Buy These 5 Low Leverage Stocks To Avoid Interest Rate Risk
Zacks Investment Research | Mar 18, 2018 10:36PM ET
In the world of business finance, leverage is a popular investment strategy, through which companies borrow funds to finance business expansion, purchase inventory and other assets as well as support other aspects of business operations. Since companies have limited funds, they need exogenous funding to boost their financial resources from time to time for expansion of operations. So, a company can rarely avoid borrowing funds.
Although one may resort to equity financing, in corporate finance, debt-financing is a more viable option due to its cheap availability. Another perk of debt financing is that the interest on debt is tax deductible.
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. In fact, the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is particularly a problem when interest rates rise or the returns from assets decline.
With the current macroeconomic scenario in the United States being in favor of interest rate hikes, the market seems to be not so suitable for borrowers.
Nevertheless, this does not mean that equity investments are too risky and investing in stocks might not lead to perceived returns. After all, in spite of such high debt levels, the United States remains the largest economy in the world in terms of GDP, representing a quarter share of the global economy per the latest World Bank figures.
In fact, it has been an inherent instrument for corporations to increase their earnings. However, the problem is that companies with high debt loads are more vulnerable during economic downturns and can even go bankrupt, especially in periods of high interest rate.
Considering this, the need of the hour is to choose stocks prudently, avoiding those that carry high debt loads. So the crux of a safe investment lies in identifying low leverage stocks.
This is where the significance of financial leverage ratio comes into play. This ratio measures the extent of financial leverage a company bears. Several leverage ratios have been developed for this purpose, with debt-to-equity ratio being the most popular.
Analyzing Debt/Equity
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 indicates improved solvency for a company.
With the Q4 reporting cycle well behind us, companies that recorded higher earnings growth will attract investors on probabilities of outperformance in Q1 as well. 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 wise to choose stocks with a low debt-to-equity ratio to ensure safe 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.
Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.
Zacks Rank #1 (Strong Buy) or 2 (Buy): Irrespective of market conditions, stocks with a Zacks Rank #1 or 2 have a proven history of success.
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