Investment Strategy Brief:
Post-Pandemic Zombie Proliferation

Below is a transcript of this week’s video.

Anyone who’s into post-apocalyptic movies and tv shows will tell you it’s always wise to avoid the zombie hordes. But they don’t just exist on screen – zombie companies are a common label for those that consistently struggle to meet their interest costs. These are typically firms that continue to receive funding despite their serial unprofitability. In theory, the capital needed to prop up these companies is diverted from projects that might otherwise hold more promise, which acts as a drag on potential economic growth. For purposes of quantifying the extent of zombie enterprises among publicly-traded companies, we tracked the number of U.S. stocks that have not earned enough to cover their interest costs over each of the past three years. At around 12% of the investable universe, the number of zombies sits near multi-decade highs, even continuing to grow through the last recession.

The pandemic recession was an unusual one for many reasons. In particular, it was the first recession in recent memory to feature a declining bankruptcy rate, which was likely a factor keeping many zombie companies afloat.

One of the bigger reasons for that was the unprecedented levels of government stimulus provided during that recession and the months thereafter. The annual growth level of the money stock is a proxy for how accommodative monetary policy was during the period. In addition, the federal budget deficit fell to record peacetime levels from stimulus to businesses and individuals. These factors allowed many zombie companies to survive the typical recession wash-out and continue growing the horde.

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, the second definition includes only those that did not generate enough cash flow to pay their interest. And the last cut gives a better idea of most at risk firms with less than two years’ worth of cash expenses on hand. While the number of companies altogether 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 that investors should keep an eye on. Going one step further, looking at the composition of these companies by sector, it reveals that the vast majority are small biotech and new tech companies. This makes sense, because many of these businesses often follow a business model that seeks to build a “proof of concept” before monetizing and turning profitable.

And since many of these companies appear in the small cap universe, that’s where investors should pay most attention to the exposures that they are targeting in their portfolios. 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 zombie companies 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 looking to get exposure to this asset class would do well to prefer a quality orientation in small cap equities, in which he or she is more likely to avoid these zombie companies.

So to summarize, the share of companies that are consistently struggling to meet their debt costs (otherwise known as zombies) now sits near multi-decade highs. Zombies’ share of listed companies in the U.S. has continued to grow through the COVID-19 recession, in part due to unprecedented government stimulus that likely kept many afloat during difficult times. For the moment, zombies appear unlikely to contribute to systemic market issues, especially since they represent only about 3% of market cap, and those most at risk over the next two years make up less than a half percent. 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 equity investing is more likely to focus on stocks that actually turn a profit.

This material is intended to review matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. When provided to a client, advice is based on the client’s unique circumstances and may differ substantially from any general recommendations, suggestions or other considerations included in this material. Any opinions, recommendations, expectations or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Outcomes (including performance) may differ materially from any expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss any matter discussed herein with their Glenmede representative.