Leverage, referred to the use of debt to acquire additional assets, plays a key role in the field of corporate finance. Notably, a company needs exogenous funds for smooth operations, to meet obligations and expand business.
While companies can obtain such funds either using debt or equity, it has been observed that debt financing over equity is more preferred by companies as per a comparative analysis of the cost of capital theory. This is because debt is available at a lower cost compared to equity, especially in periods of low interest rates.
Yet, the word “debt” is unnerving for many. This is because while debt brings with it the capacity to spend a little bit more, it also carries the burden of repayment with additional interest in the future. As a result, prudent investors try to avoid companies with large debt loads since they are more vulnerable during economic downturns.
It is imperative to mention that U.S. stocks rose in the last couple of days led by energy firms on the back of surging oil prices.
Since it is impossible to find a debt free stock, we suggest that investors look for stocks, which are relatively less leveraged.
And here comes the importance of leverage ratios, which have been constructed 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 shows improved solvency for a company.
Investors are on the lookout for stocks that exhibited solid earnings growth in the last couple of quarters. 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.
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 have a proven history of success.
Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 33 stocks that made it through the screen.
Mobile Mini, Inc.: 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.: 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.
AZZ Inc.: This is a global provider of galvanizing, welding solutions, specialty electrical equipment and highly engineered services. It came up with average positive earnings surprise of 6.65% in the preceding four quarters and carries a Zacks Rank #2.
WellCare Health Plans, Inc.: It offers government-sponsored managed care services to families, children, seniors and individuals with complex medical needs primarily through Medicaid, Medicare Advantage and Medicare Prescription Drug Plans. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 13.52% in the preceding four quarters.
Plains All American Pipeline, L.P.: This company owns and operates midstream energy infrastructure and provides logistics services for crude oil, natural gas liquids and natural gas. It carries a Zacks Rank #2. It delivered average positive earnings surprise of 28.58% in the last four quarters.