“When you combine ignorance and leverage, you get some pretty interesting results.” -- Warren Buffett.
In the complex world of investment, understanding the amount of financial leverage a company bears is crucial. To this end, it is imperative to define what financial leverage is. Notably, it is the degree to which a company uses fixed-income securities such as debt.
Of course, there exist options for equity financing. Still, historically, debt financing has achieved more popularity than equity financing. This is because debt financing is available at a cheap rate compared to equity financing. Debt financing is also desirable because interest on debt is tax deductible.
Obviously, for companies opting for debt financing, as long as they generate a higher rate of return compared to the interest rate they have to pay, there’s no worry for shareholders. However, exorbitant debt financing is something that companies should avoid any day.
This is because the more debt financing a company uses, the higher its financial leverage is. A high degree of financial leverage means high interest payments, which affects the company's earnings per share. As a company increases debt and preferred equities, interest payments increase, resulting in lower earnings.
So, to be on the safe side, a company should keep track of its debt levels. Empirically, it has been found that in periods of low interest rates, debt financing has gained more traction. At present, with robust parameters supporting growth across the U.S. economy and thereby favoring interest rate hike, the market is not very attractive for hugely burdened companies. Therefore, the crux of safe investment lies in identifying low leverage stocks as debt-free stocks are rare.
Therefore, to safeguard one’s portfolio from losses, an investor should prudently determine whether the stock’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.
With the Q2 reporting cycle in full swing right now, investors must be targeting stocks that have historically exhibited solid earnings growth and are expected to do the same this time around. However, blindly pursuing high earnings yielding stocks might drain all your money before you know, if the stock bears a high debt-to-equity ratio.
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 25 stocks that made it through the screen.
Werner Enterprises (WERN - Free Report) : The company is a premier transportation and logistics provider, engaged in hauling truckload shipments of general commodities in both interstate and intrastate commerce. It pulled off an average positive earnings surprise of 7.32% in the trailing four quarters and currently sports a Zacks Rank #1.
MGIC Investment (MTG - Free Report) : It operates as a mortgage insurer in the United States. The company holds a Zacks Rank #2 and delivered an average positive earnings surprise of 32.99% in the trailing four quarters.
EMCOR Group (EME - Free Report) : The company is one of the leading providers of mechanical and electrical construction, industrial and energy infrastructure, and building services for a diverse range of businesses. It pulled off an average positive earnings surprise of 24.48% 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.
Forward Air (FWRD - Free Report) : It is a leading provider of ground transportation and related logistics services to the North American air freight and expedited LTL market. The company carries a Zacks Rank #2 and pulled off an average positive earnings surprise of 5.72% in the trailing four quarters.
Schnitzer Steel Industries (SCHN - Free Report) : It collects, processes and recycles raw scrap metal (ferrous and nonferrous) and provides processed scrap metal to mills and foundries around the world. The company currently sports a Zacks Rank #1 and delivered an average positive earnings surprise of 0.73% 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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