In corporate finance, leverage is a popular investment strategy that involves borrowing of funds to expand business, purchase inventory and other assets as well as support different aspects of business operations. This borrowing can be through equity or debt financing.
Now, the theory of cost 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.
Yet, debt financing has its share of drawbacks. Particularly, one should keep in mind that debt financing is 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 cause bankruptcy in a worst-case scenario.
Nevertheless, this should not discourage investors from spending on U.S. stocks since debt has been part of the economy since its foundation and yet the country leads others.
Since, a debt-free entity is rare to find, we should focus on those carrying low debt levels. Historically, several leverage ratios have been developed to measure the amount of debt a company bears. 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 the Q4 reporting cycle gaining pace slowly, investors must be looking for stocks that have a history of reporting solid results. However, blindly investing in stocks displaying solid earnings growth, without 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. 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. VGM Score of A or B: 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 24 stocks that made it through the screen.
Gibraltar Industries Inc. ROCK: The company manufactures products ranging from ventilation and expanded metal to mail storage solutions and rain dispersion products and solutions. It delivered positive earnings surprise of 1.95% on average in the last four quarters and currently carries a Zacks Rank #2. Amedisys ( AMED Quick Quote AMED - Free Report) : It provides home health and hospice services throughout the United States to the growing chronic, co-morbid, and aging American population. The company sports a Zacks Rank #1 and delivered positive surprise 21.08% on average in the trailing four quarters. Chevron Corp. CVX: It is one of the largest publicly traded oil and gas companies in the world, based on proved reserves. The company came up with average four-quarter beat of 14.78% and holds a Zacks Rank #2. You can see . the complete list of today’s Zacks #1 Rank stocks here MDU Resources Group MDU: It is a utility natural gas distribution company. The stock is Zacks #1 Ranked and pulled off average positive earnings surprise of 2.79% in the preceding four quarters. Chemed Corp. CHE: It is engaged in diverse business activities including provision of end-of-life hospice care along with plumbing and drain cleaning services. The company carries a Zacks Rank #2, while its four-quarter positive earnings surprise is 3.43%, on average.
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. Click here to sign up for a free trial to the Research Wizard today 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.