The U.S. Federal Reserve raised the benchmark lending rate by a quarter-point recently, projecting two more increases this year. Consequently, U.S. stocks rallied with the Federal Open Market Committee (FOMC) anticipating more-or-less balanced near-term risks to the nation’s economic outlook.

It is true that a rate hike reflects stable growth in the economy, as also corroborated by Fed chairperson, Janet Yellen, who said in a press conference that the “simple message is the economy is doing well”. However, the real impact of a rate hike cannot be analyzed so simply.  

A rate hike immediately pumps up the prime rate, i.e. the credit rate, which banks extend to their customers. Since most industries in the U.S. are highly capital intensive, debt financing has always been an inherent strategy adopted by large corporations in the country to boost their operations. A rate hike will thus increase the burden of debt along with interest payments for such corporations.

Next, a rate hike magnifies borrowing costs for the government, thereby raising national debt. In fact, a 2015 report by the Congressional Budget Office and Dean Baker, a director at the Center for Economic and Policy Research in Washington, estimated that the U.S. government may end up paying $2.9 trillion more over the next decade due to increases in interest rate.

At the moment, the national debt of the country is approximately $20 trillion, which itself raises question as to whether adding more to this number will prove to be any wiser. Higher public debt will drag the economy to a path of decelerated growth and put pressure on U.S. taxpayers.

Considering no chances of tightening of rates in the near term, investors might be reluctant to pick any U.S. stock for the time being. However, a mere rate hike should not discourage investors since the U.S. economy has been debt dependent since its foundation and is still the largest in the world. What they need to do is pick companies that have a lower debt burden.

This is where the significance of financial leverage ratio comes into play as it measures the extent of financial leverage a company bears. To choose a corporation that is not so highly indebted, several leverage ratios have been developed over the years, with debt-to-equity ratio being the most popular.

Analyzing Debt-to-Equity

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 and therefore investing in it could prove to be risky.

With the Q1 reporting cycle about to begin, investors will now target stocks exhibiting solid earnings growth.

But choosing stocks that boast earnings growth only might not be a wise investment strategy. A higher degree of leverage can turn an attractive investment option into a nightmare in times of financial crisis

The Winning Strategy

It goes without saying that the uncertainty as to whether a rate hike will actually boost the U.S. economy under Trump is making investors more skeptical by the day. Therefore, choosing low leverage stocks is a wise move.

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.

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 or 2 have a proven history of success.

VGMScore 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 16 stocks that made it through the screen.

James River Group Holdings, Ltd. (JRVR Quick QuoteJRVR - Free Report) : This company provides specialty insurance and reinsurance services in the U.S. It carries a Zacks Rank #2 and witnessed an average positive earnings surprise of 8.21% in the trailing four quarters.

Louisiana-Pacific Corporation (LPX Quick QuoteLPX - Free Report) : It manufactures and sells building products primarily for use in new home construction, repair and remodeling, and outdoor structures, as well as light industrial and commercial construction. The company carries a Zacks Rank #1 and witnessed an average positive earnings surprise of 66.28% in the trailing four quarters.

Bank of the Ozarks, Inc. : This corporation operates as a bank holding company for Bank of the Ozarks that provides various retail and commercial banking products and services. It witnessed an average positive earnings surprise of 6.31% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Huntington Ingalls Industries, Inc. (HII Quick QuoteHII - Free Report) : This largest ship builder in the U.S. engages in designing, building, overhauling, and repairing of ships. It carries a Zacks Rank #1 and witnessed an average positive earnings surprise of 19.85% in the trailing four quarters.

Aegean Marine Petroleum Network Inc. : It operates as a marine fuel logistics corporation that markets and supplies refined marine fuel and lubricants to vessels in port, at sea, and on rivers worldwide. It carries a Zacks Rank #2 and reported a positive earnings surprise of 12.34% last quarter.

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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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