In the complex world of investment, debt financing is a well known strategy adopted by the majority of corporations for expanding their business operations from time to time. Dearth of ample funds is the primary driving force behind this strategy. Yet, resorting to debt is still considered a taboo as it carries the burden of interest payments.
In particular, companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst case scenario. Of course, companies may resort to equity financing as an alternative option to boost their financial resources. However, it is the easy and cheap availability of debt that makes it more popular among corporations.
In fact, statistics indicate that America, the richest economy in the world, is the biggest borrower too. Notably, huge spending on wars, big tax cuts and stimulating economic programs have all added to the nation’s burden over the years. The Congressional Budget Office estimates that the debt held by the public will rise to 150% of the economy’s GDP in 2047 from 77% currently.
Nevertheless, this should not discourage investors from spending on U.S. stocks, since debt has been part of the economy since its foundation and yet the country stands atop others. What investors need to do is choose stocks with caution, thus avoiding those that carry high debt loads.
Here comes the significance of leverage, better to say financial leverage, which indicates the degree to which a company utilizes debt to boost its operations and earn escalated profit margins. Usually investors tend to avoid companies bearing higher degree of financial leverage.
The next question that comes to our mind is that how can we measure a company’s degree of financial leverage. To this end, several leverage ratios have been constructed as efficient tools to evaluate a company’s credit level to support prudent equity investments.The most popular among them is the debt-to-equity ratio.
Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio implies that it has a more or less financially stable business, thereby making it a more worthy investment opportunity.
With the Q3 reporting cycle set to gain steam in the coming weeks, an investor must be looking for solid growth stocks. Blindly investing in stocks displaying solid earnings growth without considering their debt level might not be a wise move. As, uncertainty can hit the global equity market any time, it is reasonable to expect that investors will be more attracted to companies with low leverage than high earnings growth.
The Winning Strategy
In theory, the optimal capital structure for a company is one with the ideal debt-to-equity ratio that maximizes its value and minimizes its cost of capital. Since, in practice, screening stocks based on these criteria is a bit difficult, herein, we choose low leverage stocks as these are considered safe bets.
However, an investment strategy based solely on the debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other factors.
Here are the other parameters:
Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.
Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.
Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.
Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.
Zacks Rank #1 (Strong Buy) or #2 (Buy): No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 or 2 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 46 stocks that made it through the screen.
Humana Inc. (NYSE:HUM): It is a health services company that facilitates the delivery of health care services through networks of providers to its medical members. The company carries a Zacks Rank #2 and came up with an average positive earnings surprise of 7.24% in the trailing four quarters.
Alibaba Group Holding Limited (NYSE:BABA): The company operates online and mobile marketplaces in retail and wholesale trade, as well as cloud computing and other services.It carries a Zacks Rank #2 and delivered an average positive earnings surprise of 12.16% in the trailing four quarters.
Honeywell International Inc. (NYSE:HON): It is a global diversified technology and manufacturing company with a wide range of aerospace products and services. It pulled off an average positive earnings surprise of 1.08% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
AGNC Investment Corporation (NASDAQ:AGNC) :It is a real estate investment trust (REIT) that focuses on leveraged investments in agency MBS. This includes residential mortgage pass-through securities and collateralized mortgage obligations (CMOs). The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 11.73% in the trailing four quarters.
Wintrust Financial Corporation (NASDAQ:WTFC): It a bank holding company, which provides banking services, trust and investment services, commercial insurance premium financing, short-term accounts receivable financing, and certain administrative services. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 7.17% in the trailing four quarters.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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