Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 386

Is growth of zombie companies real or fiction?

Contrary to the popular belief that 'zombie companies' are increasing rapidly, the number has been relatively constant over the last decade, suggesting that the risk to portfolios is not as concerning as some might think.  

Zombie companies are those that would normally have gone bankrupt or faced restructuring but have been kept alive by sympathetic credit policy and interest rates which are artificially low.

Zombies usually small companies

While some commentators have expressed concern about a rise in such companies in recent years, our recent analysis shows that this phenomenon has been remarkably steady among mid- and large-cap companies, and the descent into zombie territory is mostly confined to a long tail of small players.

In a paper from the Bank of International Settlements, Banerjee and Hoffmann found the percentage of zombie firms has been increasing steadily for many years to what appears to be alarming levels. In our new paper, we set out to test this conclusion with our own, broader data set and to see if this exposed our investments to significant portfolio risk.

We found that the problem was far less of an issue when low-quality ‘penny dreadfuls’ and other small firms were excluded. 

Defining the data set

The Banerjee and Hoffmann dataset was confined to 14 countries and used all listed companies regardless of size, quality or whether they can be easily traded. This created a total of 32,000 that includes even the smallest firms.

Our data set is broader, covering almost four times as many countries across developed markets (24 countries, 13,000 stocks), emerging markets (29 countries,10,550 stocks) and Australia (1,000 stocks), from 1999 to 2019. However, it does not cover as many names - we concentrate on larger, more investable stocks, with a total of approximately 25,000.

There are many ways to define a zombie firm, but our primary measure is closest to the 'narrow' definition of Banerjee and Hofmann and consists of:

  • Three consecutive years of interest cover (IC) less than 1
  • ‘Tobin’s Q’, which is a ratio of market value (what the market thinks it’s worth) to book value (its value as recorded in the financial statements). We looked at where this was less than sector average
  • Firm age greater than three years.

Using this definition and our revised data set, we see that the number of zombie firms has actually been quite consistent over the last decade, as shown in Figure 1.

Figure 1: Percentage of Zombie Firms 1999-2019

Source: Realindex, data as at 31 December 2019

Note the data does not include 2020 and the stresses brought about by COVID-19. However, the definition of three years of consistent underperformance allows for one-off events to interrupt a company’s operations.

Overall, these results provide some interesting insights:

  • We do not see the increasing trend to zombie firms within developed markets that Banerjee and Hofmann see. The proportion is fairly stable over the last decade at around 4% of the universe in each year.
  • Emerging market zombies were a large proportion of the universe in the early 2000s, but that trend has also moderated in the last decade.
  • Australian zombies were a large proportion of the universe post GFC, but even that proportion has fallen in recent years.
  • On average, Australian firms are more likely to be zombies than the other universes. (Full sample percentages: Australia 6.4%, developed markets 3.6%, emerging markets 6.3%, all stocks 4.6%, US 3.7%, Japan 0.8%). The data suggests this is largely a sector effect. The materials, energy and consumer staples sectors all have a higher proportion of zombies, and these sectors are well-represented in the Australian market.

Overall, the lack of this previously observed developed market zombie trend is somewhat surprising, but should be comforting to economists and investors alike.

Size matters: smaller firms drive the ‘undead’ phenomenon

A possible explanation is the different data sets we use. The Realindex data set is across all 24 developed market countries and is probably much more large-cap focused than (for example) Banerjee and Hofmann. This size effect is examined below and this seems to yield a partial explanation for this difference.

To look at this, we divide our developed markets universe up into deciles (10 percent bands) by market cap at each year (as indicated in the Legend), and then calculate the zombie percentage in decile.

Figure 2 shows the results:

Figure 2: Zombie percentages by large and small cap

Source: Realindex, data as at 31 December 2019

Previous research has shown that the zombie firm effect has a significant small-cap bias, which we can also see here. In fact, the results are dominated by small caps. However, the recent increasing trend in zombie firms is only seen in the smallest 10% of developed markets stocks, which suggests that this effect is small cap only. The proportion of large cap firms which classify as zombies is small.

This is a useful insight when considering the risks posed to portfolios in a period of cheap, easy credit and generous government support. The key is to look to mid- and large-cap companies to avoid the risks of high debt, poor management and low earnings that combine to keep a company on life-support. Of course, this would be a useful approach in any investment process, regardless of the investment style.

 

This paper follows an earlier study entitled “COVID and Credit and Zombies” (Realinsights Deep Dive, 10-2020). Here, we use Realindex data to investigate some of the empirical nature of the zombie companies’ phenomenon in more detail.

David Walsh is Head of Investments at Realindex Investments, a wholly owned investment management subsidiary of First Sentier Investors, a sponsor of Firstlinks. This article is primarily for information. It discusses ideas that are important to the Realindex investment process and clients but may not be affected in the ways discussed here.

For more articles and papers from First Sentier Investors, please click here.

 

RELATED ARTICLES

How diversified bond portfolios yield 7%

Is there any point in holding cash?

US rate rises would challenge multi-asset diversified portfolios

banner

Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.