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COVID heritage and higher interest rates

Raging global COVID-19 pandemic that the world lived through over last two years has now been replaced by shocks of soaring inflation. Thus it is not surprising that Central Banks have adopted aggressive stance. Since beginning of the year ECB increased rates by 1.25%, and FRS, usually being few steps ahead, increased rate by 3% to fight inflation that was initially labelled as “transitory”. In some cases, this new reality can become dangerous for certain amount corporate and for sovereign debt. And it is deadly for zombie companies – heavily indebted businesses having lower productivity and lower employment growth as compared to non-zombie firms. Having interest coverage ratio below one over three consecutive years and being older than 10 years (OECD definition), zombie companies are not able to generate enough income to service their debt.

COVID times, characterized by helicopter money and generous state support packages, was fertile times for sustaining zombies and creating new ones. We have seen surge in the number of zombie companies recently. Three years ago, there were 92 zombies in the broadest global stock index, MSCI World AC. Now there are 109 zombie companies, which are exposed to the significant failure risk due to more expensive debt servicing. This fact, again, gathers clouds of doubt around the quality of indices constituents, making index investing not really an immediate choice for quality investors.

Zombies in stock indices – Infected sectors and countries

Unsurprisingly, the most critical sector is Financials, as it accounts for almost half of all the zombies. IT is the second most critical sector that one should be careful with. Financials and IT are being followed by Consumer Discretionary and Communication sectors. Abovementioned sectors have higher weightings in zombie universe as compared to the general market. Three years ago, zombie universe was primarily dominated by players from the Financial sector (63%), followed by Health Care (8%) and Consumer Discretionary (5%).

Figure 1: Zombie companies (left) and MSCI AC World Index (right) by industries

Source: Hérens Quality Asset Management, Reuters

The largest number of toxic companies- same as few years ago- is still to be found in Asia, primarily China and Hong Kong. One must be indeed careful with these markets as investing there sometimes can be comparable to walking through the minefield, given that the largest number of frauds comes from this region. Europe and Americas, contrary to that, experienced certain “purification”, so the risk of having zombies in portfolio when investing in broad index has decreased (Fig. 2).

Figure 2: Zombie companies and MSCI AC World Index by regions

Source: Hérens Quality Asset Management, Reuters

Development of zombies

We have compared the financials and valuation of the ‘walking dead’ companies now, three years ago and in 2008. Valuation as proxied by PE obviously got healthier and much closer to reflecting reality. Balance sheets in average were becoming stronger carrying less debt. Interestingly, that substantial part of zombies exhibits rather robust financial health having equity ratio above 50%, meaning that although they are well-packed in terms of capital structure, they are struggling to generate substantial earnings to cover the interest payments on relatively low amounts of debt. This leads to devaluation of ‘equity ratio’ concept as proxy for company’s solvency. One of the options to have a more objective indicator is to consider market’s opinion on the company’s quality and its ability to operate successfully further. For instance, it could be debt to market cap, which though has decreased recently still exceeds the market level three times.

Figure 3: Financial and valuation ratios of zombie companies (2008, 2018, 2021)

Source: Hérens Quality Asset Management, Reuters

Zombies vs. quality

There is a truly deep abyss between zombies and the average company on the market if to consider quality of financials (balance sheet and capital profitability). The abyss becomes even much deeper if to compare zombies with quality companies. The same applies to valuation – market recognizes quality with a substantial premium, while valuation of zombies is heading towards zero on PE side. Interestingly, that when it comes to dividends zombies are more generous compared to quality firms, which are usually in the active investment mode and are reluctant to paying out earnings.

Figure 4: Financial and valuation ratios of zombie companies, Quality companies and MSCI AC World Index

Source: Hérens Quality Asset Management, Reuters

In short, zombies are still here, having increased their population in stock indices recently. So, watch out from deep value and stay away as far as possible from zombies given increased risk of failure witnessing interest rates further growth.

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