Good times continue for Wall Street, with the Nasdaq rising on strong performance of technology stocks and the S&P 500 recording its longest bull run on Aug 22. Notably, the optimism stems from resumed trade talks between the United States and China, which drove stocks higher across the globe.
With other fundamental data indicating a healthy economy, the stage is set for the U.S. market to remain on an upward trajectory, raising hopes for more such upswings in the future.
However, considering the fact that uncertainty can hit the global equity market anytime, it is better to take measures beforehand than repent later. This is why investors need to be aware about leverage.
Notably, leverage, in particular financial leverage, is a popular investment strategy of using borrowed capital to finance expansion of business, purchase of inventory and other assets as well as support other aspects of business operations. In other words, it is the degree to which a company uses fixed-income securities such as debt.
While there exists an option for equity financing, historically, debt financing has achieved more popularity among corporations when compared with equity financing. This is because, on availing debt financing, the company’s equity does not get diluted as a result of issuing more shares of the stock. In other words, the borrower has no claim in the company’s shares.
Another perk of debt financing is that the interest on debt is tax deductible.
Yet, debt financing has got its own drawbacks. It tends to shoot up the company’s risk of bankruptcy. This is because companies with high debt loads are more vulnerable during economic downturns.
Considering the current debt scenario in the United States, the situation might not seem to be much favorable for those planning to opt for debt financing. In June 2018, the Congressional Budget Office estimated that federal debt held by the public will rise from 78% of GDP at the end of 2018 to 96% in 2028. Such a huge debt load enhances the probability of the whole nation falling into a debt trap if timely measures are not taken.
On top of that, with the present macroeconomic scenario in the United States being in favor of interest rate hikes, the market seems to be not so suitable for borrowers.
Nevertheless, this does not mean that investors should altogether avoid equity investments. 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 need of the hour is to choose stocks prudently, avoiding those that carry high debt loads. So the crux of safe investment lies in identifying low leverage stocks.
And here comes the importance of leverage ratios, which have been constructed historically to safeguard investors from becoming victims of debt trap. Debt-to-equity ratio is one such measure, perhaps the most popular one, to evaluate a company’s creditworthiness for potential equity investments.
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 its last lap right, investors must be targeting stocks that are exhibiting solid earnings growth. 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.
Thus, 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 19 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.
Huntington Ingalls Industries (HII - Free Report) : It designs, builds and maintains nuclear-powered ships such as aircraft carriers and submarines, and non-nuclear ships such as surface combatants, expeditionary warfare/amphibious assault and coastal defense surface ships. The company holds a Zacks Rank #2 and delivered an average positive earnings surprise of 9.48% 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.
Alamo Group (ALG - Free Report) : It designs, manufactures, distributes and offers service of high quality equipment for infrastructure maintenance, agriculture and other applications. The company currently holds a Zacks Rank #2 and delivered an average positive earnings surprise of 6.06% 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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