U.S. stocks have been on a downward trajectory for the past couple of days. On Oct 10, the Wall Street suffered its worst fall in more than eight months that sent shares of once high-flying technology stocks tumbling. Another reason of this decline might be America’s escalating trade war with China.
This indicates how fragile the stock market can be at times of crisis and the bubble may burst at any moment. Therefore, investors should be extra cautious while choosing stocks and keep their portfolio as less risky as possible.
So, the most obvious question at this point is “Which stocks are risky?” No equity is risk free. Yet, to avoid maximum loss, one should know the art of identifying less risky stocks and one such strategy is to opt for low leverage stocks.
Notably, leverage, in particular financial leverage, is a popular investment strategy of using borrowed capital to finance expansion of business, purchase of inventory and other assets as well as support other aspects of business operations. In other words, it is the degree to which a company uses fixed-income securities such as debt.
While there exists an option for equity financing, historically, debt financing has achieved more popularity among corporations when compared with 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 on the company’s shares.
Another perk of debt financing is that the interest on debt is tax deductible.
Yet, debt financing has got its own drawbacks. It tends to shoot up the company’s risk of bankruptcy. This is because companies with high debt loads are more vulnerable during economic downturns.
In fact, debt brings with it the capacity to spend a little bit more. However, it carries the burden of repayment with additional interest in the future. As a result, prudent investors try to avoid companies with large debt loads since they are more vulnerable during economic downturns.
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 creditworthiness 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 indicates improved solvency for a company.
With the third-quarter earnings season approaching, investors must be targeting stocks that exhibited solid earnings growth in prior quarters. But if a stock bears a high debt-to-equity ratio, in times of economic downturns, its so-called booming earnings picture might turn into a nightmare.
Thus, 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 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 21 stocks that made it through the screen.
Werner Enterprises WERN: The company is a premier transportation and logistics provider, engaged in hauling truckload shipments of general commodities in both interstate and intrastate commerce. It pulled off an average positive earnings surprise of 7.32% in the trailing four quarters and currently sports a Zacks Rank #1.
Huntington Ingalls Industries HII: It designs, builds and maintains nuclear-powered ships such as aircraft carriers and submarines and non-nuclear ships such as surface combatants, expeditionary warfare/amphibious assault and coastal defense surface ships. The company holds a Zacks Rank #2 and delivered an average positive earnings surprise of 9.48% in the trailing four quarters.
Haverty Furniture Companies HVT: The company is a full-service home furnishings retailer. It pulled off an average positive earnings surprise of 24.10% in the trailing four quarters and currently carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
EMCOR Group EME: It is one of the leading providers of mechanical and electrical construction, industrial and energy infrastructure, and building services for a diverse range of businesses. The company sports a Zacks Rank #1 and pulled off an average positive earnings surprise of 24.48% in the trailing four quarters.
Magic Investment Corp MTG: It is the leading provider of private mortgage insurance coverage in the United States to the home mortgage lending industry. The company currently holds a Zacks Rank #2 and delivered an average positive earnings surprise of 32.99% 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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Werner Enterprises, Inc. (WERN) : Free Stock Analysis Report
Huntington Ingalls Industries, Inc. (HII) : Free Stock Analysis Report
EMCOR Group, Inc. (EME) : Free Stock Analysis Report
MGIC Investment Corporation (MTG) : Free Stock Analysis Report
Haverty Furniture Companies, Inc. (HVT) : Free Stock Analysis Report
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