“Leverage” is a term used casually and frequently in everyday business, but deep down it is of grave importance. Basically, leverage, better known as financial leverage, refers to the use of debt financing by any corporation to boost its business. Although companies also have the option to resort to equity financing, the majority of them see debt financing as a more viable choice.

This is because debt financing brings in money at a lower cost than equity financing, especially in periods of historically low interest rates. However, too much debt can turn out to be detrimental for any business.

Particularly, it is better to avoid companies bearing a high degree of financial leverage as they are the most vulnerable ones in times of financial distress and may even go bankrupt in the worst case scenario.

Considering this, it is reasonable to conclude that investors should measure the extent of financial leverage a company is bearing before putting their hard-earned money in its stock. Several leverage ratios have been constructed for this purpose, debt-to-equity ratio being the most popular among them.

Analyzing the Ratio

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

This metric is a liquidity ratio that reflects how much debt a company currently bears. A lower debt-to-equity ratio implies a comparatively less risky business and thereby greatly contributes to an investor’s confidence in a company’s financial stability.

With the second-quarter earnings season on the last lap, investors must be flocking to high earnings-yielding companies. However, it will be rather stupid to target stocks exhibiting a surge in earnings only. This because if a stock has a high debt-to-equity ratio, its so-called booming earnings picture might turn into a nightmare any time soon.

So instead of choosing companies bearing high earnings growth, low leverage stocks should be ideal investment choices; for a sensible investor.

Picking the Right Strategy

Choosing stocks based solely on one financial metric might not fetch the desired outcome.

To ensure the maximum possible return from this strategy, we have expanded our screening procedure to include some other criteria. Particularly, we added a low P/E ratio and a favorable Value Style Score to the screen to shortlist cheap stocks.

Here are the 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): No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have a proven history of success.

Value Score of A or B: Our research shows that stocks with a Value Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential. 

P/E (using F1 estimates) less than or equal to 16: This selects undervalued stocks.

Although 14 stocks passed the screen, we have eliminated those that have a negative or a zero debt-to-equity ratio.

Here are five stocks from the final eight:

Omega Protein Corporation : This renowned producer of a custom line of omega-3 fish oil, protein-rich specialty fish meal and organic fish solubles currently sports a Zacks Rank #1 and witnessed a 6% improvement in its current year consensus estimate in the last 30 days.

General Dynamics Corporation (GD Quick QuoteGD - Free Report) : This global aerospace and defense company, which carries a Zacks Rank #2, witnessed a 1.1% improvement in its current year consensus estimate in the last 30 days.

Argo Group International Holdings, Ltd. : This international underwriter of specialty insurance and reinsurance products carries a Zacks Rank #1. Last quarter, this company witnessed a 61.5% of positive earnings surprise.

Stepan Company (SCL Quick QuoteSCL - Free Report) : This chemical solutions corporation holds a Zacks Rank #1 and witnessed a 6.9% improvement in its current year consensus estimate in the last 30 days.

CONE Midstream Partners LP : This company develops natural gas gathering and other midstream energy assets and currently carries a Zacks Rank #2. It witnessed a 2.8% improvement in its current year consensus estimate in the last 30 days.

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.

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