Leverage, in particular financial leverage, is the amount of debt that an entity uses to buy more assets. In corporate finance, debt financing is a well-known term, which is used as a tool by companies to ensure smooth business operations. Since companies have limited funds, they need exogenous funding to boost their financial resources from time to time for expansion of operations.
Even with the option for equity financing, companies prefer borrowing funds as these are easily and cheaply available. Moreover, using financial leverage rather than acquiring more equity capital is favored as equity financing reduces the earnings per share of existing shareholders.
Yet the word “debt” is unnerving for many. This is because while debt brings with it the capacity to spend a little bit more, it also carries the burden of repayment with additional interest in the future. In fact, the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline.
Also when theamount of debt a company bears becomes exorbitant, it poses greater risk. In fact, companies with high debt loads are more vulnerable during economic downturns and can even go bankrupt.
Considering this and the fact that analysts are currently estimating a hike in U.S. interest rates at the upcoming Fed meet this month, investors may feel shaky. Nevertheless, this does not indicate that one should totally dissuade from equity investment.
What investors need now is tochoose stocks prudently, avoiding those with high debt loads. So the crux of safe investment lies in identifying low leverage stocks.
And here comes the importance of leverage ratios, which have been constructed historically to safeguard investors from becoming victims of debt trap. Debt-to-equity ratio is one such measure, perhaps the most popular one, to evaluate a company’s credit worthiness, for potential equity investments.
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.
As we approach the end of Q4, the growth picture seems to be improving compared to what we saw in the year-ago quarter. Naturally, this would entice investors to pour money in stocks exhibiting solid earnings growth.
But in the uncertain world of investment, markets can trip 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.
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 20 stocks that made it through the screen.
Norbord Inc. OSB: This corporation is a producer of wood-based panels. It pulled off an average positive earnings surprise of 0.28% in the trailing four quarters and carries a Zacks Rank #1.
Huntington Ingalls Industries, Inc. HII: The company designs, builds and maintains nuclear and non-nuclear ships for the U.S. Navy and Coast Guard and provides after-market services for military ships around the globe. It carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 14.22% in the trailing four quarters.
Lam Research Corporation LRCX: It provides market-leading equipment and services for semiconductor wafer processing. It pulled off an average positive earnings surprise of 5.33% in the trailing four quarters and carries a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
SK Telecom Co., Ltd. SKM: It is the provider of the world's first commercial CDMA digital cellular service. The company carries a Zacks Rank #2 and has a long-term earnings growth rate of 7.7%.
Citizens Financial Group, Inc. CFG: It offers a broad range of retail and commercial banking products and services to individuals, small businesses, middle-market companies, large corporations and institutions. The company carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 9.10% 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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Huntington Ingalls Industries, Inc. (HII) : Free Stock Analysis Report
Norbord Inc. (OSB) : Free Stock Analysis Report
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Lam Research Corporation (LRCX) : Free Stock Analysis Report
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