Leverage is an investment strategy adopted by corporations wherein borrowed capital is used to expand operations and amplify possible returns from risk capital. Per the theory of cost of capital, a company’s capital structure reflects a mix of debt and equity that is used to finance capital projects.
Empirically, 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. 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. The problem arises when the amount of debt a company bears becomes exorbitant. A high degree of financial leverage means high interest payments, which affect the company's bottom line.
Therefore, to safeguard one’s portfolio from notable losses, the real challenge for an investor is determining whether the 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 around the corner, investors must be eyeing companies 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 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 20 stocks that made it through the screen.
WellCare Health Plans, Inc.: It offers government-sponsored managed care services through Medicaid, Medicare Advantage and Medicare Prescription Drug Plans. The company delivered average positive earnings surprise of 15.43% in the last four quarters and currently carries a Zacks Rank #2.
Domtar Corporation: It is a leading provider of a wide variety of fiber-based products including communication, specialty and packaging papers, market pulp and absorbent hygiene products. The company currently holds a Zacks Rank of 2 and delivered average positive earnings surprise 8.66% for the last four quarters.
Amedysis, Inc.: It offers home health and hospice services throughout the United States to a growing chronic, co-morbid, and aging population. The company came up with average positive earnings surprise of 19.59% in the preceding four quarters and carries a Zacks Rank #2.
Fastenal Company: It engages in the wholesale distribution of industrial and construction supplies. Currently, the company carries a Zacks Rank #2. It came up with average positive earnings surprise of 3.78% in the preceding four quarters.
DMC Global Inc.: The company is a diversified technology company. It currently sports a Zacks Rank #1 and delivered average positive earnings surprise of 48.24% in the last four quarters.