Debt financing – a well know business strategy in the corporate finance space – refers to borrowing of money, mostly by selling debt instruments to individuals or institutional investors. 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.
Yet, debt is something that everyone likes to avoid. This is because debt financing means borrowing against future earnings, which simply means that instead of using all future profits to grow the business, one has to allocate a portion for repayments.
In fact, given the current macroeconomic scenario in the United States in favor of interest rate hikes, the market seems to be not so suitable for borrowers. In March 2018, the Federal Reserve raised rates for the sixth time since the policymaking Federal Open Market Committee began lifting rates from near zero in December 2015. While long-term interest rates remain low by historical standards, a material rise in long-term interest rates is a key risk for capital intensive stocks, in particular those which rely heavily on capital markets for access to funds
Therefore, for an investor, the real challenge is determining whether the stock in which he/she is investing has a sustainable debt level, since only a small number of companies can avoid taking debt for their business growth.
Considering this and the fact that companies with high debt loads are more prone to bankruptcy at times of crisis, the need of the hour is to choose stocks prudently and particularly target low leverage stocks.
This is where the concept of “leverage” comes in. Leverage simply indicates the level of debt a corporation carries at present. 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 indicates improved solvency for a company.
With the Q1 earnings season set to gather steam from next week, investors must be eyeing stocks that have historically exhibited solid earnings growth.
But in the uncertain world of investment, markets can falter anytime, particularly affecting companies with a higher degree of financial leverage. Therefore, blindly investing in stocks displaying solid earnings growth without considering their debt level might not be a wise move.
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.
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 (Strong Buy) or 2 (Buy) offer the best upside potential.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.
Zacks Rank #1 or 2: Irrespective of market conditions, 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 24 stocks that made it through the screen.
Louisiana-Pacific Corporation (NYSE:LPX): The company manufactures building materials and engineered wood products in the United States, Canada, Chile and Brazil. It pulled off an average positive earnings surprise of 5.18% in the trailing four quarters and sports a Zacks Rank #1.
DMC Global Inc (NASDAQ:BOOM): It is a diversified technology company. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 22.95% in the trailing four quarters.
Alamo Group, Inc. (NYSE:ALG): The company is engaged in the design, manufacture, distribution and service of high quality equipment for infrastructure maintenance, agriculture and other applications. It pulled off an average positive earnings surprise of 12.17% in the trailing four quarters and sports a Zacks Rank #1.
Curtiss-Wright Corp. (NYSE:CW): It is an innovative engineering company that provides high-tech, critical function products, systems and services to the commercial, industrial, defense and power markets. The company sports a Zacks Rank #1 and pulled off an average positive earnings surprise of 15.06% in the trailing four quarters.
Huntington Ingalls Industries Inc (NYSE:HII): It designs, manufactures and maintains nuclear and non-nuclear ships for the U.S. Navy and provides after-market services for military ships around the globe. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 3.85% 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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