U.S. stocks tumbled at the beginning of this week as the trade dispute between America and China flared up, with both nations determined to impose import tariffs. Such heightened trade tensions between the world’s two biggest economies initially spooked investors and sparked a sell-off in the share market.
However, by the end of yesterday’s trading session, major market indexes recovered to some extent and ended well off their lows. In particular, a rise in oil price drove energy shares and thereby stopped the stock market from a bigger fall.
Nevertheless, investors should take a lesson from this and maintain a relatively less risky portfolio so that at times of uncertainty, one can safeguard his/her portfolio from huge loss. Herein comes the need for investors to remain well versed about leverage.
In the complex world of corporate finance, a company needs exogenous funds for smooth operations, meeting obligations and expanding business. The two financial resources often resorted to are debt and equity.
A comparative analysis of the cost of capital theory reveals that most companies prefer debt financing over equity as debt is available at a lower cost compared to equity, especially in periods of low interest rates.
However, debt financing has its own drawbacks. The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. In particular, companies with large debt loads are more vulnerable during economic downturns and can even go bankrupt in the worst case scenario.
Therefore, for a safe investment strategy, understanding the amount of financial leverage that a company bears is crucial. This is because financial leverage multiplies the underlying business risk.
Of course, entirely avoiding companies with debt load is virtually impossible as debt financing is an inherent feature of corporate financing. Still eliminating those bearing exorbitant debt loads might be a wise idea, since the more the company is leveraged the more it is prone to get hit at times of a financial crunch.
Therefore, to safeguard their portfolio from losses, the real challenge for an investor is to determine whether the organization’s debt level is sustainable. Historically, several leverage ratios have been developed to measure the amount of debt a company bears and 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 indicates improved solvency for a company.
According to estimates compiled by FactSet, analysts are predicting earnings growth of 18.9% in the second quarter of 2018 and a continuation of double-digit growth for the rest of the year. Considering such projections, investors will most likely go for stocks that are exhibiting solid earnings growth. 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.
Considering this, it will be wise for investors to select companies with low leverage. These are financially more secure and immune to financial bankruptcy.
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.
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 (Strong Buy) or 2 (Buy) offer the best upside potential.
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 27 stocks that made it through the screen.
HollyFrontier Corporation (HFC - Free Report) : The company produces and markets gasoline, diesel, jet fuel, asphalt, heavy products and specialty lubricant products. It pulled off an average positive earnings surprise of 41.26% in the trailing four quarters and currently sports a Zacks Rank #1.
Amedisys Inc. (AMED - Free Report) : It provides home health and hospice services throughout the United States to the growing chronic, co-morbid and aging American population. The company sports a Zacks Rank #1 and delivered an average positive earnings surprise of 10.58% in the trailing four quarters.
MGM Growth Properties LLC (MGP - Free Report) : The company is one of the leading publicly traded real estate investment trusts engaged in the acquisition, ownership and leasing of large-scale destination entertainment and leisure resorts. It pulled off an average positive earnings surprise of 5.25% in the trailing four quarters and currently carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Oshkosh Corporation (OSK - Free Report) : It is a leading manufacturer and marketer of access equipment, specialty vehicles and truck bodies for the primary markets of defense, concrete placement, refuse hauling, access equipment and fire & emergency. The company sports a Zacks Rank #1 and pulled off an average positive earnings surprise of 42.24% in the trailing four quarters.
KLX Inc. : It is a distributor and service provider of aerospace fasteners and consumables. The company currently carries a Zacks Rank #2 and delivered an average positive earnings surprise of 10.57% 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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