What follows is a practical investment guide, centred on the concept of debt.
The zombies are coming. Not for your brains, but for your investment portfolio.
The Bank for International Settlements (BIS) has found an increasing number of companies are now classified as a ‘zombie firm’.
A zombie firm is classified as ‘a listed firm, with ten years or more of existence, where the ratio of EBIT (earnings before interest and taxes) relative to interest expense is lower than one.’
In simple terms, a company who can’t cover its debt payments with its profits.
Low interest rates sustain zombie companies for longer
With low interest rates, the BIS has found that companies are staying in zombie mode for longer.
Every year they re-finance their debt, allowing them to stay in operation.
As seen below, the number of zombies and the length of time that a company is a zombie growing:
Source: Bank for International Settlements
Where there was once a 40% chance that a company could snap out of it the following year, this probability has now been cut to 15%.
Once a zombie, (almost) always a zombie, it seems.
The problem with these types of companies is that they are particularly susceptible to market downturns and interest rate hikes.
What makes matters worse is that both of these things are looking more likely with each passing day.
The Federal Reserve has indicated that it will continue to raise interest rates, and Bloomberg’s ‘neural net’ algorithm points to the chance of a recession hovering around 50% in the next year to two years.
Zombies harm economies because they draw funds away from more profitable companies and sectors. They are at a basic level, responsible for the misallocation of resources.
How to avoid investing in zombie companies
Unfortunately, many investors overlook some basic principles when assessing companies.
They buy the shares that are considered ‘hot’ or that have delivered share price growth for a sustained period of time.
Too often they forget to look at debt. It’s incredibly easy to do this.
Just go to the financials tab of your stock trading platform.
If interest payments exceed, EBIT, it could be wise to look elsewhere for investment profits, you’ve found a zombie.
Also, as a rule of thumb, and especially for asset intensive industries like mining, you can use the price to book (P/B) ratio.
This ratio indicates if you are paying too much for what would remain if the company went bankrupt immediately.
For companies that have negative earnings, you can still see if the company has relative value.
Apply the principle of debt to your investing strategy today.
You may be surprised by the results.
For Money Morning