relation between operating leverage and BE/ME, and between financial leverage and size. In addition, there is generally a positive association between financial leverage and BE/ME after conditioning for size. While the evidence from Table II is suggestive, it does not constitute formal evidence. Thus, we assess the statistical significance of the previous results in Table III. Because the average monthly sample sizes shown in Table II are small, particularly among large and high BE/ME stocks, in Table III, we form quintiles based on either BE/ME or size, and compare the two extreme quintiles. High BE/ME stocks have DOL levels that are typically 2.33 higher than those of low BE/ME stocks. This difference is statistically significant at the 1% level. Similarly, when DOL is measured as fixed assets divided by total assets, the difference is 0.04 and is also highly significant. In contrast, there is no evidence that high BE/ME stocks have higher DFL levels than low BE/ME stocks. Although the DFL difference is 0.04, it is not significantly

19

different from zero. Therefore, there is strong evidence that high BE/ME stocks have greater DOL levels than low BE/ME stocks, but there is no clear association between BE/ME and DFL.

Insert Table III about here.

Additionally, when we compare the two extreme size quintiles, we find that small stocks have higher DOL levels and lower DFL levels than big stocks. In terms of book values, small stocks have lower levels of both DOL and DFL estimates. Therefore, small stocks are less financially leveraged than big stocks, at least in the univariate analysis. In Table III, we perform two types of sensitivity analyses. First, we note than there does not seem to be a statistically significant value premium in our sample when stock returns are value weighted. Although the average monthly difference between high and low BE/ME stocks is 0.15%, the t-statistic is only 0.48. This contrasts with an average monthly difference of 0.73 (the t-statistic is 2.90) when stock returns are equally-weighted. Therefore, as a sensitivity check, we examine differences between the high and low BE/ME stocks within the smallest quintile. Previous research (Petkova and Zhang, 2005) has also focused on the smallest quintile as the value effect appears to be strongest among small firms. 8 In Table III, we confirm that there exists a value premium in the smallest quintile of stocks, in terms of both equally-weighted and valueweighted returns. Similar to the full sample, high BE/ME stocks have significantly greater DOL levels than low BE/ME stocks in the smallest quintile of stocks. As a second sensitivity check, we compute cross-sectional medians by quintile and average them across the 17 years in our sample period. As shown in Table III, there is evidence

20

of a statistically significant positive correlation between DOL and BE/ME and between DFL and size. 9 The results of this section are broadly consistent with recent theoretical models that predict a positive association between operating leverage and BE/ME.

IV. DOL and the Cross-Section of Average Stock Returns In this section, we investigate the association between DOL and DFL and the crosssection of stock returns. Theoretical models predict a positive association between operating leverage and stock returns because operating leverage increases systematic risk. In Table IV, we report average monthly percent stock returns by deciles based on estimates for DOL (Panel A), DFL (Panel B), or DTL (Panel C). Portfolios are formed each June based on estimates as of the previous fiscal year end. Reported returns are monthly averages over the twelve months following each June. There is evidence that firms with higher DOL estimates earn higher subsequent returns. Equally-weighted monthly stock returns increase from an average of 0.78% for the lowest to 1.15% for the highest DOL decile. In addition, stock returns for the first five deciles are consistently lower than returns for the higher deciles. The average of the monthly return difference between stocks in the highest decile and stocks in the lowest decile is a positive 0.37%, which is significantly different from zero at the 5% level (the t-statistic is 2.35). Consistent with the results of the previous section, BE/ME monotonically increases as DOL increases.

Insert Table IV about here.

8

Fama and French (2006) find that the value premium is 55% larger for small stocks than for big stocks from 19262004. They report no evidence of a statistically significant value premium (based on BE/ME) for big stocks in the U.S. over the 1926-1963 or the 1963-2004 subsample periods. 9 The sample size of 17 is small. However, results are similar when we compare distributions using the Wilcoxon signed rank test with tables for the null distribution of ranks sums based on the sample size.

21

In Panel B, there is weak evidence of an association between DFL and realized stock returns. Although the average stock returns for the highest DFL decile are higher than for the lowest DFL decile (1.18% and 0.96%, respectively), the association is not monotonic. Furthermore, the average of the monthly return differences between stocks in the highest and the lowest deciles is 0.22%, which is marginally different from zero (the t-statistic is 1.71). To the extent that stocks with higher DFL levels are more likely to experience financial distress, the finding that there is a weak relation between DFL and stock returns is consistent with previous research (Dichev, 1998; Campbell et al., 2008). In addition, the association between DTL and stock returns (Panel C) is positive and significant, but it is not as strong as the one between DOL and returns. In Table IV, we also present average beta estimates by decile. We estimate firm-level betas as in Fama and French (1992). In the univariate analysis, there does not appear to be a relation between systematic risk and DOL, which is inconsistent with the operating leverage hypothesis. However, as we discuss below, this result may be due to measurement error in the estimates of beta and/or DOL. In Table V, we present regression analysis results at the firm level. Following Fama and MacBeth (1973), we report the time-series averages of slopes from monthly cross-sectional regressions of stock returns on beta, size, BE/ME, DOL, and DFL. Because we estimate DOL and DFL within the sample, inferences are likely to be biased. Nevertheless, the firm-level regressions indicate that there is, in our sample, a positive association between BE/ME and the cross-section of stock returns consistent with the previous literature. In addition, the regression results suggest that there is also a positive relation between DOL and stock returns in the cross-

22

section, but that such an association is weakened when BE/ME is also included in the regressions. In contrast, there does not seem to be a relation between DFL and stock returns. 10

Insert Table V about here.

To account for measurement errors in the estimation and testing of DOL and DFL within the sample, we follow the previous literature and employ a portfolio-grouping approach. Specifically, each month, we form 50 portfolios based on variables expected to be correlated with operating and financial leverage, and compute value-weighted portfolio returns, DOL, and DFL averages. We then run regressions using these value-weighted portfolio averages. Our instrumental variables, expected to be positively correlated with operating and financial leverage, include book DOL and book DFL, the variance of sales over the previous five years (White, Sondhi, and Fried, 2003) and industry groups based on two-digit SIC codes (52 groups). All variables are measured as of the end of the fiscal year prior to the year of portfolio formation. We report our results in Table VI. Standard errors are adjusted for autocorrelation assuming that coefficients follow an AR (1) process (Loughran and Schultz, 2005).

Insert Table VI about here.

Consistent with our previous results, there is evidence of a positive association between DOL and the cross-section of stock returns. DOL coefficient estimates are always positive and

Because DOL and DFL are related to systematic risk in a multiplicative fashion, it could be argued that the dependent variable should be transformed by taking a logarithm before running regressions. The results shown in Tables V and VI are stronger (i.e., higher significance levels for both DOL and DFL estimates) when the dependent variable is ln(stock returns) or ln(excess stock returns).

10

23

are statistically significant in three of the four regressions. DOL parameter estimates (t-statistics) when book DOL and sales variance are used to form portfolios are 0.22% (2.30) and 0.40% (2.74), respectively. When industry affiliation is the ranking variable, the estimate is 0.20% (1.76). DOL parameter estimates are insignificant only when book DFL is used to form portfolios. In contrast, DFL parameter estimates are never statistically significant. The essence of the operating leverage hypothesis is that the value premium reflects compensation for higher levels of systematic risk caused by firm-level investment activity. Thus, it is important to examine whether there is a relation between operating leverage and systematic risk. Accordingly, in Table VI, we also present the results of cross-sectional regressions of beta on DOL and DFL. Because researchers have not agreed on how to best estimate beta, we follow Fama and French (1992), an influential paper on the value premium literature. There is evidence of a consistent positive relation between DOL and beta when book DOL, book DFL, industry affiliation, and beta are used to form portfolios. Additionally, there is evidence of a negative association between DFL and beta for all instrumental variables used to form portfolios. Although not shown, the results are similar, in sign and statistical significance, when only DOL or only DFL are included in the regressions. The finding that there is a positive relation between DOL and beta should be viewed with caution, however. Both DOL and beta are measured with error and estimated within the sample. Nevertheless, the finding is consistent with the rest of the evidence we present, and provides further support for the operating leverage hypothesis. Furthermore, the finding that there is a negative relation between DFL and beta is consistent with the reported negative association between financial distress risk and returns (Campbell et al., 2008) and may account for the poor performance of beta estimates in explaining the cross-section of average stock returns (Fama and French, 1992).

24

Overall, the results of this section suggest that there is a positive relation between DOL and systematic risk and between DOL and stock returns in the cross-section, which is consistent with the operating leverage hypothesis. In the next section, we examine the association between DOL and BE/ME using regression analysis.

V. Operating Leverage and BE/ME In recent theoretical models (Carlson et al., 2004), operating leverage plays an essential role in the explanation of the value premium. In this section, we provide direct evidence of a link between BE/ME and DOL using regression analysis. Specifically, we perform annual crosssectional regressions of DOL on BE/ME at the firm level. In Table VII, we report the time-series average of coefficient estimates and t-statistics based on time-series standard errors adjusted for autocorrelation following Loughran and Schultz (2005). In the regressions, we set DOL as the left-hand side variable, so that measurement error can be absorbed by the disturbance term.

Insert Table VII about here.

As reported in the table, when DOL is regressed against BE/ME, the coefficient estimate of 0.31 is highly significant, statistically and economically. For example, for an increase in the BE/ME ratio from the median value of 0.62 to the third quintile of 1.03, the regression results predict an increase in DOL levels from 1.60 to 1.88 or a 20% increase. As a sensitivity check, we follow Fama and French (1992) and break up BE/ME into the ratio of total assets to market equity (TA/ME) and the ratio of total assets to book equity (TA/BE). Because TA/ME can be interpreted as a measure of operating leverage, while TA/BE

25

(i.e., the equity multiplier) is a measure of financial leverage, this regression specification can provide evidence on the operating leverage hypothesis, controlling for financial leverage. As demonstrated in Table VII, the TA/ME coefficient estimate of 0.31 is also statistically significant. The TA/BE coefficient estimate is negative and statistically indistinguishable from zero. Further, results do not change when we control for size (lnME). In unreported robustness checks, the results do not change when we include average sales (i.e., demand levels) or sales variance (i.e., demand volatility) computed over the five years prior to each cross-section year. These control variables can be motivated within the model of Carlson et al., (2004). For completeness, in Table VII, we also report regression results when the left-hand side variable is DFL. We make two observations. First, consistent with our previous results, there is evidence of a positive association between BE/ME and DFL, controlling for size. Second, there is a positive relation between the equity multiplier and DFL, but not between TA/ME and DFL suggesting that our DFL variable is indeed a measure of financial leverage. Overall, the results of this section support the main prediction of recent theoretical papers linking operating leverage and the book-to-market ratio.

VI. Robustness Checks In this section, we report the results of two types of robustness checks. First, we demonstrate that firms with high (low) DOL levels display characteristics typically associated with value (growth) stocks. This evidence offers further support for the operating leverage hypothesis. Second, we report the results of a battery of robustness checks of our sample, methods,

26

and variable definitions. Overall, our results are only sensitive to detrending the earnings and sales series before estimating DOL. However, after controlling for size, there is evidence of a significantly positive association between DOL and BE/ME even if the series are not detrended.

A. DOL and Value and Growth Characteristics We examine the evolution of growth in earnings, assets, sales, and capital expenditures around the portfolio formation year. We compute portfolio growth rates following Fama and French (1995). In particular, they look at the evolution of the ratio of portfolio equity income to market equity income, EIp(t)/ EIm(t), around the portfolio formation year (Year 0). The two ratios are averaged separately across portfolio formation years. In addition, the ratios are standardized so that they are 1.0 for all portfolios in the year of the portfolio formation. We report our results in Table VIII.

Insert Table VIII about here.

The evolution of profitability for high and low DOL stocks resemble that of high and low BE/ME stocks (Fama and French, 1995). Specifically, the profitability of high DOL stocks deteriorates prior to and improves subsequent to portfolio formation, while the opposite is true for low DOL stocks. In addition, in unreported results, we also find that low DOL stocks are consistently more profitable than high DOL stocks. Previous research has found that low (high) BE/ME stocks experience increases (decreases) in total assets, sales, and investment prior to portfolio formation (Fama and French, 1995; Lakonishok et al., 1994; Anderson and Garca-Feijo, 2006). As illustrated in Table VIII,

27

we find that low (high) DOL stocks experience increases (decreases) in their economic fundamentals around the portfolio formation year.

B. Sample, Methods, and Variable Definition Previous research regarding the association between operating leverage and stock returns has focused on manufacturing firms (Mandelker and Rhee, 1984). Due to our sample construction requirements, 63% of our firm-year observations belong to the manufacturing industry (SIC code between 2000-3999). When we repeat the analysis including manufacturing firms only, the results are very similar to those of the full sample. There is evidence of a weaker univariate association between DOL estimates and average stock returns. The average equallyweighted monthly return difference between high and low DOL decile stocks, although positive (0.30%), becomes statistically indistinguishable from zero (t-statistic of 1.53). In our analysis, we have followed O'Brien and Vanderheiden (1987) and detrended the series of earnings and sales before estimating DOL using the time-series regression approach of Mandelker and Rhee (1984). Our results are sensitive to this adjustment. If we follow the original approach of Mandelker and Rhee (1984), we find there is a significantly negative association between DOL estimates and BE/ME, and no significant association between DOL and stock returns. In Table III, for example, the average DOL estimate for firms in the lowest B/M quintile is 5.79, while the estimate for the highest quintile is 4.89; the difference of -0.90 is significantly different from zero at the 1% level. However, there is evidence of a significantly positive relation between DOL and BE/ME after controlling for size. Within the smallest quintile in Table III, DOL is 4.46 for the high BE/ME stocks and 3.52 for the low BE/ME stocks; the difference of 0.94 is significant at the 1% level. Moreover, the estimated coefficient on B/M in

28

Table VII after controlling for size is 0.35%, which is significantly different from zero at the 1% level. Our reported results do not include stocks with negative DFL estimates because a negative degree of financial leverage has no economic meaning. Stocks with negative DFL estimates represent about 8% of our sample firm-years, and are distributed evenly between manufacturing and non-manufacturing industries. None of our conclusions regarding DOL, BE/ME, and stock returns are affected by the inclusion of negative DFL firms. Similarly, our results do not change if we delete firms with negative DOL estimates, or if we retain the negative sign (firms with negative DOL estimates tend to be firms with very low values of the book-tomarket equity ratio). Furthermore, our results are not sensitive to the exclusion of firms with negative earnings. There is a strong positive link between DOL and BE/ME, and a weak, but still positive relation between DOL and stock returns. In a previous version of Gulen et al. (2008), Xing and Zhang (2004) estimate DOL at the portfolio level. If we follow their approach, we find evidence of a negative relation between DOL and BE/ME. Estimates are 1.00 for the Growth quintile, and 0.72 for the Value quintile; DOL estimates are not significantly different from one except for the Value quintile. Detrending the series of sales and earnings leads to generally lower DOL estimates, except for the Value portfolio. After detrending, there is weak evidence of a positive association between DOL and BE/ME at the portfolio level. DOL estimates are 0.81 for the Growth quintile and 0.92 for the Value quintile, with only the estimate for the Growth quintile being (marginally) different from one. Finally, when we examine the time-series evolution of the association between DOL and BE/ME, we find that the link is very persistent. For example, in Figure III, we plot annual

29

median values of DOL estimates by BE/ME quintile (the middle quintile is omitted in the graph). It should be noted that firms in the higher (lower) BE/ME quintiles have consistently exhibited higher (lower) DOL levels. This offers further support for the predictions of the existing theoretical models.

VII. Summary We test the broad prediction of the models of Carlson et al.(2004), Zhang, (2005), Cooper (2006), and Novy-Marx (2007) that there should be a positive association between operating leverage and the book-to-market ratio (BE/ME) in the cross-section. Consistent with the models, we find 1) a positive association between BE/ME and estimates of the degree of operating leverage (DOL), 2) a positive association between DOL estimates and subsequent stock returns, and 3) a positive association between DOL and beta estimates. To estimate DOL, we use the time-series regression approach of Mandelker and Rhee (1984), but detrend the series of earnings and sales following the recommendations of OBrien and Vanderheiden (1987). If we do not detrend the series, we find evidence of a significantly negative link between DOL and BE/ME, and no significant relation between DOL and stock returns. However, after controlling for size, there is evidence of a significantly positive association between DOL and BE/ME, even if the series of earnings and sales are not detrended. Further, our results do not materially change if we exclude observations with negative earnings or negative DOL estimates. Overall, we find support for a risk-based explanation for the value premium that is consistent with recent theoretical models.

30

References

Aguerrevere, F.L., 2009, Real Options, Product Market Competition, and Asset Returns, Journal of Finance 64, 957-983.

Anderson, C.W. and L. Garca-Feijo, 2006, Empirical Evidence on Capital Investment, Growth Options, and Security Returns, Journal of Finance 61, 171-194.

Ang, J. and P.P. Peterson, 1984, The Leasing Puzzle, Journal of Finance 39, 1,055-1,065.

Berk, J.B., R.C. Green, and V. Naik, 1999, Optimal Investment, Growth Options and Security Returns, Journal of Finance 54, 1,153-1,607.

Bowman, R.G., 1979, The Theoretical Relationship between the Systematic Risk and Financial (Accounting) Variables, Journal of Finance 34, 617-630.

Campbell, J.Y., J. Hilscher, and J. Szilagyi, 2008, In Search of Distress Risk, Journal of Finance 63, 2,899-2,939.

Carlson, M., A. Fisher, and R. Giammarino, 2004, Corporate Investment and Asset Price Dynamics: Implications for the Cross Section of Returns, Journal of Finance 59, 2,577-2,603.

Chen, N. and F. Zhang, 1998, Risk and Return of Value Stocks, Journal of Business 71, 501-

31

535.

Cooper, I., 2006, Asset Pricing Implications of Non-Convex Adjustment Costs and Irreversibility of Investment, Journal of Finance 61, 139-170.

Daniel, K. and S. Titman, 1997, Evidence on the Characteristics of Cross-Sectional Variation in Stock Returns, Journal of Finance 52, 1-33.

Darrat, A.F. and T.K. Mukherjee, 1995, Inter-Industry Differences and the Impact of Operating and Financial Leverages on Equity Risk, Review of Financial Economics 4, 141-155.

DeYoung, R. and K.P. Roland, 2001, Product Mix and Earnings Volatility at Commercial Banks: Evidence from a Degree of Total Leverage Model, Journal of Financial Intermediation 10, 54-84.

Dichev, I.D., 1998, Is the Risk of Bankruptcy a Systematic Risk? Journal of Finance 53, 1,131-1,147.

Dotan, A. and S.A. Ravid, 1985, On the Interaction of Real and Financial Decisions of the Firm under Uncertainty, Journal of Finance 40, 501-517.

Dugan, M.T. and K. A. Shriver, 1989, The Effects of Estimation Period, Industry, and Proxy on the Calculation of the Degree of Operating Leverage, Financial Review 24, 109-122.

32

Dugan, M.T. and K.A. Shriver, 1992, An Empirical Comparison of Alternative Methods for the Estimation of the Degree of Operating Leverage, Financial Review 27, 309-321.

Fama, E.F. and K.R. French, 1992, The Cross-Section of Expected Stock Returns, Journal of Finance 47, 427-465.

Fama, E.F. and K.R. French, 1993, Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics 33, 3-56.

Fama, E.F. and K.R. French, 1995, "Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance 50, 131-155.

Fama, E.F. and K.R. French, 1996, Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance 51, 55-84.

Fama, E.F. and K.R. French, 2006, The Value Premium and the CAPM, Journal of Finance 61, 2,163-2,185.

Fama, E.F. and J.D. MacBeth, 1973, Risk, Return and Equilibrium: Empirical Tests, Journal of Political Economy 81, 607-636.

33

Ferri, M.G. and W.H. Jones, 1979, Determinants of Financial Structure: A New Methodological Approach, Journal of Finance 34, 631-644.

Gahlon, J.M. and J.A. Gentry, 1982, On the Relationship between Systematic Risk and the Degrees of Operating and Financial Leverage, Financial Management 11, 15-23.

Gomes, J., L. Kogan, and L. Zhang, 2003, Equilibrium Cross-Section of Returns, Journal of Political Economy, 111, 693-732.

Griffin, H.F. and M.T. Dugan, 2003, Systematic Risk and Revenue Volatility, Journal of Financial Research, 26, 179-189.

Gulen, H., Y. Xing, and L. Zhang, 2008, Value versus Growth: Time-Varying Expected Stock Returns, University of Michigan Working Paper.

Hamada, R.S., 1972, The Effect of the Firms Capital Structure on the Systematic Risk of Common Stock, Journal of Finance 27, 435-452.

Ho, Y.K., Z. Xu, and C.M. Yap, 2004, R&D Investment and Systematic Risk, Accounting and Finance 44, 393-418.

Huffman, L., 1983, Operating Leverage, Financial Leverage, and Equity Risk, Journal of Banking and Finance, 7, 197-212.

34

Jagannathan, R. and Z. Wang, 1993, The CAPM Is Alive and Well, Staff Report 165, Federal Reserve Bank of Minneapolis.

Kale, J.R., T.H. Noe, and G.G. Ramrez, 1991, The Effect of Business Risk on Corporate Capital Structure: Theory and Evidence, Journal of Finance 46, 1,693-1,715.

Lakonishok, J., A. Shleifer, and R. W. Vishny, 1994, Contrarian Investment, Extrapolation and Risk, Journal of Finance 49, 1,541-1,578.

Lev, B., 1974, On the Association between Operating Leverage and Risk, Journal of Financial and Quantitative Analysis 9, 627-641.

Ljungqvist, A. and W.J. Wilhelm, Jr., 2005, Does Prospect Theory Explain IPO Market Behavior? Journal of Finance 60, 1,759-1,790.

Lord, R., 1996, The Impact of Operating and Financial Risk on Equity Risk, Journal of Economics and Finance, 20, 27-38.

Lord, R., 1998, Properties of Time-Series Estimates of Degree of Leverage Measures, Financial Review 33, 69-84.

35

Loughran, T. and P. Schultz, 2005, Liquidity: Urban Versus Rural Firms, Journal of Financial Economics 78, 341-374.

Mandelker, G.N. and S.G. Rhee, 1984, The Impact of the Degrees of Operating and Financial Leverage on Systematic Risk of Common Stock, Journal of Financial and Quantitative Analysis 19, 45-57.

Newey, W.K. and K.D. West, 1987, "A Simple, Positive Semi-Definite Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica 55, 703-708.

Novy-Marx, R., 2007, Operating Leverage, University of Chicago and NBER Working Paper.

OBrien, T.J. and P.A. Vanderheiden, 1987, Empirical Measurement of Operating Leverage for Growing Firms, Financial Management 16, 45-53.

Opler, T.C. and S. Titman, 1994, Financial Distress and Corporate Performance, Journal of Finance 49, 1,015-1,040.

Petkova, R. and L. Zhang, 2005, Is Value Riskier than Growth? Journal of Financial Economics 78, 187-202.

Prezas, A.P., 1987, Effects of Debt on the Degrees of Operating and Financial Leverage, Financial Management 16, 39-44.

36

Reilly, F.K. and K.C. Brown, 2003, Investment Analysis and Portfolio Management, Mason, OH: Thomson South-Western.

Rosett, J.G., 2001, Equity Risk and the Labor Stock: The Case of Union Contracts, Journal of Accounting Research 39, 337-364.

Rubinstein, M.E., 1973, A Mean-Variance Synthesis of Corporate Financial Theory, Journal of Finance 28, 167-182.

Ryan, S.G., 1997, A Survey or Research Relating Accounting Numbers to Systematic Equity Risk with Implications for Risk Disclosure Policy and Future Research, Accounting Horizons 11, 82-95.

Schwert, G.W., 2003, Anomalies and Market Efficiency in G. Constantinides, M. Harris, and R. Stulz, Ed., Handbook of the Economics of Finance, Vol. 1B, Amsterdam, Elsevier Science.

Shumway, T., 1997, The Delisting Bias in CRSP Data, Journal of Finance 52, 327-340.

Shumway, T. and V. Warther, 1999, The Delisting Bias in CRSPs Nasdaq Data and Its Implications for the Size Effect, Journal of Finance 54, 2,361-2,379.

37

Trezevant, R., 1992, Debt Financing and Tax Status: Tests of the Substitution Effect and the Tax Exhaustion Hypothesis Using Firms Responses to the Economic Recovery Tax Act of 1981, Journal of Finance 47, 1,557-1,568.

Xing, Y. and L. Zhang, 2004, Cyclical Variations in Expected Returns, University of Michigan Working Paper.

White, G.I., A.C. Sondhi, and D. Fried, 2003, The Analysis and Use of Financial Statements, Hoboken, NJ: Wiley.

Zhang, L., 2005, The Value Premium, Journal of Finance, 60, 67-103.

38

Table I. Summary Sample Statistics

We collect data on sales, earnings before interest and taxes (EBIT), and earnings after interest and taxes (EAIT) for all companies included in COMPUSTAT over fiscal years 1981-2002. We estimate DOL and DFL from 1986-2002 by running the following regressions at five-year overlapping intervals (i.e., 1982-1986, 1983-1987, etc) at the individual-firm level: Ln EBITt = Ln EBIT0 + gebit t + t, ebit Ln Salest = Ln Sales0 + gsales t + t, sales where EBIT0 and Sales0 are the beginning levels of EBIT and Sales, respectively. To compute logs of negative earnings, we use the following transformation: ln (1+EBIT) if EBIT 0, and ln (1-EBIT) if EBIT < 0. Once the t, ebit, and t, sales residual series are produced by the regressions, we estimate the following equation: t, ebit = OL t, sales + et where et is an error term. OL, the estimate of DOL, measures the average sensitivity of the percentage deviation of EBIT from its trend relative to the percentage deviation of sales from its trend. For consistency, we estimate DFL similarly. That is, we run the following two additional regressions: Ln EAITt = Ln EAIT0 + geait t + t, eait t, eait = FL t, ebit + ut FL, the estimate of DFL, measures the average sensitivity of the percentage deviation of EAIT from its trend relative to the percentage deviation of EBIT from its trend. We obtain data on market value and stock returns from the Center for Research in Security Prices (CRSP). We compute BE/ME using end-of-fiscal year values from COMPUSTAT from 1986-2002, ME using market value from CRSP at the end of June in the calendar year following the end of the fiscal year, and stock returns from CRSP over the period June 1987-December 2003. To compute BE/ME, we ignore companies with negative book-values. We exclude regulated and financial firms, and we do not include firms until they are on the COMPUSTAT database for five years to reduce survival biases. To mitigate survivorship bias, we follow Shumway (1997) and Shumway and Warther (1999). We measure DOL in absolute value and delete all firms for which DFL is negative. DTL is defined as DOL times DFL. Book DOL is the five-year average ratio of fixed assets to total assets, and book DFL is the five-year average ratio of total debt divided by total assets. Panel A. Descriptive Statistics for the Test Variables Std Dev P5 P25 P50 16.33 -23.08 -7.19 0.00 0.75 0.12 0.35 0.62 2.21 1.38 3.07 4.48 7.23 0.11 0.69 1.69 1.40 0.23 0.71 0.94 8.19 0.08 0.56 1.58 0.20 0.05 0.15 0.26 0.20 0.16 0.34 0.49

Variable Returns % BE/ME LnME DOL DFL DTL BookDOL BookDFL

Mean 1.07 0.82 4.68 3.96 1.23 4.18 0.30 0.48

P75 7.85 1.03 6.15 3.92 1.23 4.07 0.41 0.62

P95 28.12 2.15 8.55 15.46 3.11 17.03 0.73 0.80

Panel B. Pearson Correlation Coefficients for the Test Variables Returns LnBE/ME LnME LnDOL LnDFL LnDTL LnBookDOL LnBookDFL 0.02 -0.00 0.01 0.00 0.01 -0.00 -0.01 LnBE/ME 1.00 -0.37 0.18 -0.00 0.16 0.05 -0.01 LnME 1.00 0.02 0.14 0.09 0.18 0.11 LnDOL LnDFL LnDTL LnBook DOL LnBook DFL

1.00 -0.08 0.87 0.08 0.09

1.00 0.42 0.05 0.09

1.00 0.10 0.13

1.00 0.18

1.00

39

Table II. Average Monthly Percent Returns and Characteristics for Quintile Portfolios Formed on Size and Book-to-Market Equity
Each year, we divide NYSE, AMEX, and NASDAQ stocks into five groups based on their size (price times shares outstanding) at the end of June of year t, and into five groups based on ranked values of BE/ME for individual stocks. BE/ME is the ratio of book value equity at the end of fiscal year t-1 divided by market value of equity at the end of December of calendar year t-1. Only positive values of BE/ME are considered. We use NYSE stocks to determine the size and B/M breakpoints. We form 25 portfolios by combining the sorts by size and by BE/ME. DOL, DFL, and DTL are the degree of operating, financial, and total leverage, respectively, which are computed as explained in Table I. Book DOL is the five-year average ratio of fixed assets to total assets, and book DFL is the five-year average ratio of total debt divided by total assets as of the end of the fiscal year prior to the portfolio-formation year. Size Quintile Book-to-Market Equity (BE/ME) Quintile 2 3 4 High All Low 2 3 4 High All Average Monthly Return Average Degree of Operating Leverage (Percent) (DOL) 0.25 1.01 1.24 1.32 1.39 1.11 2.76 3.24 3.63 4.03 4.98 3.96 0.73 1.06 1.23 1.16 1.20 1.04 3.64 3.53 4.26 4.92 6.44 4.24 1.01 1.11 1.24 1.25 1.50 1.13 3.24 3.57 4.76 5.27 7.89 4.16 1.23 1.25 1.23 1.39 1.69 1.26 2.97 3.24 4.76 7.38 6.39 4.06 1.09 0.87 1.05 1.07 1.22 1.01 2.34 3.64 5.26 5.28 7.09 3.46 0.65 1.02 1.23 1.28 1.38 2.86 3.36 4.05 4.47 5.20 Book-to-Market Equity (BE/ME) Quintile Low 2 3 4 High All Low 2 3 4 High All Average Degree of Financial Leverage Average Degree of Total Leverage (DFL) (DTL) 0.96 1.02 1.04 1.08 1.07 1.04 2.47 2.98 3.47 3.75 4.62 3.67 1.08 1.24 1.34 1.44 1.85 1.33 3.44 3.73 4.92 5.77 7.56 4.68 1.26 1.27 1.54 1.72 1.86 1.42 3.54 3.91 5.70 6.62 9.30 4.81 1.55 1.53 1.79 2.19 2.26 1.68 3.65 4.29 6.70 9.64 9.62 5.36 1.55 1.99 2.61 2.74 3.79 1.98 3.54 6.24 9.17 10.16 14.32 5.92 1.17 1.25 1.31 1.30 1.19 3.01 3.70 4.59 4.82 5.11 Low

Small 2 3 4 Big All Size Quintile

Small 2 3 4 Big All

40

Table II. Average Monthly Percent Returns and Characteristics for Quintile Portfolios Formed on Size and Book-to-Market Equity (Continued)
Size Quintile Low Small 2 3 4 Big All Size Quintile Small 2 3 4 Big All 2 Book-to-Market Equity (BE/ME) Quintile 3 4 High All Low 2 3 4 High All Average Book DOL Average Book DFL 0.25 0.27 0.28 0.28 0.30 0.28 0.50 0.47 0.47 0.46 0.46 0.47 0.27 0.31 0.33 0.32 0.38 0.31 0.43 0.46 0.47 0.49 0.57 0.47 0.28 0.33 0.36 0.40 0.43 0.34 0.46 0.47 0.50 0.53 0.55 0.49 0.30 0.37 0.41 0.50 0.49 0.37 0.47 0.50 0.54 0.58 0.60 0.51 0.32 0.37 0.43 0.47 0.43 0.36 0.51 0.56 0.62 0.62 0.63 0.55 0.27 0.31 0.32 0.32 0.31 0.49 0.48 0.49 0.48 0.48 Book-to-Market Equity (BE/ME) Quintile Low 2 3 4 High All Low 2 3 4 High All Average Monthly Number of Firms Average June Market Value Equity($millions) 222 172 198 228 433 1,252 57 63 60 53 36 50 75 76 72 56 32 312 311 317 302 293 284 304 60 58 40 25 12 197 755 756 747 732 736 750 61 50 30 19 7 167 2,005 1,981 1,947 1,903 1,863 1,970 79 38 21 10 4 152 22,010 12,115 11,194 7,650 8,393 17,590 497 395 361 338 488 5,039 1,715 996 504 173

41

Table III. Characteristics for Quintile Portfolios Formed on Book-to-Market Equity Ratio or Size
The table reports the mean values of monthly equally- and value-weighted stock returns and operating and financial leverage measures for stocks grouped into five portfolios based on BE/ME or size. Only values for stocks in the smallest/largest group and the lowest/highest BE/ME group are shown. Variable definitions are described in Table I. Time-Series Averages of Monthly Cross-Sectional Means Book-to-Market Equity Quintiles Market Equity Quintiles High Low Diff t-stat Small Big Diff t-stat Full Sample Full Sample EWret % 1.38 0.65 0.73*** 2.90 1.11 1.01 0.10 0.33 VWret % 1.25 1.10 0.15 0.48 1.18 1.01 0.18 0.52 DOL 5.20 2.86 2.33*** 31.92 3.96 3.46 0.50*** 4.30 DFL 1.19 1.17 0.02 1.23 1.04 1.98 -0.94*** -15.51 DTL 5.11 3.01 2.11*** 26.03 3.67 5.92 -2.25*** -7.10 BookDOL 0.31 0.27 0.04*** 11.34 0.28 0.36 -0.08*** -25.45 Book DFL 0.48 0.49 -0.01*** -3.36 0.47 0.55 -0.08*** -17.84 Small Quintile EWret % 1.39 0.25 1.14*** 4.33 VWret % 1.43 0.51 0.92*** 2.59 DOL 4.98 2.76 2.22*** 53.25 DFL 1.07 0.96 0.12*** 14.63 DTL 4.62 2.47 2.16*** 59.93 BookDOL 0.30 0.25 0.05*** 27.55 Book DFL 0.46 0.50 -0.04*** -17.19 Time Series Averages of Annual Cross-Sectional Medians Book-to-Market Equity Quintiles Market Equity Quintiles High Low Diff t-stat Small Big Diff t-stat 2.43 1.23 1.19*** 14.16 1.82 1.38 0.45*** 6.57 0.88 0.94 -0.06*** -11.63 0.90 1.13 -0.23*** -7.65 2.23 1.12 1.11*** 13.14 1.60 1.65 -0.05 -0.37 0.26 0.22 0.04*** 6.49 0.23 0.32 -0.09*** -13.71 0.49 0.48 0.00 0.44 0.47 0.55 -0.08*** -9.33

DOL DFL DTL BookDOL Book DFL ***Significant at the 0.01 level

42

Table IV. Average Monthly Percent Returns and Characteristics for Decile Portfolios Formed on the Degree of Operating Leverage and the Degree of Financial Leverage
At the end of June of each year t, t = 1987-2003 and decile portfolios are formed based on DOL, DFL, or DTL as of the end of fiscal year t-1. Returns are computed over the twelve months following portfolio formation (total of 198 months). Deciles are ranked in ascending order. FFBeta is the beta estimate from rolling regressions (Fama and French, 1992). Other variable definitions are in Table I. The last two columns present the average monthly return difference between the High and Low leverage groups (t-stats based on Newey-West (1987) standard errors are in parenthesis). High-Low (Deciles) 0.37** (2.35) 0.53 (1.32) High-Low (Quintiles) 0.27** (2.34) 0.36 (1.09)

Low EW Return (%) VW Return (%) DOL DFL BE/ME ME ($millions) Book DOL FFBeta EW Return (%) VW Return DFL DOL BE/ME ME ($millions) Book DFL FFBeta EW Return (%) VW Return DTL BE/ME ME ($millions) ***Significant at the 0.01 level **Significant at the 0.05 level *Significant at the 0.10 level 0.78 0.82 0.12 1.57 0.70 1399 0.29 1.21 0.96 0.78 0.23 4.28 0.85 2376 0.51 1.17 0.81 0.90 0.08 0.72 1591

2 1.05 0.96 0.39 1.40 0.71 2164 0.30 1.19 1.05 1.00 0.54 3.94 0.92 1995 0.48 1.17 0.85 0.95 0.30 0.70 2450

High

Panel A. Portfolios based on the degree of operating leverage (DOL) 1.02 1.00 1.13 1.18 1.20 1.20 1.23 1.15 1.16 1.01 1.32 1.18 0.96 0.68 1.28 1.35 0.70 1.05 1.47 2.00 2.77 4.00 6.61 20.6 1.22 1.19 1.20 1.27 1.20 1.18 1.13 1.01 0.72 0.75 0.77 0.84 0.85 0.94 0.97 1.06 2458 2950 2160 1663 1706 1447 800 942 0.30 0.29 0.30 0.30 0.31 0.31 0.31 0.33 1.18 1.18 1.19 1.20 1.19 1.20 1.22 1.22 Panel B. Portfolios based on the degree of financial leverage (DFL) 1.25 0.99 1.17 1.23 0.92 1.13 1.07 1.18 1.23 0.76 1.18 1.06 1.28 0.94 1.10 1.10 0.71 0.81 0.90 0.97 1.06 1.24 1.63 4.27 4.66 5.34 5.21 4.04 3.66 3.11 2.76 2.70 0.94 0.87 0.80 0.68 0.74 0.80 0.82 0.87 1071 1166 1172 1017 2080 2125 1986 2704 0.45 0.45 0.45 0.41 0.44 0.49 0.53 0.60 1.20 1.24 1.25 1.30 1.22 1.16 1.14 1.13 Panel C. Portfolios based on the degree of total leverage (DTL) 1.09 1.10 1.05 1.16 1.31 1.15 1.31 1.10 0.86 1.20 1.02 1.22 1.29 0.67 1.22 1.11 0.57 0.91 1.34 1.93 2.76 4.16 7.07 22.90 0.76 0.77 0.80 0.80 0.86 0.92 0.97 1.00 2455 2089 2068 1815 1416 1189 1029 1586

0.22* (1.71) 0.32* (1.82)

0.12 (1.11) 0.16 (0.93)

0.28* (1.80) 0.20 (0.63)

0.37*** (3.36) 0.20 (0.80)

43

Table V. Average Parameter Values from Cross-Sectional Regressions of Monthly Returns on Size, Book-to-Market Ratio, and Operating and Financial Leverage Measures
Raw monthly returns are regressed on size (ME), BE/ME, and DOL, DFL, or DTL estimates. Size is the market value (price times shares outstanding) at the end of June of each year t, t = 1987-2003. BE/ME is the ratio of book value equity at the end of fiscal year t-1 divided by market value of equity at the end of December of calendar year t-1. The estimation of DOL and DFL is explained in Table I. DTL is the product of DOL times DFL. FFBeta is the beta estimate from rolling regressions following Fama and French (1992). Average parameter values are the time series averages, and t-statistics are time-series averages divided by time-series standard errors (198 months). Ln denotes natural logarithm. Regression Specification, Average Parameter Values (%) and t-statistics Specification Ln FFBeta Ln(ME) Ln(BE/ME) Ln(DOL) Ln(DFL) Ln(DTL) 0.09 0.06 0.38*** (1) (0.27) (0.83) (3.83) 0.07*** (2) (2.62) 0.05 (3) (1.20) 0.07*** 0.06 (4) (2.69) (1.39) 0.00 0.06** 0.05 (5) (0.10) (2.53) (1.50) 0.33*** 0.03 0.05 (6) (3.51) (1.16) (1.19) 0.07*** (7) (2.96) 0.00 0.06*** (8) (0.10) (2.82) 0.33*** 0.04 (9) (3.55) (1.44) ***Significant at the 0.01 level **Significant at the 0.05 level

44

Table VI. Average Parameter Values from Cross-Sectional Regressions of Monthly Returns on Operating and Financial Leverage Measures at the Portfolio Level
At the end of June of each year t, t = 1987-2003; 100 portfolios are formed based on the ranking variable measured at the end of fiscal year t-1. Each month, value-weighted monthly portfolio returns (or FFBeta estimates) are regressed on value-weighted portfolios formed based on DOL and DFL estimates. The estimation of DOL and DFL and other variable definitions are in Table I. FFBeta is the beta estimate from rolling regressions following Fama and French (1992). Varsales is the variance of sales over the five years prior to the portfolio formation year. Average parameter values are the time series averages, and t-statistics are time-series averages divided by time-series standard errors adjusted for autocorrelation following Loughran and Schultz (2005). Ln denotes natural logarithm. Average Parameter Values (%) and t-statistics Dep. Variable Ranking Variable to Form Portfolios Book DOL Book DFL Returns Varsales Two Digit SIC Code Book DOL Book DFL Ln FFBeta Varsales Two Digit SIC Code FFBeta ***Significant at the 0.01 level **Significant at the 0.05 level *Significant at the 0.10 level Intercept 0.48 (1.22) 0.61 (1.63) -0.04 (-0.08) 0.23 (0.62) 4.89*** (16.51) 0.32 (0.77) 0.22*** (37.28) 1.01*** (2.83) 1.67 (1.40) Ln DOLp 0.22** (2.30) 0.05 (0.51) 0.40*** (2.74) 0.20* (1.76) 0.24*** (3.74) 3.92*** (10.05) -19.84*** (-27.40) 5.60*** (13.13) 11.98*** (15.54) Ln DFLp -0.01 (-0.15) -0.06 (-0.46) 0.27 (1.05) 0.25 (1.61) -6.19*** (-18.68) -4.69*** (-12.70) -1.63*** (-5.60) -10.17*** (-19.92) -19.37*** (-20.08)

45

Table VII. Annual Regression Results at Individual Firm Level

The table displays results of annual cross-sectional regressions of leverage measures on size, BE/ME, total assets divided by market equity (TA/ME), or total assets divided by book equity (TA/BE). Average parameter values are the time series averages, and t-statistics are time-series averages divided by time-series standard errors adjusted for autocorrelation following Loughran and Schultz (2005). Ln denotes natural logarithm. Variable definitions are in Table I. Average Parameter Values and t-statistics Intercept Ln ME Ln BE/ME LnTA/ME 0.62*** 0.31*** (23.85) (21.36) 0.47*** 0.31*** (14.87) (17.78) 0.34*** 0.07** 0.37*** (5.90) (2.14) (13.61) -0.10*** -0.01 (-8.36) (0.27) -0.15*** 0.01 (-12.83) (0.49) -0.35*** 0.06*** 0.05*** (20.35) (8.08) (2.83)

Dep. Variable

LnTA/BE

Ln DOL

-0.09 (-1.55)

Ln DFL

0.06*** (6.55)

***Significant at the 0.01 level

46

Table VIII. Economic Fundamentals in the 11 Years Around Portfolio Formation

At the end of June of each year t, t = 1987-2003, quintile portfolios are formed based on DOL at the end of fiscal year t-1. The estimation of DOL is explained in Table I. EI(t) is earnings before extraordinary items, but after interest, depreciation, taxes, and preferred dividends for the fiscal year ending in calendar year t; A(t) is total assets; S(t) is sales; and CE(t) is capital expenditures. For a portfolio p, EI, A, S, and CE are the sums of the stocks in the portfolio. Portfolio measures are relative to the values of the variables for the market portfolio, and then standardized so the ratios are 1.0 in the portfolio formation year following Fama and French (1995). The market portfolio m includes all stocks in the five DOL quintiles. Year i Relative to Portfolio Formation -4 -3 -2 -1 0 1 2 3 4 Earnings: Mean [EIp (t + i)/ EIm (t + i)]/ Mean [EIp (t )/ EIm (t )] 0.939 0.967 0.910 0.936 0.970 1.000 1.002 0.955 0.996 1.050 0.849 0.901 0.910 0.912 0.967 1.000 0.948 0.921 0.918 0.968 1.136 1.087 1.131 1.147 1.038 1.000 0.979 0.970 0.940 0.853 3.310 2.570 2.060 1.820 1.210 1.000 2.250 3.110 3.340 3.130 Assets: Mean [Ap (t + i)/ Am (t + i)]/ Mean [Ap (t )/ Am (t )] 0.996 1.023 0.975 0.973 0.985 1.000 1.022 1.032 1.063 1.101 0.888 0.913 0.968 0.964 0.975 1.000 1.027 1.045 1.068 1.102 1.075 1.047 1.042 1.023 1.017 1.000 1.000 0.979 0.901 0.857 1.121 1.131 1.108 1.086 1.049 1.000 0.967 0.960 0.982 0.962 Sales: Mean [Sp (t + i)/ Sm (t + i)]/ Mean [Sp (t )/ Sm (t )] 1.045 1.047 1.015 0.992 0.993 1.000 1.010 1.004 1.021 1.038 0.872 0.906 0.947 0.966 0.994 1.000 1.001 1.012 1.040 1.068 1.041 1.021 1.022 1.006 1.005 1.000 1.009 0.991 0.937 0.934 1.168 1.163 1.128 1.085 1.038 1.000 0.984 0.986 1.004 0.990 Capital Expenditures: Mean [CEp (t + i)/ CEm (t + i)]/ Mean [CEp (t )/ CEm (t )] 1.030 1.035 1.003 0.963 0.979 1.000 1.026 1.063 1.063 1.100 0.912 0.950 0.987 1.008 1.028 1.000 1.000 0.994 1.021 1.054 1.010 1.011 1.017 1.001 1.012 1.000 1.014 0.983 0.903 0.889 1.180 1.149 1.110 1.061 1.025 1.000 0.985 1.014 1.061 1.033 -5

5 1.080 0.980 0.851 2.940 1.122 1.162 0.961 0.961 1.038 1.108 0.875 0.997 1.070 1.104 0.809 1.066

Low DOL 2 4 High DOL Low DOL 2 4 High DOL Low DOL 2 4 High DOL Low DOL 2 4 High DOL

47

Figure I. Average DOL by BE/ME and ME Quintiles

8.00

7.00

6.00

5.00

4.00

3.00

2.00 High 1.00 4 BE/ME 3 BE/ME 0.00 Small 2 ME 2 BE/ME 3 ME Low 4 ME Big

48

Figure II. Average DFL by BE/ME and ME Quintiles

4.00

3.50

3.00

2.50

2.00

1.50

1.00 High 0.50 4 BE/ME 3 BE/ME 0.00 Small 2 ME 2 BE/ME 3 ME Low 4 ME Big

49

Figure III. Median DOL by BE/ME Quintile

3.50

3.00

2.50

2.00

1.50

High BE/ME 4th 2nd Low BE/ME

1.00

0.50

0.00 1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Fiscal Year

50