“Every crisis has its own set of villains – but all require a similar ingredient to create a true crisis: too much leverage.” – Andrew Ross Sorkin

Financial leverage is a popular investment strategy that refers to the amount of debt that a company uses to finance its operations. Although debt brings with it the burden of interest payment, it is preferred to equity financing because of its cheap availability. Another perk of debt financing is that the interest on debt is tax deductible.

Interestingly, the United States — the world’s richest economy — is the biggest borrower as well. In fact, according to the FY19 Federal Budget, at the end of FY18, gross U.S. federal government debt is estimated to be $21.09 trillion, more than double the debt load in the last decade.

Yet, debt is something that everyone likes to avoid. This is because debt financing means borrowing against future earnings, which simply means that instead of using all future profits to grow the business one has to allocate a portion for debt repayments.

Nevertheless, this should not dissuade one from investing in U.S. stocks. 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

The problem arises when debt a company bears becomes exorbitant. In particular, companies with high debt loads are more vulnerable during economic downturns and can even go bankrupt, especially in periods of high interest rate.

With the Federal Reserve under new chief Jerome Powell targeting four interest rate hikes this year, more than previously expected hikes of three, the market scenario does not seem to be much in favor of companies opting for debt financing. 

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. But if such companies bear high leverage, they might not generate satisfactory returns. This is because during economic depressions, debt-ridden companies are prone to falling into a debt trap.

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.

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 or 2 offer the best upside potential.

Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 28 stocks that made it through the screen.

Louisiana-Pacific Corporation (LPX - Free Report) : The company manufactures building materials and engineered wood products in the United States, Canada, Chile and Brazil. It pulled off an average positive earnings surprise of 5.18% in the trailing four quarters and sports a Zacks Rank #1.

ManpowerGroup (MAN - Free Report) : It is a global leader in the employment services industry. The company carries a Zacks Rank #2 and has delivered an average positive earnings surprise of 2.72% in the trailing four quarters.

Kulicke and Soffa Industries, Inc. (KLIC - Free Report) : It is a leading provider of semiconductor packaging and electronic assembly solutions supporting the global automotive, consumer, communications, computing and industrial segments. The company pulled off a positive earnings surprise of 49.14% in the trailing four quarters and sports a Zacks Rank #1.

Universal Health Services (UHS - Free Report) : It is one of the nation's largest and most-respected healthcare management companies. The company carries a Zacks Rank #2 and pulled off a positive earnings surprise of 0.21% in the trailing four quarters.

DMC Global (BOOM - Free Report) : It is a diversified technology company. The company sports a Zacks Rank #1 and delivered an average positive earnings surprise of 19.10% in the trailing four quarters.