Leverage is a well-known business strategy of using borrowed funds to finance the purchase of inventory, equipment as well as other company assets. These funds can be also utilized to pay back the company’s prior debt. Companies can obtain such funds either using debt or equity.
Statistically, companies prefer debt over equity. This is because debt is available easily and is cheaper than equity financing. Moreover, in case of debt financing, notwithstanding whether the interest charges are from a loan or line of credit, the interest payments are tax deductible. 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 future profits as well.
Yet, debt financing has its share of drawbacks. In particular, one should keep in mind that debt financing remains a feasible option as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even lead to a corporation’s bankruptcy in a worst-case scenario.
Especially, in times of crisis, no one can be fully sure of how a company will perform the next day. On top of that, the ones bearing large amount of debt are more prone to bankruptcy. Therefore, the debt level of a company is an important point of consideration while making an investment decision.
Considering the fact that uncertainty can hit the share market anytime, it is better to take measures beforehand than repent later. This is why investors needs to look for stocks that are relatively less leveraged, since a corporation with zero debt hardly exists.
Therefore, to safeguard one’s portfolio from notable losses, the real challenge for an investor is determining whether an organization’s debt level is sustainable. A debt-free corporation is rare to find. Historically several leverage ratios have been developed to measure the amount of debt a company bears and the 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 shows improved solvency for a company.
With Q1 earnings over for most companies, investors must be eyeing the ones that have exhibited solid earnings growth in the past couple of quarters. However, blindly pursuing high earnings yielding stocks, which have a high debt-to-equity ratio, might drain all your money before you know.
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 (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.
Mobile Mini, Inc. (MINI - Free Report) : It is the world's leading provider of portable storage solutions through its total rental fleet of storage solutions containers and office units. The company delivered average positive earnings surprise of 1.11% in the last four quarters and currently carries a Zacks Rank #2.
James River Group Holdings, Ltd. (JRVR - Free Report) : It is an insurance company, which owns and operates specialty insurance and reinsurance companies. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise 4.72% for the last four quarters.
K12 Inc. (LRN - Free Report) : This technology-based education company came up with average positive earnings surprise of 33.17% in the preceding four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Quanta Services, Inc. (PWR - Free Report) : It is a leading specialized contracting services company, delivering infrastructure solutions for the electric power, oil and gas and communications industries. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 0.68% in the preceding four quarters.
DMC Global Inc. (BOOM - Free Report) : This diversified technology company sports a Zacks Rank #1. It delivered average positive earnings surprise of 26.56% in the last 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.