Leverage, in particular financial leverage, is a popular investment strategy of using borrowed capital. Sometimes, it also refers to the amount of debt that a company uses to finance its operations. Although there is option for equity financing, a comparative analysis of the theory of cost of capital reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates.
However, no one voluntarily wishes to be part of a debt-ridden nation. This is because debt brings with it the burden of interest payments. Therefore, companies with a lower level of debt are usually considered safe bets. This is because highly leveraged stocks are vulnerable in times of volatility.
Interestingly, America – the richest economy in the world is the biggest borrower too. In fact, according to the FY19 Federal Budget, at the end of FY 2018, gross U.S. federal government debt is estimated to be $21.09 trillion, more than double than the debt load the nation bore in the last decade.
Nevertheless, this does not indicate that one should refrain from investing in U.S. stocks. Even after holding so much of debt, the United States remains the largest economy in the world in terms of GDP, representing a quarter share of global economy per the latest World Bank figures.
Considering this, the need of the hour is to choose stocks prudently, avoiding those that carry high debt loads. So the crux of safe investment lies in identifying low leverage stocks.
This is where the significance of financial leverage ratio comes into play. This ratio measures the extent of financial leverage a company bears. Several leverage ratios have been developed for this purpose, with debt-to-equity ratio being the most popular among them.
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 in full swing, companies recording higher earnings growth will attract investors. But if they bear high leverage, then they might not generate satisfactory returns. This is because at the time of economic downturns, debt ridden companies are more prone to falling into a debt trap.
The Winning Strategy
Considering the aforementioned discussion, to ensure safe returns it is wise for investors to choose stocks bearing low debt-to-equity ratio.
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 15 stocks that made it through the screen.
Big Lots, Inc. (NYSE:BIG): It is a broad-line closeout retailer in the United States. The company offers products under various merchandising categories, which include Food, Consumables, Furniture, Seasonal, Soft Home, Hard Home, and Electronics & Accessories. Currently, Big Lots carries a Zacks Rank #2. It came up with an average positive earnings surprise of 81.10% in the trailing four quarters.
Louisiana-Pacific Corporation (NYSE:LPX): The company manufactures building materials and engineered wood products in the United States, Canada, Chile and Brazil. It carries a Zacks Rank #1 and delivered an average positive earnings surprise of 1.16% in the trailing four quarters.
Valero Energy Corporation (NYSE:VLO): It is the largest independent refiner and marketer of petroleum products in the United States. It pulled off an average positive earnings surprise of 18.24% 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.
The Bank of Nova Scotia (NYSE:BNS): It is one of North America’s premier financial institutions, which offers a diverse range of products and services including personal, commercial, corporate and investment banking. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 3.55% in the trailing four quarters.
Manulife Financial Corporation (NYSE:MFC): It is engaged in providing financial protection products and investment management services to individuals, families, businesses and groups. The company carries a Zacks Rank #1 and delivered an average positive earnings surprise of 11.08% 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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