With capital being one of the basic factors of production, companies need exogenous funds to finance their corporate expenses, run operations smoothly as well as expand their business. This is because no company has unlimited capital resources.
And here comes the concept of leverage, which is a term used to denote the practice of borrowing capital by companies to run their operations smoothly and expand the same. Mostly, such borrowings are done through debt financing, although there remains an option for equity finance. This is probably due to the cheap and easy availability of debt over equity financing.
In fact, statistics indicate that the United States, the richest economy in the world, is the biggest borrower. Over the years, huge spending on wars, big tax cuts and stimulating economic programs have all added to the nation’s burden. The Congressional Budget Office estimates federal debt to rise to 102% of the economy's GDP by the end of 2021.
One should not refrain from investing in a stock if it bears some amount of debt. However, too much debt increases the chance of a company going toward bankruptcy.
So, there is always a need for a reliable metric to measure a company’s debt level, thereby enabling an investor to choose a low-leverage stock, which is likely to bear less risk. One such metric is debt-to-equity ratio that has been used frequently in history to measure the leverage of a company.
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.
As we are in the middle of the third-quarter earnings season, investors must be eyeing stocks that have exhibited solid earnings growth in the recent past. 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 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. : 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 22 stocks that made it through the screen.
Bonanza Creek Energy : It is engaged in the acquisition, exploration and development of onshore oil and natural gas properties in the United States. The company delivered an earnings surprise of 95.24%, on average, in the trailing four quarters and carries a Zacks Rank #2 currently. Quanta Services ( PWR Quick Quote PWR - Free Report) : It is a leading national provider of specialty contracting services and one of the largest contractors serving the transmission and distribution sector of the North American electric utility industry. The company currently sports a Zacks Rank #1 and delivered an earnings surprise of 17.20% in the trailing four quarters, on average. Titan Machinery ( TITN Quick Quote TITN - Free Report) : It represents a diversified mix of agricultural, construction, and consumer products dealerships located in the upper Midwest. The company came up with a four-quarter earnings surprise of 90.20%, on average, and has a Zacks Rank of 2. You can see the complete list of today’s Zacks #1 Rank stocks here. Genco Shipping & Trading Limited ( GNK Quick Quote GNK - Free Report) : It transports iron ore, coal, grain, steel products and other drybulk cargoes along shipping routes. Currently, the company holds a Zacks Rank of 2. It delivered a four-quarter earnings surprise of 27.83%, on average. AdvanSix Inc. ( ASIX Quick Quote ASIX - Free Report) : It is a producer and supplier of Nylon 6 materials. The company currently sports a Zacks Rank #1 and delivered a four-quarter earnings surprise of 46.90%, 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.