The U.S. stock market rally continues with stronger-than-expected payrolls data out last Friday. In August, the United States witnessed record job growth, with wages marking the biggest annual increase in nine years. This bullish macroeconomic data has increased the probability of a third interest rate increase in September.
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, one must remember how stocks have been on a roller coaster ride inthe past couple of months, with investors becoming jittery on rising trade tensions from time to time.
Threats of the trade war flaring up or any other unimpressive event loom large. Therefore, maintaining a relatively less risky portfolio is a must for investors who are not so fond of taking risks more often. This is why investors need to beaware about leverage.
Now, in the world of business finance, leverage refers to an investment strategy that involves borrowing of funds to finance the expansion of the business, purchase of inventory and other assets as well as supporting other aspects of business operations. Financial leverage is the amount of debt that exists in the capital structure of a company.
While there exists an option for equity financing, a comparative analysis of cost of capital reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates.
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.
Of course, this does not mean that debt financing should be a taboo in corporate financing. Nevertheless, given the current macroeconomic scenario in the United States, in favor of interest rate hikes, the market seems to be not so suitable for borrowers.
What we really need 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 behind us, 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 48 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.
Avnet (AVT - Free Report) : The company is one of the world’s largest distributors of electronic components and computer products. It pulled off an average positive earnings surprise of 5.92% 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.
Fidelity National Financial (FNF - Free Report) : It is a leading provider of title insurance, specialty insurance and claims management services. The company currently holds a Zacks Rank #2 and delivered an average positive earnings surprise of 2.80% 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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