“Growth based on debt is unsustainable, artificial” – Jose Manuel Barroso
With capital being one of the basic factors of production, companies – especially those facing a dearth of resources – need exogenous funds to finance their corporate expenses, run operations smoothly as well as expand the realm of their business. Among equity and debt – the two most common options used to boost a company’s future earnings – debt is the more popular one. This is perhaps due to the cheap and easy availability of debt over equity financing.
However, one should not forget that too much debt can also be detrimental as companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst case scenario.
This is because while debt brings with it the capacity to spend a little bit more, it also bears the burden of repayment with additional interest in the future. 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.
Nevertheless, to be on the safe side, investors try to avoid stocks that bear large debt loads. And here comes the importance of leverage, which indicates the level of debt a corporation carries at present. Empirically several leverage ratios have been constructed to measure the exact amount of debt risk a company bears in order to safeguard investors from debt traps.
Debt-to-equity ratio is one such measure, perhaps the most popular one, which has been used to evaluate a company’s credit worthiness, for potential equity investments.
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 lower debt-to-equity ratio implies a more financially stable business, thereby making it a more worthy investment opportunity.
With the third–quarter earnings season set to pick up pace by the end of this week, investors must be gearing up to put their money in stocks exhibiting a surge in earnings. But if the stocks bear a high debt-to-equity ratio, in times of economic downturns, their so-called booming earnings picture might turn into a nightmare.
So, instead of targeting stocks showing an earnings boom, which might be short-lived, it will be wise for investors to select those with low leverage and thus are financially more secure and immune to financial bankruptcy.
Choosing the Winning Strategy
Considering the above discussion, it is imperative that a sensible investor chooses 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 or 2 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 five of the final 16 stocks that made it through the screen.
American Woodmark Corp. (AMWD - Free Report) : This manufacturer of kitchen cabinets and vanities for the U.S. remodeling and home construction markets sports a Zacks Rank #1. It witnesseda positive earnings surprise of 33.13% on an average in the trailing four quarters.
CONE Midstream Partners LP : This is a growth-oriented master limited partnership (MLP) that owns, operates, and develops natural gas gathering and other midstream energy assets. The company currently carries a Zacks Rank #1 and witnessed a positive earnings surprise of 19.38% on an average in the trailing four quarters.
NTT DOCOMO, Inc. (DCM - Free Report) : This Japanese company is a predominant mobile phone operator in the nation. The current year consensus estimate for DOCOMO was up 7.3% in the last 60 days. The company carries a Zacks Rank #1. You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.
Preferred Apartment Communities, Inc. (APTS - Free Report) : This corporation primarily acquires and operates multifamily properties in select targeted markets throughout the U.S. It carries a Zacks Rank #2 and witnessed a positive earnings surprise of 2.54% on an average in the trailing four quarters.
Gentex Corp. (GNTX - Free Report) : This manufacturer of automatic-dimming rearview mirrors and electronics carries a Zacks Rank #2 and witnessed a positive earnings surprise of 3.64% on an average in the trailing four quarters.
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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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