Dissecting Wall Street’s Latest Horror Show: THE ZOMBIE COMPANY APOCALYPSE!!!

The growing number of highly indebted firms seems to pose a manageable threat

The term “zombie company” was first applied to the Japanese firms artificially kept alive by the country’s banks after the collapse of Japan’s asset bubble in 1990. (If you don’t recall, that was when you could buy a square foot of Tokyo real estate for a mere USD 139,000, roughly 350 times what you’d pay in Manhattan.)1 Zombie companies proved less of a systemic risk than expected, but they are considered to have been a factor in Japan’s subsequent “lost decades” of economic stagnation.

Is the U.S. economy now threatened with its own zombie invasion? A few months ago, a scary chart started circulating on LinkedIn purporting to show the share of zombie companies in the Russell 3000 Index. Alarmists kept posting it along with warnings of an IMPENDING ZOMBIE APOCALYPSE!!! I usually ignore attention-seeking posts in ALL-CAPS, but the chart got my attention. 

The chart referred to the growing number of companies that aren’t generating enough profits to cover their debt payment, which is defined by a company’s interest coverage ratio, or the ratio of its earnings (before interest and taxes) to its interest expense. If that three-year average interest coverage ratio is less than 1.0…RUN! IT’S A ZOMBIE!!!

THE CHART THAT TERRORIZED LINKEDIN

Note: This chart was not created by T. Rowe Price. In fact, we’ve asked around, and we don’t fully know where it came from. The original source was noted as The Leuthold Group and the Bank of International Settlements, but we contacted The Leuthold Group, and they indicated that they use a different version. We weren’t able to replicate the chart, so we set out to do our own investigation. See Figures 1 and 2 below.

Are nearly one in four of the 3,000 largest public companies really ABOUT TO GO BANKRUPT?!!!

Following a (brief) moment of (mild) terror, I asked Cesare Buiatti, a quantitative investment analyst in the Multi-Asset Division at T. Rowe Price, to dig deeper. With his help, here’s why I’m not ready to head for the hills.

The term zombie as defined here is misleading. There are several reasons why a company with an average interest coverage ratio below 1.0 may have a relatively low risk of bankruptcy, and examples of such companies abound:

1. A company’s fast revenue growth may improve their coverage ratio over time. Some tech companies remain unprofitable for several years as they focus on growing sales and gaining market share to establish their moat. As one member of our Asset Allocation Committee pointed out “In its early days, Amazon was a zombie for a long time.”
2. Even without fast sales growth, a company’s business prospects may be quite positive. Biotech companies are good examples. They may qualify as zombies as they invest in Research & Development and start clinical trials. It doesn’t necessarily mean they’re about to go bankrupt.
3. A company may have a significant cash or liquid asset reserve that could cover years of future interest payments. In other words, a simple coverage ratio analysis ignores the strength of a company’s balance sheet.

The inconsistency between this overbroad definition of zombies and bankruptcy risk becomes obvious when you consider the fact that more than two-thirds of them didn’t significantly underperform the S&P 500 Index over the prior two years, according to research by Goldman Sachs published in September 2022.2

From a macro perspective, we don’t think the apocalypse is imminent.

Cesare was able to put three nails into the infected brain of the zombie hypothesis. (Look it up—you’ve got to get rid of the brain.) And if you’ll allow me a bit of clickbait, YOU WON’T BELIEVE THE THIRD ONE—IT’S A SHOCKER!!!

Nail #1: Zombies are typically micro-caps.

Based on our own analysis, zombies make up only 4% of the stock market’s capitalization, not 20% to 25%. That’s still elevated relative to history (higher than it’s been 90% of the time), but from a macro perspective, it’s reassuring to know that we’re dealing almost entirely with small-cap zombies.

Small-cap zombies have less of an impact on aggregate employment and economic growth than suggested by the original scary chart. Moreover, if we look at the three prior episodes when the share zombies spiked to comparable levels since 2005, these spikes weren’t followed by stock market crashes (more on this topic below). On top of that, many of these micro-caps (the smallest 1,000 companies in the Russell 3000 Index) could be acquired by larger companies.

Nail #2: There’s a better way to look at default risk

A more credible way to estimate probability of default is to use the Altman Z-score, which accounts for the strength of the balance sheets (working capital relative to cash), the market value of equity, sales, margins, and so on.3 Introduced in 1968, this model has since predicted defaults with 80–95% accuracy within a one-year horizon.?

Here, we get a remarkably different picture: Altman-zombies are near an all-time low—indeed, lower than 78% of the time since 2005. Leverage is low, and cash levels and margins are high, especially for larger companies. By historical standards, corporate balance sheets seem downright healthy.

In this chart, a company is classified as a zombie if its Z-score is below 1.81, which is a threshold recommended by Altman (2000)?. A word of caution: An unweighted version of the chart below shows a zombie proportion in the top 10% or so of its historical range since 2005. The number of small-cap companies that appear to be in trouble (including many so-called non-earners) is indeed high by historical standards.

Nail #3: A proliferation of zombies has historically been a risk-on signal.

You read that right. The reason appears to be the so-called Fed put. Historically, economic stress has spiked around times when the Fed has had to loosen monetary conditions, as at the outset of the pandemic. When the Fed loosens monetary conditions, risk assets tend to rally.

But before you load up the truck on risk assets, there are two obvious caveats. First, the Fed may not choose to exercise its put as policymakers focus on fighting sticky inflation. Second, the evidence that zombies are a contrarian indicator is mixed when it comes to small-caps. 

Small-caps face stresses, but active management can seek out the healthy ones.

Ultralow interest rates have enabled companies to borrow more and invest in projects with low expected returns or very distant cash flows.

Now that rates are higher—and the law of gravity has returned to finance—there’s some reason to worry about companies with poor interest coverage ratios. As they inevitably refinance their maturing debt, I believe many companies will face a significant increase in interest expenses, which will be difficult to cover with low revenues.

All things considered, however, I still think our being overweight in higher-quality small-caps makes sense. Above all, small-cap valuations remain near their most attractive levels in history (based on the valuation of the S&P 600 Index, which filters out the non-earners). That includes even after the sell-offs in 2008 and 2020.?

Moreover, I’m comfortable knowing that I’m working for an asset manager with a world-class fundamental research platform, with experienced analysts who often follow companies with little or no Wall Street coverage. This is one example of where their careful fundamental research can really make a difference.

You might say we have a lot of experienced zombie hunters.

References

1 https://www.scmp.com/magazines/style/news-trends/article/3091222/japan-1980s-when-tokyos-imperial-palace-was-worth-more

2 “Goldman Sachs Research [included] firms whose equity underperformed the S&P 500 Index of U.S. equities by at least 5% in each of the past two years. With that filter in place, the number of so-called zombies shrinks [from over 12%] to less than 4% of U.S. companies, accounting for around $200 billion of net debt.”

Goldman Sachs, “The Invasion of Zombie Companies that Wasn’t,” September 2022.

https://www.goldmansachs.com/insights/pages/the-invasion-of-zombie-companies-that-wasnt.html

3

? Altman, E., “Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA? Models,” July 2000. https://pages.stern.nyu.edu/~ealtman/Zscores.pdf

? As of March 31, 2023. Sources: S&P and Bloomberg Finance, L.P.

Please see Vendor Indices Disclaimers for more information about the sourcing information here. https://www.troweprice.com/institutional/us/en/site-content/disclaimers/vendor-indices-disclaimers/us-mutual-fund-vendor-indices-disclaimers.html

Important Information

The views contained herein are those of the author as of April 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price companies and/or associates.

This information is for informational purposes only and is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types; advice of any kind; or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not consider the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. The charts are shown for illustrative purposes only.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal.

Index performance is for illustrative purposes only and is not indicative of any specific investment. Investors cannot invest directly in an index. Actual investment results may differ materially.

T. Rowe Price Associates, Inc.

? 2023 T. Rowe Price. All Rights Reserved. 

202304-2866623