Zombie Companies: Everything You Need To Know

For investors (and for everyone else), 2020 has been a year where a crisis seems to be followed by yet an even bigger crisis. It started with growing political tensions threatening global trade, then came a global pandemic and an oil price crash which in turn led to one of the worst economic crises in history. And once it looked like things were slowly recovering, mass civil unrest ensued and we have only made it halfway through the year.

Yet, despite all of this, the market so far has managed to remain surprisingly resilient, edging into a downturn but not it to a complete catastrophe like the one seen during the Great Depression. However, another impending crisis could well make it so, if not far worse. The number of ‘zombie’ companies is growing rapidly and if the situation does not improve, we could head towards a financial nightmare.

What is a zombie company?

A zombie describes a being that should technically be dead yet remains alive. A zombie company is similar – one that is heavily in debt but earns just enough to continue operating and service its debt (but not pay it off). As one would expect, such companies, just barely managing to scarpe by, are especially vulnerable to market disruptions. A small rise in interest rates, a decline in consumer spending, or a single poor quarterly performance and the company can become insolvent.

In a completely efficient market, zombie businesses wouldn’t exist, and would be  quickly replaced by more productive competitors. In real life, however, they remain animated by cheap credit, the access to which reduces pressure for these companies to invest in innovation and efficiency and shifts the need for hard decisions well into a hazy future.

Zombie companies can often be massive and politically costly to be allowed to fail which is what allows these non-competitive corporations to continue to lumber onward with repeated bailouts or generous bank loans. While this avoids a negative economic outcome in the short-term, in the long-term, this leads to the crowding out of productive investment and reduces entry of newer, more innovative companies. The lack of innovation, in turn, can lead to a steady decline in growth and chronic stagnation as seen in Japan.

What You as an Investor Should Be Worried?

Since the 2008 financial crisis, the number of zombie companies had more than doubled by 2017 accounting for roughly 16% of the components of the Russell 3000. The current economic crisis likely may have led to an even larger increase in the number of zombies. However, slower future expansion as a result of misallocation of capital into these companies isn’t the only cause for concern.

If a zombie is sufficiently large, a failure can be contagious. If one zombie fails, it can result in a panic and mass sell-off of other zombie stocks, resulting in a chain reaction of more and more zombie companies going under. If banks, in response to the resulting chaos, start raising interest rates the problem can escalate further. As an increasing number of companies default, banks and credit agencies who lent to zombies also suffer and risk illiquidity.

The resulting downward spiral can lower overall investor confidence and cause stocks of otherwise healthy companies to decline as well.

Given the present uncertainties in the market and the robust rally following the March crash, many experts fear another crash this year. The longer the recession persists, the more likely it is that zombie companies will become insolvent and worsen the crisis further.

Moody’s analysts predict that the corporate default rate globally could climb to 6.8%, more than double the default rate witnessed in February 2020. Without the right intervention, such a scenario can potentially spiral into a prolonged period of economic contraction.

How To Spot A Zombie Company

As the number of zombie companies continues to increase, every investor should learn to recognize them to avoid significant losses. There is no strict definition of a zombie company, but here at Finbox we've put together a few simple rules that will help you detect them.

The most common characteristics of zombie companies is a substantial amount of debt relative to equity and an inability to repay these debts. We set up the Finbox Stock Screener with three simple metrics to help identify such companies:

This screen provides us with an initial list of potential zombie companies. However, any company can go through a short difficult period, especially due to an unforeseen crisis, such as the coronavirus outbreak. To further narrow down the list, we can use the Finbox add-on to identify companies with an interest coverage ratio lower than one (1) for three consecutive years. You can follow these 3 simple steps:

Click here for a detailed tutorial on how to use the add-on.

Zombie Companies Performance

As you can see, zombie companies have drastically underperformed the market in the last five years. That's why learning to recognize them is very important for every investor who wants to avoid massive drawdowns and permanent capital losses!

Here's the updated performance: Zombie Companies Index

Zombie Companies List

1. Sunrun Inc.
2. Mattel, Inc.
3. Vivint Solar, Inc.
4. Kennedy-Wilson Holdings, Inc.
5. SunPower Corporation
6. Scientific Games Corporation
7. BEST Inc.
8. Bloom Energy Corporation
9. Mr. Cooper Group Inc.
10. Azure Power Global Limited
11. Golar LNG Limited
12. Diebold Nixdorf, Incorporated
13. Globalstar, Inc.
14. Community Health Systems, Inc.
15. Front Yard Residential Corporation
16. Green Plains Inc.
17. MBIA Inc.
18. Clear Channel Outdoor Holdings, Inc.
19. Houghton Mifflin Harcourt Company
20. Uxin Limited
21. Ellomay Capital Ltd.
22. Gogo Inc.
23. Quantum Corporation
24. Invacare Corporation
25. Hertz Global Holdings, Inc.
26. Accuray Incorporated
27. GWG Holdings, Inc.
28. comScore, Inc.
29. Transcontinental Realty Investors, Inc.
30. Tiptree Inc.
31. Team, Inc.
32. Pacific Ethanol, Inc.
33. BlueLinx Holdings Inc.
34. A-Mark Precious Metals, Inc.
35. Hovnanian Enterprises, Inc.
36. Scorpio Bulkers Inc.
37. American Realty Investors, Inc.
38. Babcock & Wilcox Enterprises, Inc.
39. HC2 Holdings, Inc.
40. Roadrunner Transportation Systems, Inc.
41. AgroFresh Solutions, Inc.
42. EVO Transportation & Energy Services, Inc.
43. Cengage Learning Holdings II, Inc.
44. Senseonics Holdings, Inc.
45. Drive Shack Inc.
46. Genesis Healthcare, Inc.
47. CVR Partners, LP
48. Braemar Hotels & Resorts, Inc.
49. StoneMor Inc.
50. Exela Technologies, Inc.
51. Inspired Entertainment, Inc.
52. Valaris plc
53. Medallion Financial Corp.
54. Concord Medical Services Holdings Limited
55. Grindrod Shipping Holdings Ltd.
56. Top Ships Inc.
57. SEACOR Marine Holdings Inc.
58. Kingsway Financial Services Inc.
59. Great Elm Capital Group, Inc.
60. Sky Solar Holdings, Ltd.
61. RumbleON, Inc.
62. CBAK Energy Technology, Inc.
63. Forum Energy Technologies, Inc.

The Upside

While this on-going recession is likely to become worse before a real recovery starts, the contagious effect of zombie companies may not be as severe as originally envisioned. The current crisis reflects an opportunity for market corrections and a pruning of market inefficiencies, leading to a healthier and more resilient future economic landscape.