A company needs exogenous funds for smooth operations, meeting obligations and expanding business; with capital being one of the basic factors of production. Although there is option for equity financing, a comparative analysis of the cost of capital theory reveals that most companies prefer debt financing over equity. This is because debt is available at a lower cost compared to equity, especially in periods of low interest rates.
Interestingly, the U.S. — the world’s richest economy — is the biggest borrower as well. In fact, according to the FY19 Federal Budget, at the end of FY18, gross U.S. federal government debt is estimated to be $21.09 trillion, more than double the debt load in the last decade.
No one voluntarily wishes to be part of a debt-ridden nation. This is because debt brings with it the burden of interest payments.
Then again, this should not dissuade one from investing in U.S. stocks. After all, in spite of such high debt levels, the United States remains the largest economy in the world in terms of GDP, representing a quarter share of the global economy per the latest World Bank figures.
The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. In particular, companies with high debt loads are more vulnerable during economic downturns and can even go bankrupt.
Therefore, the need of the hour is to choose stocks prudently, avoiding those with high debt loads. So the crux of safe investment lies in identifying low leverage stocks.
This is where the significance of financial leverage ratio comes into play. This ratio measures the extent of financial leverage a company bears. Several leverage ratios have been developed for this purpose, with debt-to-equity ratio being the most popular
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 implies that it has a more or less financially stable business, thereby making it a better investment pick.
With the Q3 reporting cycle well behind us, companies that recorded higher earnings growth will attract investors on probabilities of outperformance in Q4 as well. But if such companies bear high leverage, they might not generate satisfactory returns. This is because during economic depressions, debt-ridden companies are prone to falling into a debt trap.
The Winning Strategy
Considering the aforementioned factors, it is wise to choose stocks with a low debt-to-equity ratio to ensure safe 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.
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): Irrespective of market conditions, 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 20 stocks that made it through the screen.
EMCOR Group, Inc. (EME - Free Report) : This corporation is engaged in design, integration, installation, start-up, testing, operation and maintenance of complex mechanical and electrical systems. It pulled off an average positive earnings surprise of 16.96% in the trailing four quarters and carries a Zacks Rank #1.
Huntington Ingalls Industries, Inc. (HII - Free Report) : The company designs, builds and maintains nuclear and non-nuclear ships for the U.S. Navy and Coast Guard and provides after-market services for military ships around the globe. It carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 14.22% in the trailing four quarters.
Lam Research Corp. (LRCX - Free Report) : It provides market-leading equipment and services for semiconductor wafer processing. It pulled off an average positive earnings surprise of 5.33% in the trailing four quarters and carries a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
SK Telecom Co., Ltd. (SKM - Free Report) : It is the provider of world's first commercial CDMA digital cellular service. The company carries a Zacks Rank #2 and boasts a long-term earnings growth rate of 7.7%.
Landstar System, Inc. (LSTR - Free Report) : It is a provider of integrated transportation management solutions worldwide. The company carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 4.97% 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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