Investment Strategy Brief:
Corporate Zombification

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

With Halloween quickly approaching, expect to see goblins, ghouls and vampires roaming the streets with bags of candy seeking tricks and treats. But that’s not the only place people can find scary roaming creatures these days. Zombie companies, which refer to firms that consistently struggle to meet their interest costs, have been on the rise in the post-pandemic period after unprecedented levels of government support. Currently, about 11.5% of listed stocks in the U.S. can be classified as zombies, which is elevated relative to historical norms. Keeping these companies afloat is not always such a good thing for the economy, as dedicating capital to keeping firms on the brink of profitability in business can hamper growth by using resources that could otherwise be used for more productive purposes.

Just because a company does not have enough earnings to meet their interest costs does not necessarily mean they are at imminent risk. Many may be newer companies that are just starting to establish a market for their products and services. For example, small biotechnology and new technology companies tend to follow a business model that seeks a proof of concept before monetizing. But those companies that do fit the traditional mold of zombie companies may be facing risks on the near-term horizon. For instance, the average yield on corporate bonds in the U.S. has been rising dramatically over the past few years, meaning that those companies that must return to the capital markets to finance their ongoing operations are likely to find it increasingly expensive to do so.

Higher borrowing costs coupled with heightened recession risks could begin to tip zombie companies into bankruptcy. In fact, there are already some nascent signs that this is occurring. The year-over-year change in chapter 11 bankruptcy filings in U.S. courts has started to jump higher over the last few months, suggesting that the business operating environment has become more challenging. 

Digging deeper into the data uncovers some interesting observations. To start, there’s multiple ways to classify zombies. Some can be considered a zombie from a pure accounting standpoint, by taking a look at their income statement and seeing if they’ve had enough earnings to pay off interest on their debt. However, accounting earnings are not what pays back debt in practice – businesses often need cash to pay that interest. To that end, a second definition includes only those that did not generate enough cash flow to pay their interest. A third definition gives a better idea of the most at-risk firms that have less than two years’ worth of cash expenses on hand. While the number of companies that meet these definitions is certainly non-negligible, their share of market value is actually quite low, since many are smaller in scale than your typical large cap companies. As a result, zombies appear unlikely to cause systemic, market-wide issues at this time. 

With that said, this is still something investors should keep an eye on. Going one step further, looking at the composition of these companies by sector, it reveals that many are small biotech and new tech companies. This makes sense, because many follow a business model that seeks to build a business and find ways to monetize later on. 

And since many of these companies appear in the small cap universe, that’s where investors should pay most attention to their exposures. For example, there are two main indexes that follow different approaches in this space. The Russell 2000 index is an all-encompassing, broad-based small cap index with roughly a quarter of its stocks that can be considered zombies. On the other hand, an index such as the S&P 600 features profitability screens that dramatically reduce the incidence of zombies in its universe. The latter is roughly consistent with quality investing, which focuses on companies that are actually turning a profit. With that in mind, investors seeking exposure in this asset class would do well to prefer a quality orientation, in which he or she is more likely to avoid these zombie companies. 

So to summarize, the number of zombie companies remains elevated in the U.S., sitting near multi-decade highs. Those unprofitable companies on the brink now face higher borrowing costs and higher-than-normal recession risks, which could put these zombies at risk of bankruptcy. While the number of zombies appears high, their share of market cap is a mere 2%, and those most at risk of missing payments due to cash shortfalls is lower still. The zombie ranks are dominated by smaller biotech firms and tech companies, where unprofitability in the early stages is often a byproduct of their business models. And finally, for investors hoping to avoid the zombie hordes, a quality bias in small cap investing is more likely to focus on stocks that actually turn a profit.
Thanks for listening! And please don’t hesitate to reach out with any questions.