Zombie Companies And Where To Find Them

This Halloween promises to be a hollow affair compared to the fright-fests of years past. After all, guising loses its bite when monster masks are swapped for surgical. And bobbing (or ‘dooking’) for apples loses its, debatable, appeal when weighed against the threat of Covid.

In the investment world, the spectre of the pandemic has caused some to overlook a horror lurking in plain sight. We mean, of course, zombie companies. The stockmarket’s living dead – artificially animated by years of central bank stimulus and low interest rates. In normal market conditions, companies with weak balance sheets and uncompetitive products would have turned to dust, but access to cheap capital has prolonged their lifespans unnaturally.

The idea of a zombie company isn’t new. They’ve been proliferating since the global financial crisis of 2008, gorging on the cheap money pumped into the financial system. Such businesses are reasonably easy to spot, because they’re shambling along, not making any profits and relying on capital markets to cover their costs. Often, their earnings barely cover the interest on their borrowing.

The rise of passive investing has also fuelled the growth of zombies. As we know, passive funds track an index, keeping costs down by dispensing with a manager’s stock picking skills. Such funds have proven very popular, but an unintended by-product is their support of these types of companies. Passive funds own stocks regardless of the health and prospects of the underlying business.

Prior to Covid, the Bank of International Settlements estimated that 12% of the companies in the S&P 1500 index were zombies. The pandemic exacerbated many trends and a surge of zombie companies is no exception, as a fresh wave of support measures by governments and central banks formed a whole new line of them.

Who can slay the zombies?

Under normal circumstances, unviable businesses would fall by the wayside as better alternatives took their place. But the circumstances we’re living through now are anything but normal. Personal freedoms have been curtailed to levels that would have been unthinkable just a year ago, and the capitalist system as a whole is somewhat dysfunctional.

That leaves authorities in a tight spot. Withdrawing financial incentives and letting these businesses go under would not be a popular move. But equally, zombies are devouring capital that might otherwise be used by a productive and profitable business, thereby holding back healthy economic growth. As long as the pandemic continues, governments face tough choices that will mean life or death to some businesses.

While we can’t do much to influence government policy, we can, as active managers, seek investments that will remain in the land (and hands) of the living.

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations.

The Scottish Investment Trust PLC has a long-term policy of borrowing money to invest in equities in the expectation that this will improve returns for shareholders. However, should markets fall these borrowings would magnify any losses on these investments. This may mean you get back nothing at all.