Operating Leverage, Profitability, and Stock Returns under Different Aggregate Funding Conditions

Operating leverage (OL) and profitability are interrelated determinants of stock returns. We show that the outperformance of firms with high OL is driven by periods of unconstrained aggregate funding conditions. Firms with high OL are more risky in general, but when the Fed eases funding constraints, investors bid up their stock prices to reflect lower risk and greater performance expected for these stocks. This time-varying OL effect also explains the differential performance of alternative profitability measures that treat OL differently. Our results extend research linking monetary policy, OL, and profitability by documenting important time-varying interrelations among these characteristics and returns