Leverage refers to an investment strategy that involves borrowing of funds to expand business, purchase inventory and other assets as well as support other aspects of business operations. Financial leverage is the amount of debt that exists in the capital structure of a company.
Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity used to finance capital projects. A comparative analysis of the same theory reveals that most companies prefer debt financing over equity since debt is cheaper, especially in periods of low interest rates.
This is because when a company resorts to debt financing, it takes on fixed expenses in the form of interest payments for a specific time period.
However, in case of equity financing, a shareholder not only becomes a partial owner of the company but develops a direct claim on the company's profits as well. So, debt financing valued by corporates.
Yet, debt financing is not always a welcome way. This is because companies with heavy debt loads are more vulnerable during economic downturns and can even go bankrupt if things go downhill.
So, if a company is highly leveraged, in other words carries an exorbitant amount of debt, investors will not be willing to add the stock. A high degree of financial leverage means high interest payments, which affects the bottom line.
Nevertheless, this should not shift investor attention from U.S. stocks since debt has been part of the economy since foundation and yet the country boasts the largest stock market in the world. What investors need to do is choose stocks with caution, avoiding those with high debt loads.
This is where the significance of financial leverage ratio comes into play as it measures the extent of financial leverage a company bears. To choose a corporation that is not so heavily indebted, several leverage ratios have been developed over the years, with the 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 shows improved solvency for a company.
Now investors must be eyeing companies that exhibited solid earnings growth in the Q4 earnings season. But, in the uncertain world of investment, markets can falter, particularly affecting companies with a higher degree of financial leverage. Therefore, investing in stocks displaying solid earnings growth and not considering their debt level is not a wise move.
The Winning Strategy
Considering the aforementioned factors, it is prudent to choose stocks with a low debt-to-equity ratio to ensure steady 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 or 2 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 46 stocks that made it through the screen.
RLI Corp. (RLI - Free Report) : It is a specialty property-casualty (P&C) underwriter that caters primarily to niche markets. The company delivered average positive earnings surprise of 144.08% in the last four quarters and currently carries a Zacks Rank #2.
Nextera Energy Inc. (NEE - Free Report) : It is engaged in the generation, transmission, distribution, and sale of electric energy. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise of 2.52% for the last four quarters.
Amedysis, Inc. (AMED - Free Report) : It offers home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging population. The company came up with average positive earnings surprise of 19.59% for the preceding four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Southwest Airlines Co. (LUV - Free Report) : It is a passenger airline that provides scheduled air transportation in the United States. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 3.27% in the preceding four quarters.
Titan Machinery Inc. (TITN - Free Report) : The company owns and operates a network of over 70 full-service agriculture and construction equipment stores across an 11-state footprint in the United States and six countries in Europe. It currently carries a Zacks Rank #2 and delivered average positive earnings surprise of 68.67% in the last four quarters.
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.