Leverage, in particular financial leverage, is a common yet a difficult-to-grasp concept. It refers to the amount of debt a nation utilizes to boost its economy. At the micro level, it indicates the corporate debt of individual companies.

Although debt financing is quite common, no one wishes to be a part of a debt ridden economy. Yet, in matured economies, the debt market is larger than the equity market in terms of market capitalization.

Speaking of debt ridden nations, it is imperative to mention the U.S. Yes, America – the richest economy in the world is the biggest borrower too. In fact, if we consider the latest report released by the U.S. Congressional Budget Office, the country’s debt this year is estimated to jump to the highest level since 1950, relative to the size of the economy.

However, this should not disappoint investors putting their money into U.S. stocks, as debt has been part of the U.S. economy since its foundation and yet the country stands atop others. Investors however need to choose wisely and select companies bearing less amount of debt.

This is where financial leverage ratio plays an important role as it indicates the extent to which a company is using debt to finance itself. Debt-to-equity is one such ratio used to identify the amount of debt a company bears.

Define the Ratio

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

Debt-to-equity is a liquidity ratio that indicates the amount of financial risk a company bears. A higher debt-to-equity ratio indicates that the company uses more debt financing compared to equity financing, thereby investing in its stock could prove to be risky.

Although companies reflecting high earnings growth should be ideal investment choices, those with high leverage might not generate satisfactory returns. This is because at the time of economic downturns, debt ridden companies are more prone to become victims of a debt trap.   

Picking the Right Strategy

Considering the above discussion, it is obvious that a sensible investor will go for stocks bearing low debt-to-equity ratios. However, choosing stocks based solely on one financial metric might not fetch the desired outcome.

To ensure the maximum possible return from this strategy, we have expanded our screening procedure to include some other criteria.

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): No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) 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 the five from the final 16.

Omega Protein Corporation : This renowned producer of a custom line of omega-3 fish oil, protein-rich specialty fish meal and organic fish solubles currently sports a Zacks Rank #1 and witnessed a 6% improvement in its current year consensus estimate in the last 30 days.

Universal Forest Products Inc. (UFPI Quick QuoteUFPI - Free Report) : This manufacturer of wood, wood alternative and related products, which carries a Zacks Rank #1, witnessed a 6.8% improvement in its current year consensus estimate in the last 30 days.

American Woodmark Corp. (AMWD Quick QuoteAMWD - Free Report) : This major manufacturer of quality kitchen and bath cabinets carries a Zacks Rank #1. Last quarter, this company witnessed a 34.04% of positive earnings surprise.

Stepan Company (SCL Quick QuoteSCL - Free Report) : This chemical solutions corporation holds a Zacks Rank #2 and witnessed a 9.1% improvement in its current year consensus estimate in the last 60 days.

CONE Midstream Partners LP: This company develops natural gas gathering and other midstream energy assets and currently carries a Zacks Rank #2. It witnessed a 2.8% improvement in its current year consensus estimate in the last 30 days.

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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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