Perspective: Fear the walking dead
Zombie firms – those dependent on the easy availability of cheap credit – threaten to suck the life out of otherwise viable companies
- Zombie companies are not only a problem in themselves but also for the wider market
- Market economies are widely seen as progressing through ‘creative destruction’, by which weak companies are allowed to fail while new dynamic firms can emerge
- The zombie phenomenon first emerged in Japan in the early 2000s but it has since become prevalent across developed markets
- Practitioners not only have to avoid zombies but they must cope with the distortions caused by long periods of ultra-loose money
Zombie companies. They are the walking dead. Firms which, according to a standard definition, cannot cover debt servicing costs from current profits over an extended period. Under normal circumstances they would have deceased long ago but in these peculiar times of ultra-easy credit they have somehow managed to escape the gravediggers.
Economists love talking about them but fund managers, with some exceptions, tend to be more wary of discussing their significance. Among the high-powered organisations which have produced analytical reports on the subject are the Bank for International Settlements (BIS), the Bank of England, the Bundesbank, the National Bureau for Economic Research and the Organisation for Economic Cooperation and Development (OECD). Among investment practitioners it is typically the strategists – often one removed from stockpicking decisions – who are most willing to comment.
It is widely accepted among the experts that zombie companies not only exist but they are a growing phenomenon. That means, at a minimum, that there is a risk that that active managers will invest in them while passive managers certainly do.
There is also a strong argument that zombies can suck the life out of healthier sections of the market. Many experts contend that the existence of zombies can depress returns for living companies within their respective sectors. While some firms appear to be thriving many are facing a challenging time. And the situation could get scarier when interest rates start to show signs of an imminent upturn or the economic growth rate falls still further.
It is also worth noting that there are some who take a different view of zombies. For example, Todd Jablonski, the chief investment officer of Principal Portfolio Strategies, says: “We are updating that definition specifically to specifically to include firms whose business model is under assault through technology.” From this starting point he goes on to argue that “the incidence varies greatly depending on one’s geography and even more importantly depending on the nature of one’s business”.
He points to music, retail and publishing as among those that are being particularly disrupted by technology and innovation. “There are a great many firms in the States whose business models are no longer suited to the competitive environment,” he says.
To understand the zombie threat it, helps to break the discussion down into three parts. First, its significance can be outlined in relatively abstract terms. Second, key points of the recent economic debate on zombies can be considered more concretely. Finally, it is possible to divine what it means for investors in practical terms.
To properly grapple with the broader significance of zombies – that is to go beyond the truism that they are a bad investment – it is necessary to look at the concept of ‘creative destruction’. That is the idea that capitalism regenerates itself through a double-sided process which involves both the destruction of the old and the creation of the new.
One way of viewing this is to see recessions as a form of healing process for a market economy. The bankruptcy of weaker unprofitable firms creates an opening for new more dynamic ones to emerge.
The idea of creative destruction is generally associated with Joseph Schumpeter, an economist originally from Austria who later became a Harvard professor. Far less well known is that he adapted the idea from Karl Marx. Indeed the first four chapters of Schumpeter’s classic text Capitalism, Socialism and Democracy, first published in 1942, are on different aspects of Marx’s thought.
The idea of capitalism as both a creator and a destroyer is a central idea in Capital, Marx’s master work. What most people would see as opposites – creation and destruction – were for Marx part of a dialectical unity embodied in the capitalist mode of production.
Schumpeter’s work, by his own admission, was a conservative reading of Marx’s concept. It was essentially Marx’s notion stripped of its revolutionary political conclusions.
This may seem a long way from the current plight of western companies but it is in fact extremely pertinent. There is a strong case that extraordinary monetary policy, including quantitative easing (QE), has kept alive many companies which would otherwise have been long buried. The advantage of such approach is that it maintains stability in the short and arguably medium-term rather than seeing many companies going under and unemployment surging. The downside is that the healing process embodied in recessions does not take place. It only stores up problems which are likely to manifest themselves more violently in the future.
From a corporate perspective it means that firms that would otherwise be insolvent can carry on living. In the technical jargon, they are benefiting from forbearance lending. These are the so-called zombie companies. It also means that there is less room for new entrepreneurial firms – companies which will start off small but may later grow – to emerge.
“That is how capitalism works,” says Roelof Salomons, chief strategist at Kempen Capital Management. “Through creative destruction, the companies which are ill-managed and have too much debt or are not profitable get cleaned up, creating room for new companies.”
There are many economic studies which show zombie firms are an important feature of contemporary developed economies. Not so much alive and well but the living dead surviving on the life support of cheap credit. Their exact definitions of zombies vary but generally they see they are on a rising trend. Often it is the capital-intensive sectors – such as airlines, banking and logistics – which among the most problematic.
Zombie banks are a particular cause of concern in Europe. Many survive despite making a poor return on equity. Although it is more than a decade since the emergence of the global financial crisis, the sector is still widely regarded as suffering from substantial overcapacity. Most notably, merger talks between Deutsche Bank and Commerzbank collapsed despite a concerted attempt to combine two of Germany’s banking giants. Since then a proposed merger between Deka and Helaba, two German state-backed banks, could help prompt further consolidation. Overall, the European banking sector looks vulnerable when the world tips into recession – and it will inevitably happen at some point, even if the day of reckoning is postponed.
But it was in Japan that the discussion of zombies first emerged in the early 2000s. As often seems to be the case nowadays, the troubled Asian economy has provided a model which the rest of the developed world has more-or-less followed. It should be remembered that both stock and land prices tumbled in the 1990s from their peak at the end of 1989. The authorities then introduced extraordinary monetary policy to prop up weak firms in a move which, with hindsight, is reminiscent of what the authorities in the US and Europe did a decade later. The Bank of Japan introduced a zero interest rate policy as far back as 1999, followed by quantitative easing (QE) in 2001.
Some 20 years on from the onset of easy money in Japan there is a plethora of comparative international studies looking at zombies. For the OECD, for example, they are essentially firms that are at least 10 years old and their profits are insufficient to cover interest payments. On this basis, an authoritative OECD study published in 2018 estimated that zombies have been on a rising trend since the early 2000s. By 2014 over 10% of firms in selected European markets, Japan and the US could be defined as zombies. The same study estimated that zombies were surviving longer than in the past.
Studies of the subject also often discuss mechanisms through which the performance of the corporate sector more broadly could suffer. For a start there are ‘congestion effects’ in which zombie firms lock in resources that could otherwise be used more productive firms. Zombie companies can also depress prices (since they increase the supply of goods and services) while also increasing wages (since they increase the demand for labour).
These effects are not simply hypothetical. For instance, a study by Absolute Strategy Research, a macro-strategy research provider, says that smaller companies in the US are already complaining about rising labour costs. Hiring and capital spending could slow down as margins and cash flow come under pressure.
To be fair, there are exceptions to the zombie consensus. For instance, a Bundesbank study published in December 2017 concluded that zombie companies only made up a small percentage of German firms and the share has not increased during the period of low interest rates. The scope of the study does not extend beyond Germany.
Arguably the flip side of the rise of zombies is a high level of market concentration with a growing gap between the most productive companies and the rest. For example, the International Monetary Fund argued in the April 2019 edition of its World Economic Outlook that a small fraction of more productive and innovative firms have benefited from a large increase in market power. That is an ability to raise and maintain the prices of their products. This is another important finding to note.
Although asset managers look at these questions through a different lens – they are practitioners rather than economists – they seem to draw broadly similar conclusions.
For a start, they accept that the zombie concept is a meaningful one. Alistair Wittet, a portfolio manager specialising in European equities at Comgest, says: “I think there are loads of companies out there surviving when they shouldn’t because there is so much liquidity and the money needs to go somewhere and they are benefitting from that.”
He points to the airline sector as particularly prone to this problem. “For a number of reasons you can survive for quite a long time as a zombie in the airline sector.” For a start, airlines have the advantage that people have to pay before they fly. That means they have a flow of cash coming into the firms to keep them going. In addition, airlines have fixed assets, most notably planes, that they can securitise.
Nick Edwards, a fund manager at Guinness Asset Management, says: “I’m sure there are plenty of companies in Europe that are not earning their cost of capital and that are effectively being bailed out by ultra-low interest rates.”
Naturally both managers are keen to emphasise that, although they see zombies as a problem in general, they are careful to avoid them. “Our entire process is designed in reverse in that we focus on companies that generate persistent high returns on capital and therefore our entire universe has no so-called zombies in it,” says Edwards.
Similarly for Wittet: “The companies we invest in are the high quality, cash-generative winners.”
However, both acknowledge that the existence of zombies makes life more difficult even for those asset managers who succeed in avoiding them.
“The free cost of capital has been a real problem for incumbents. Capital-intensive incumbents haven’t done very well since the financial crisis,” says Edwards. “Zero cost of money depresses returns across the spectrum.”
Wittet points to the airline sector where the downward pressure on fares is driving the overcapacity of airlines in Europe. Although there have been relatively few bankruptcies so far, more could be on the way.
It may spook some readers but Principal’s Jablonski – who it should be remembered uses a broader definition of zombies – says a significant number of asset managers may be among the living dead. “I see investment managers all around me whose AUM totals have grown as the market has risen at double-digit rates since March 2009,” he says.
Whether or not active managers can avoid zombie companies, or whether they are more-or-less confined to passive portfolios, is a moot point. Salomons of Kempen says that it should be possible to avoid them in theory but short-term investors might be inclined to buy them in a cyclical upturn.
Jablonski is more definitive. In his view, many active managers hold zombie companies. “It is most prevalent in value investing but also in momentum,” he says. In contrast, he says that low volatility and quality companies are best equipped to avoid the perils.
Overall he says that certain types of asset managers are not well adapted to spotting zombies. “It requires a degree of scrutiny that is hard to achieve at a top-down level,” he says.
Of course, the spectre of zombie companies will not be fully unveiled until the next recession hits. If those who lay emphasis on the phenomenon are scaremongering then it is not likely to be frightening. However, if undead firms are indeed as widespread as they seem to be then the ride could be hair-raising.