“When you combine ignorance and leverage, you get some pretty interesting results.”– Warren Buffett
In everyday business, “leverage” is a familiar term that indicates the use of various financial instruments by corporations to multiply their profits. But from the perspective of an investor, this term holds the key to prudent investment. In fact, financial leverage specifically indicates the amount of capital a firm has borrowed to boost its operations, thereby indicating the level of risk it bears.
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. However, too much debt can be unhealthy for a company because while it brings with it the chance of drawing higher profits in the future, it also bears the risk of paying higher interest and thereby dragging the company into a debt trap.
No doubt in the uncertain world of investment, markets can trip anytime affecting companies bearing a higher degree of financial leverage. This makes low leverage companies more attractive for investment purposes.
Naturally, to be on the safe side, investors will be eager to know how much leverage a company currently bears. Several leverage ratios have been constructed so far for this purpose, the most common one being debt-to-equity ratio.
Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
In simple terms, debt-to-equity is a solvency ratio that measures the extent of financial leverage a company is bearing. A lower debt-to-equity ratio implies a more financially stable business, thereby making it a more worthy investment opportunity.
In general, investors target companies exhibiting solid earnings growth projections. But if these 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 the aforementioned discussion, it is imperative for an investor to choose stocks that bear a low debt-to-equity ratio. However, choosing stocks based solely on one financial metric might not be a wise investment strategy.
To ensure maximum possible return from this strategy, we have expanded our screening procedure to include some other criteria.
Here is the final screen:
Debt/Equity less than X-Industry Median: Those 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.
Here are five stocks from the 20 stocks that passed the screen:
- Apogee Enterprises, Inc. (APOG - Free Report) : This prominent player in architectural products and services currently carries a Zacks Rank #2 and witnessed a 3.7% improvement in its current year consensus estimate in the last 30 days.
- NTT DOCOMO, Inc. : This mobile communications services provider, which carries a Zacks Rank #1, witnessed a 10.8% improvement in its current year consensus estimate in the last 30 days.
- BofI Holding, Inc. : It operates as the holding company for BofI Federal Bank and carries a Zacks Rank #2. Its long-term expected earnings growth rate is 10%, which is higher than industry average of 9.7%.
- Manulife Financial Corporation (MFC - Free Report) : This financial services provider holds a Zacks Rank #2 and its long-term expected earnings growth rate is 10%, which is higher than industry average of 9.6%.
- Diplomat Pharmacy, Inc. : This specialty pharmacy, which currently carries a Zacks Rank #2, witnessed a 5.7% improvement in its current year consensus estimate in the last 60 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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