Zombie Companies – Undead or Unloved

/, Monetary Policy/Zombie Companies – Undead or Unloved

Zombie Companies – Undead or Unloved

The term ‘zombie company’ has seen increased usage, particularly over the last five years.  A variety of definitions exist, but they all describe a company whose operating income is insufficient to cover debt service.  The use of the term is growing because the number of companies with this problem is growing.  As central characters in shows like The Walking Dead, zombie humans have a central role.  When it comes to zombie companies, however, they serve no purpose and are best to be avoided.

Creative destruction is an economic concept around innovation and the business cycle.  Money losing or weaker companies should be starved of capital, shut down, or left to reorganize to become more competitive.  On the other hand, innovative and inventive companies should be rewarded with capital to seek additional profits for investors.  Zombie companies are those who continually lose money and struggle to compete yet continue gathering funds to service debt or try yet again to become competitive.  There is always some number of zombie companies as the creative destruction of capitalism moves forward, but lately their numbers are multiplying.

The Bank for International Settlements posted a recent working paper on corporate zombies that revealed several conclusions.  Using their definitions across 14 advanced economies, the number of zombie firms has risen from 4% of all listed firms in the mid-1980s to as many as 15% by 2015.  The problem stems from low-interest rates.  When they are low as they have been since 2008, highly levered companies have an increased ability to survive and hope for a better day.

Of the total number of zombie firms that emerged since the mid-1980s, about 25% have exited the market, and 60% have managed to recover.  No mention is made of the remaining 15%; presumably, their fate was not worth recording.  Still, recovery is not permanent; those that recover have a 3x greater chance of returning to zombie status than the average company becoming a zombie in the first place.

Now the Federal Reserve has lowered rates to zero again and provided massive support of the public markets debt.  According to data compiled by Deutsche Bank Securities last summer, nearly one in five publicly traded U.S. companies is a zombie.

The growth in zombie firms matters for two reasons.  First, it underscores the risks to blind acceptance of investing in benchmarks, through which investors intentionally accept exposure to the strong and the weak.  Working to identify specific companies poised to grow more than others also offers the benefit of avoiding the more challenged competitors in any marketplace.

Second, it acts as a millstone to the momentum needed to get our economy back in gear and impedes the mechanisms of capitalism.  To the extent that physical, human, and intellectual capital is trapped in organizations that can barely cover debt service, such capital will never find its way towards innovative and more competitive uses that would benefit a greater number of economic participants.  Zombie companies are certainly undead, and they should be unloved too.

Disclosure: https://mitchcap.com/disclosure/

2020-11-20T10:50:02-06:00 November 20th, 2020|Investment Management, Monetary Policy|0 Comments