Zombie companies do exist but are not staffed by people that behave like extras in the “Walking Dead”. Actually, a zombie company is a technical term for a business which, if it is not yet numbered among the undead, is only earning just enough cash to pay the interest on its borrowings. It does not generate enough in profit to invest and expand its product range, or to take on any more people. It is only just surviving.
Dawn of the dead
The term ‘zombie company’ was first used in Japan in the so-called Lost Decade (1991-2000). A period of serious economic stagnation. In the twenty years beforehand, Japan looked like it was on track to become a world leader in manufacturing, property investment and banking. Its cars, cameras, consumer electronics and TV sets were state of the art, affordable, well designed and above all, highly reliable. But the bursting of the Japanese asset bubble changed everything. Larger companies were kept afloat by government supported banks to keep their people in work, avoid a recession, protect savings, and above all to save face. The Japanese reflationary project is still underway.
The numbers have risen since the Financial Crisis pushed interest rates to 300 year lows.
28 (ish) years later
Around the world, the number of zombie companies has risen since the Financial Crisis of 2008. The Bank of International Settlements (BIS) has estimated that 10% of all US public companies can be defined as zombies. There are zombie companies here in the UK, in Europe and China. The numbers have risen since the Financial Crisis pushed interest rates to 300 year lows. This simply made it easier to service overdrafts and loans. As banks began to find themselves awash with the new liquidity, it was even possible to borrow more. In a standard interest rate environment the zombies may have gone bankrupt as banks and creditors demanded repayment. Banks have been reluctant to force the issue over more recent times. What would be the worth of assets if they were forcibly sold? Would creditors, realistically, be paid?
If the policy objective was a return of confidence and an increase in economic activity, you might ask if zombie companies were good or even necessary for the wider economy. Employees of zombie companies would argue that they are still employed, still paying taxes and still spending in the shops. Therefore, maintaining supplier businesses and not drawing the dole, like their grandparents did in the 1930s. However looking to the longer term perhaps the economic analysis is less positive.
Above all a zombie company prevents “creative destruction”. Artificially kept alive, they prevent their own replacement by dynamic new firms which would innovate and thrive without support. You see this on the High Street where the older department store is struggling in the face of online shopping. Can we use this “retail” space in our cities for a different type of business or even conversion to housing, badly needed in many parts of the country? Also, zombies are low productivity companies. With no cash to invest and hoarding skilled labour, the zombies will hold back aggregate productivity. Finally they crowd out other companies from access to credit as the banks, nervous of revealing their own over-commitment, continue to roll over or even extend loans to keep the undead zombie ‘alive’.
Is the Day of the Dead almost over?
So what does the future hold for these vestiges of a former age? The era of quantitative easing has come to an end in both the US and UK. The US Federal Reserve is raising rates at a fair clip. While in the UK we’ve raised rates twice in the past year. So, it is likely the interest bill for a zombie company will rise. If the business does not achieve success, generating cash to meet interest payments and repay debt, it may prove impossible to service the burden.
How are we navigating the horde?
What does this mean for investors? We will be watching this theme play out across bonds, property and equities. The effect on passive funds is worth noting. Passively managed funds are forced by their own rules to buy the debt and equity of the zombies, and of the debt and equity of the banks propping them up. The bigger and scarier the zombie company, the more a passive investor will hold. Active managers face a different danger – from not spotting when a business that looks ‘cheap’, relative to its scale, is actually rotten at the core. When we quiz our selected fund managers as the “quantitative tightening” process gets underway, we will be checking to see if they have taken fright lately in any of their larger holdings.
This article was previously published by Aberdeen Standard Investments on 22nd October 2018