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Stepan Lavrouk
Stepan Lavrouk
Articles (195) 

The Rise of the Living Dead

Zombie firms represent a growing percentage of businesses

July 10, 2019

Over the past 12 months, there has been a distinct increase in the coverage of so-called "zombie firms" - unprofitable, debt-laden companies that cannot even cover their interest payments. Investors like Stanley Druckenmiller (Trades, Portfolio) and Jeffrey Gundlach have recently spoken out against the buildup in corporate debt, and the issue has also been addressed elsewhere on GuruFocus. How did we get here, and what are the economic implications of this trend?

What are zombie firms?

There are varying definitions of what a zombie firm is, but in a general sense, they are companies that lack profitability, an inability to service debt, age (younger companies tend to go through initial loss-making periods) and low expected profitability. Businesses like this have always existed, but in recent years their number has swelled. By some measures, as many as 14% of companies in the S&P 1500 are zombies. A paper published by the Bank of International Settlements estimates that across 14 developed economies, the share of zombie firms rose from an average of 2% in the late 1980s to 12% in 2016.

How did this happen? The same paper argues zombie companies now face significantly less pressure to reduce debt and cut back on loss-making activities. A decade of low interest rates has created a class of companies that are unable to make interest payments, and a class of investors that are happy to give them "evergreen" loans.

This has been an unintended consequence of overly accommodative monetary policy. When central banks cut rates and instituted various quantitative easing programs to stimulate the economy after the financial crisis, it was assumed that the flow of easy money would encourage investors to allocate capital to more productive projects. While that did happen to a certain extent, it also made it easier for non-productive companies to survive where they would have otherwise folded. Moreover, as the paper shows, once a company becomes a zombie, it is increasingly likely to stay that way.

Long-term consequences

The most obvious problem with this is there is a clear misallocation of capital happening - if weak and unprofitable companies are getting handouts from investors, then that is money that could be better spent elsewhere. But arguably a more significant issue is that as these companies become a bigger and bigger portion of the economy, it puts central banks in a tricky position when deciding whether or not to raise interest rates.

Higher rates may result in zombie firms defaulting on their debt, leading to layoffs and other cascading effects on the economy. Federal Reserve Chairman Jerome Powell recently commented on this exact issue, saying:

“Business debt is near record levels, and recent issuance has been concentrated in the riskiest segments...As a result, some businesses may come under severe financial strain if the economy deteriorates.”

The result is a vicious cycle - the Fed gets ready to cut rates once more in order to juice the economy, which will just lead to a further proliferation of unprofitable companies. What is the solution? Even the best-case scenario probably involves a period of pain in the short term, but it is a tradeoff that investors should welcome. The long-term stability of the economy requires it.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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