Financial leverage refers to a popular investment strategy that involves borrowing of funds to expand business, purchase inventory and other assets as well as support different aspects of business operations.
Although there is option for equity financing, historically, debt financing has been preferred over equity because of its easy and cheap availability.
Yet, debt financing has its share of drawbacks. The problem arises when the amount of debt a company bears becomes exorbitant. A high degree of financial leverage means high interest payments, which affect the company's bottom line.
Now, in this context it is imperative to mention that the impact of the coronavirus outbreak that sent the global economy on a rollercoaster ride at the onset of the pandemic continues to cause turbulence.
So investors should choose stocks wisely amid these uncertain times as debt-ridden stocks bear high risk of solvency. Since a debt-free stock is hardly found, investing in a stock with comparatively lower debt level should a prudent choice by investors.
Historically several leverage ratios have been developed to measure the amount of debt a company bears and the debt-to-equity ratio is one of the most common ratios.
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 shows improved solvency for a company.
With the U.S. stock market still staggering to make a noticeable progress, investors mustbe eyeing stocks that have exhibited solid earnings growth historically. 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.
The Winning Strategy
Considering the aforementioned factors, it is prudent to choose stocks with a low debt-to-equity ratio to ensure steady 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. : 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. VGM Score of A or B 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 32 stocks that made it through the screen.
Kinsale Capital Group ( KNSL Quick Quote KNSL - Free Report) : It offers various insurance and reinsurance products across all 50 states of the United States, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. The company delivered an earnings surprise of 7.99%, on average, in the trailing four quarters and currently carries a Zacks Rank #2. Plexus Corp. ( PLXS Quick Quote PLXS - Free Report) : It is a leading provider of electronic contract manufacturing services to original equipment manufacturers (OEMs) in a wide range of industries, including networking/ communications, health care/life sciences, industrial/ commercial and defense/security/aerospace..The company currently has a Zacks Rank #2 and delivered an earnings surprise of 22.16% in the trailing four quarters, on average. Farmers National Banc Corp. ( FMNB Quick Quote FMNB - Free Report) : It is a full-service national bank engaged in commercial and retail banking.The company came up with a four-quarter earnings surprise of 34.40%, on average, and sports a Zacks Rank #1. You can see . the complete list of today’s Zacks #1 Rank stocks here D.R. Horton ( DHI Quick Quote DHI - Free Report) : It is one of the leading national homebuilders, primarily engaged in the construction and sale of single-family houses both in the entry-level and move-up markets. Currently, the company sports a Zacks Rank #1 and came up with a four-quarter earnings surprise of 16.78%, on average. Lumber Liquidators Holdings ( LL Quick Quote LL - Free Report) : It is a retailer of hardwood flooring. It currently holds a Zacks Rank #2 and delivered a four-quarter earnings surprise of 432.50%, on average.
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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