Good morning. Markets do not snooze through Thanksgiving week, as Morningstar pointed out yesterday: for the S&P 500, the three-day holiday week has the average swing of plus or minus 1.5 per cent, about the same as a normal five-day week. So keep your wits about you, and while you are at it, send us an email: email@example.com and firstname.lastname@example.org.
How bad is the zombie problem?
If you read the financial press, you’ll have encountered arguments like this (from David Trainer of research house New Constructs, earlier this month):
WeWork’s bankruptcy is just the beginning and we expect many more zombie companies to claim bankruptcy. There are hundreds of zombie companies, many of them went public in 2021, that are unprofitable and burn through ridiculous amounts of cash . . .
WeWork’s bankruptcy is just the beginning of the zombie company collapse. Investors need to focus on companies that actually make money and have viable business models. Burning cash is not a business model.
The intuition is that quantitative easing and zero rates created an environment of heedless risk-taking, leaving markets stuffed with undead firms kept upright by a drip feed of cheap capital. Now that the free money era is over, the zombies will collapse. These arguments are accompanied by charts like this, showing the rising share of public companies that can’t cover interest payments out of cash flow (from BCA Research):
Or perhaps like this:
The Russell 3000 index above captures nearly all public companies, big or small. Across the public-company universe, the share of unprofitable companies has risen markedly in the past couple decades, a trend that has not been stopped by periodic recessions. Much of the rise, moreover, has happened in the post-GFC, low rates era. One FT op-ed last year laid out the thinking:
So how can the Fed change a perfectly sound company into a zombie? It can’t. But it can create an environment where zombification is possible. When interest rates are at zero, creditors are encouraged to renew financing to unproductive companies. When interest payments are low, not much is needed to keep a zombie going. Moreover, weak companies pay slightly higher interest — an important fact for investors desperately hunting returns in an ultra-low-rate environment . . .
Why is this a problem? Zombies trap assets and employees, making life harder for start-ups, slowing innovation. Moreover, their existence lowers margins, making investing in healthy competitors less attractive.
All these effects directly distort the crucial process of “creative destruction” . . . resources (capital and people) are inefficiently allocated. This in turn is a significant cause of slowing productivity growth, as observed in western countries over the past two decades.
This story is too neat. For one thing, low rates in the past decade have coincided with higher, not lower, US corporate margins. For another, it is rather odd to worry about zombies crowding out investment in “healthy competitors” in the easy money era, when investment-grade yields hit all-time lows.
But we take seriously fears of a default wave among companies whose business models work with base rates near zero, but not when they rise to 5 per cent. Generically, rising rates will always destroy the economics of some businesses, by driving their cost of capital above their return on capital (how many companies this happens to will depend in part on why rates are rising). The question is if investors have been financing so many moribund businesses that their collective collapse could have systemic implications.
One problem is the definition of a “zombie”. Is it fair to attach the label to any unprofitable public company? Doing so risks capturing growth companies that might plausibly flip to profitability in the future (was Amazon a zombie company in 2002?).
In a recent note to clients, Goldman Sachs credit analysts try three different definitions. The first, ebitda unprofitability, is clearly rising. The second — unprofitability plus sagging share prices (defined as two consecutive years of undershooting the Russell 2000) — is meant to exclude growth groups that equity investors judge as having realistic prospects. The third — unprofitable, underperforming companies that have raised money from bond markets — most closely matches the “zombie” intuition that investors are propping up non-viable businesses. Very few companies meet the third, strictest definition (green line below):
This suggests US bond investors are not keeping zombies alive. “We had a bunch of zombie firms that did default in 2020 in the aftermath of the Covid crisis,” Lotfi Karoui, Goldman’s chief credit strategist, told us. “Is it true that triple-C firms have interest coverage ratios below 1? Definitely, but that’s always been the case. I have yet to be convinced that years of ultra-accommodative monetary policy and an extremely low cost of capital have actually fuelled growth in zombie firms in public debt markets.”
Karoui’s point is backed up by the distribution of credit ratings. The weakest slice of companies (light green bars below) takes up a historically normal share of the high-yield universe, according to Moody’s:
What about equity investors? Using Goldman’s second, looser definition of zombie (unprofitable + underperforming shares, but not tapping the bond market), for whom equity financing has been enough, there’s a noticeable increase in the past year or two. A sector breakdown shows that these companies are highly concentrated in biotech (dark blue line below). At one point last year, biotechs made up more than half of zombies and still comprise about 40 per cent:
Remember though that biotechs are a different beast than most equities, rising and falling based on progress in clinical trials. They are probabilistic bets on successful R&D: most of the time your investment goes to zero, but occasionally you’ll get a massive outsized return. Perhaps easy money pushed investors further out on the risk spectrum, providing equity funding for far more moonshot biotechs than will realistically have a viable product. If so, then over time biotech research will fail to produce commercial results and the stocks will suffer. But that’s no zombie apocalypse.
This isn’t to say rising rates don’t threaten companies with weaker balance sheets. The point is that once-loose monetary policy has not set up for an exceptionally severe credit cycle. Interest rates are important, but for companies they are just one expense line and can be accommodated via slower hiring, capex cuts and so on. These are well understood risks. As Marty Fridson of Lehmann Livian Fridson Advisors puts it:
[Those convinced of impending zombie doom] are projecting a change in valuations. What’s going to be the catalyst? [The notion that] one day people are just going to wake up and realise [that valuations are dramatically off] is ridiculous! . . . It’s not rocket science to project what a company’s financial picture is going to look like, assuming rates stay up where they are . . .
You can make a case that [interest rate] risk is priced in with too high or too low a probability. In my career, I’ve seen some instances where predictable things simply weren’t priced in. But to say there are hundreds of companies in the Russell 3000 that are [wildly overvalued] strains credulity for me.
A recession could change the outlook, but assuming we get a softish landing, a more plausible outcome is normalisation. We are seeing some of this already: defaults and bankruptcies rising closer to historical averages, growth companies pivoting to profits, small caps with weaker balance sheets underperforming the S&P 500. Ted Yarbrough, chief investment officer at Yieldstreet, draws a helpful comparison to commercial real estate, another asset class financed back in the easy money era. Across weaker companies and weaker properties, capital structures and valuations need updating, but not every B-grade office building is facing the bulldozer.
In private markets, however, firm conclusions are hard to come by. Is there some VC or PE fund out there loaded with zombie tech or biotech companies and ready to burst? Maybe; the rise in PE distress certainly isn’t encouraging. Still, many have overestimated this risk before. Even one Robert Armstrong, writing in February 2020, saw the possibility of a “corporate zombie apocalypse”:
If rates jump, bubbles and zombies will go from being a negative but manageable policy side effect to a pressing threat to stability. The bubbles would burst just as the zombie hordes were forced into a rush of disorganised reorganisations and liquidations.
He was wrong! Rates have jumped without zombies threatening stability, partly because profits have been strong and asset prices have held up. A higher level of corporate distress has been handled in an orderly fashion so far. At the risk of tempting fate, sometimes the apocalypse turns out to be manageable. (Ethan Wu)
One good read
“From 1998 to 2019, Japan has grown slightly faster than the US in terms of per working-age adult: an accumulated 31.9 per cent vs. 29.5 per cent … if we focus on the period 2008-2019 … Japan has the highest growth rate in terms of per working-age adult among our sample of G7 countries plus Spain.”