Leverage is a well-known business strategy to use borrowed funds for financing the purchase of inventory, equipment and other company assets. These funds can also be utilized to repay the company’s prior debt. Companies can obtain such funds either using debt or equity.
Historically, debt financing has been preferred over equity. This is because when a company resorts to debt financing, it incurs 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 company’s partial owner but also gets entitled to a direct claim to its future profits.
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 a corporation’s bankruptcy in a worst-case scenario.
A high degree of financial leverage means heavy interest payments, which affect a company's bottom line.
Therefore, to protect one’s portfolio from notable losses, the real challenge for an investor is to ascertain if an organization’s debt level is sustainable.
A debt-free entity is rare to find. Historically, several leverage ratios are 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 the Q3 reporting cycle over for majority of sectors, an investor must be looking for solid growth stocks. However, blindly investing in stocks displaying solid earnings growth, without considering their debt level, might not be a wise move. As uncertainty can hit the global equity market any time, it is reasonable to expect that investors will be more attracted to companies with low leverage than high earnings growth.
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 54 stocks that made it through the screen.
Manulife Financial MFC: The company is one of the three dominant life insurers in Canada. It delivered average positive earnings surprise of 2.81% in the last four quarters and currently carries a Zacks Rank #2.
Gibraltar Industries ROCK: It is a leading manufacturer and distributor of building products for the industrial, infrastructure and residential markets. The company has a Zacks Rank of 2 and average positive surprise 0.01% for the trailing four quarters.
Omnicell OMCL: It develops and markets end-to-end automation solutions for the medication-use process. The company came up with average four-quarter beat of 15.88% and holds a Zacks Rank #2.
SolarEdge Technologies SEDG: It offers power optimizers, inverters and a cloud-based monitoring platform to the solar market. The stock is Zacks #2 Ranked and pulled of average positive earnings surprise of 1.05% for the preceding four quarters.
Career Education Corporation CECO: It is an educational services company and sports a Zacks Rank #1. Its average four-quarter positive earnings surprise is 23.89%.
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