“Growth based on debt is unsustainable, artificial” – Jose Manuel Barroso.
With capital being one of the basic requirements for production, companies need exogenous funds to finance their corporate expenses, run operations smoothly as well as expand the realm of their business. This is because depending solely on retained earnings for business growth is next to impossible.
It is worth noting that among equity and debt – the two most common options used to boost a company’s future earnings – debt is the more popular one. This is perhaps due to the cheap and easy availability of debt over equity financing. Moreover, interest on debt is tax deductible, which makes it an attractive option.
However, debt financing has its own drawbacks. The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. In particular, companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst case scenario.
Of course, this does not mean that debt financing, which is an inherent instrument for corporations to grow their earnings, should be a taboo in corporate financing.
Nevertheless, 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.
Therefore, to be on the safe side, investors should try to avoid stocks that bear large debt loads. Empirically, several leverage ratios have been constructed to measure the exact amount of debt risk a company faces in order to safeguard investors from debt traps.
Debt-to-equity ratio is one such measure, perhaps the most popular one, which has been used 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 indicates improved solvency for a company.
With the first-quarter reporting cycle in full swing right now, investors must be targeting stocks that are exhibiting solid earnings growth. But if the stocks bear a high debt-to-equity ratio, in times of economic downturns, their so-called booming earnings picture might turn into a nightmare.
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 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 40 stocks that made it through the screen.
Louisiana-Pacific Corporation 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 currently sports a Zacks Rank #1.
IDEXX Laboratories, Inc. IDXX: It is a developer, manufacturer and distributer of products and services primarily for the companion animal veterinary, livestock and poultry, water testing and dairy markets. The company carries a Zacks Rank #2 and delivered an average positive earnings surprise of 7.28% in the trailing four quarters.
SolarEdge Technologies, Inc. SEDG: The company provides innovative solar power harvesting and monitoring solutions for residential, commercial, and utility-scale solar PV installations. It pulled off an average positive earnings surprise of 31.93% 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.
Curtiss-Wright Corporation 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 carries a Zacks Rank #2 and pulled off an average positive earnings surprise of 15.06% in the trailing four quarters.
Autohome Inc. ATHM: It offers an online destination for automobile consumers, primarily in the People's Republic of China. The company currently sports a Zacks Rank #1 and delivered an average positive earnings surprise of 21.37% in the trailing four quarters.
Get the rest of the stocks on the list and start putting this and other ideas to the test. It can all be done with the Research Wizard stock picking and back testing software.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
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.
Zacks Restaurant Recommendations: In addition to dining at these special places, you can feast on their stock shares. A Zacks Special Report spotlights 5 recent IPOs to watch plus 2 stocks that offer immediate promise in a booming sector. Download it free »
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
Autohome Inc. (ATHM) : Free Stock Analysis Report
Curtiss-Wright Corporation (CW) : Free Stock Analysis Report
Louisiana-Pacific Corporation (LPX) : Free Stock Analysis Report
IDEXX Laboratories, Inc. (IDXX) : Free Stock Analysis Report
SolarEdge Technologies, Inc. (SEDG) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research