Leverage, in particular financial leverage, is a popular investment strategy of using borrowed capital by corporations to finance their operations as well as expand the same. While there exist options for equity financing, historically, debt financing has achieved more popularity when compared to equity financing.
This is because, on availing debt financing, the company’s equity does not get diluted as a result of issuing more shares of the stock. In other words, the borrower has no claim in the company’s shares.
Another perk of debt financing is that the interest on debt is tax deductible.
Interestingly, the United States — the world’s richest economy — is the biggest borrower as well. In fact, according to the fiscal 2019 federal budget, at the end of fiscal 2018, gross U.S. federal government debt is estimated to be $21.09 trillion, more than double the debt load in the last decade.
Yet, no one voluntarily wishes to be part of a debt-ridden nation. This is because debt brings with it the burden of interest payments.
Then again, this should not dissuade one from investing in U.S. stocks. After all, in spite of such high debt levels, the United States remains the largest economy in the world in terms of GDP, representing a quarter share of the global economy per the latest World Bank figures.
The problem arises when the amount of debt a company bears becomes exorbitant. In fact, companies with high debt loads are more vulnerable during economic downturns and can even go bankrupt.
Empirically it has been found that in periods of low interest rates, debt financing has gained more traction. At present, with robust parameters supporting growth across the U.S. economy and thereby favoring interest rate hike, the market is not very attractive more hugely burdened companies. So, the crux of safe investment lies in identifying low leverage stocks as debt-free stocks are rare.
Therefore, to safeguard one’s portfolio from losses, an investor should prudently determine whether the stock’s debt level is sustainable. Historically, several leverage ratios have been developed to measure the amount of debt a company bears and debt-to-equity ratio is one of the most common ratios.
Analyzing Debt/Equity
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.
As we are off to a strong start in the Q2 earnings season, investors must be eyeing companies that have historically exhibited solid earnings growth and are expected to do the same this time around. However, blindly pursuing high earnings yielding stocks might drain all your money before you know, if the stock bears a high debt-to-equity ratio.
Considering this, it will be wise for investors to select companies with low leverage. These are financially more secure and immune to financial bankruptcy.
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 (Strong Buy) or 2 (Buy) have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 20 stocks that made it through the screen.
HollyFrontier (NYSE:HFC): The company produces and markets gasoline, diesel, jet fuel, asphalt, heavy products and specialty lubricant products. It pulled off an average positive earnings surprise of 41.26% in the trailing four quarters and currently has a Zacks Rank #2.
Amedisys (NASDAQ:AMED): It provides home health and hospice services throughout the United States to the growing chronic, co-morbid and aging American population. The company sports a Zacks Rank #1 and delivered an average positive earnings surprise of 10.58% in the trailing four quarters.
MGM Growth Properties (NYSE:MGP): The company is one of the leading publicly traded real estate investment trusts engaged in the acquisition, ownership and leasing of large-scale destination entertainment and leisure resorts. It pulled off an average positive earnings surprise of 3.02% in the trailing four quarters and currently carries a Zacks Rank #2.
Louisiana-Pacific Corporation (NYSE:LPX): It manufactures building materials and engineered wood products in the United States, Canada, Chile and Brazil. The company sports a Zacks Rank #1 and pulled off an average positive earnings surprise of 0.75% in the trailing four quarters.
Houlihan Lokey (NYSE:HLI): It is an investment bank, which focuses on mergers and acquisitions, financings, financial restructurings and financial advisory services. The company currently carries a Zacks Rank #2 and delivered an average positive earnings surprise of 20.84% 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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