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 done 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.
The current market situation seems favorable for corporates to take debt since the COVID-19 pandemic has forced the Federal Reserve to lower interest rate to a near-zero level.
Yet, debt is something that gives you the chills since it brings with it the burden of repayment with additional interest in the future.
Especially, in times of crisis, no one can be fully sure of how a company will perform. On top of that those bearing large amount of debt are even more prone to bankruptcy. Therefore, the debt level of a company is an important point of consideration while making an investment decision.
Several leverage ratios have emerged as efficient tools to evaluate a company’s credit level to support prudent equity investments. The most popular among them is the debt-to-equity ratio.
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 coming to an end, investors must be eyeing companies that have exhibited solid earnings growth. 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 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 16 stocks that made it through the screen.
NextEra Energy NEE: It is a public utility holding company engaged in the generation, transmission, distribution and sale of electric energy. The company delivered average four-quarter positive earnings surprise of 2.39% and currently carries a Zacks Rank #2.
Kinsale Capital Group KNSL: It operates as a specialty insurance company. The company currently carries a Zacks Rank #2 and delivered four-quarter average positive earnings surprise of 3.44%.
Vectrus, Inc. VEC: It offers infrastructure asset management, logistics and supply chain management, and information technology and network communication services. The company came up with four-quarter average positive earnings surprise of 0.69% and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Teekay Tankers Ltd. TNK: It is a Marshall Islands corporation recently formed by Teekay Corporation to provide international marine transportation of crude oil. Currently, the company sports a Zacks Rank #1 and came up with average four-quarter positive earnings surprise of 13%.