“When you combine ignorance and leverage, you get some pretty interesting results.” – Warren Buffett
Indeed, in the complex world of investment, understanding the amount of financial leverage a company bears is crucial. Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity that is used to finance its capital projects. Now a comparative analysis of the same theory reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates.
Moreover, when a company opts for equity financing, a shareholder not only becomes a partial owner of the company but develops a direct claim on the company’s future profits as well. Another perk of debt financing is that the interest on debt is tax deductible.
However, given the uncertainty surrounding the economy in recent times, no one can be fully sure of how a company will perform the next day. Companies bearing large amount of debts are more prone to financial crisis, especially at times of high interest rates.
With the Federal Reserve set to raise interest rates for the United States thrice in 2018, the market scenario does not seem to be much in favor of companies opting for debt financing.
That said, for the investor, the real challenge is determining whether the stock in which he/she is investing has a sustainable debt level, since a debt-free corporation is rare to find.
This is where the concept of “leverage” comes in. Leverage simply indicates the level of debt a corporation carries at present. Historically, several leverage ratios have emerged as efficient tools to evaluate a company’s credit level to support prudent equity investments. The most popular among them is 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 better investment pick.
Although companies reflecting high earnings growth should be the ideal investment choices, those with high leverage might not generate satisfactory returns. So companies with low leverage instead of high earnings will be your perfect choice on Valentine’s Day.
The Winning Strategy
Considering the aforementioned factors, it is wise to choose stocks with a low debt-to-equity ratio to ensure safe returns.
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): Irrespective of market conditions, stocks with a Zacks Rank #1 or 2 have a proven history of success.
VGM Score of A or B: Our research shows that stocks with a VGM Score of A or B when combined with a Zacks Rank #1 or 2 offer the best upside potential.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 25 stocks that made it through the screen.
MGIC Investment Corp. (NYSE:MTG): The company is the leading provider of private mortgage insurance coverage in the United States to the home mortgage lending industry. It pulled off an average positive earnings surprise of 35.11% in the trailing four quarters and carries a Zacks Rank #2.
Hancock Holding Company (NASDAQ:HBHC): It operates banking offices and automated teller machines in the states of Mississippi and Louisiana. The company carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 4.21% in the trailing four quarters.
Pfizer Inc. (NYSE:PFE): It is a research-based, global pharmaceutical company that discovers, develops, manufactures, and markets medicines for humans and animals. The company pulled off a positive earnings surprise of 4.97% in the trailing four quarters and carries a Zacks Rank #2.
Universal Health Services, Inc. (NYSE:UHS): It is one of the nation’s largest and most respected healthcare management companies. The company carries a Zacks Rank #2 and boasts a solid long-term earnings growth rate of 6%.
DMC Global Inc (NASDAQ:BOOM): It is a diversified technology company. The company sports a Zacks Rank #1 and has delivered an average positive earnings surprise of 19.10% 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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