A zombie company is one that is unable to pay its interest expenses from its EBIT (earnings before interest and tax). The number of zombie companies listed around the world has been rising as a proportion of all listed companies in most western democracies and it has many investors worried.
Among the Russell 3000 – the US small caps index – the proportion of companies unable to interest on debts from profits for at least the last three years has risen 50 per cent, from 10 per cent in 2017 to 15 per cent today. During the GFC, the proportion of such companies in the Russell 3000 was 16 per cent, so today’s number is almost on par with the experience during the GFC.
Staying with smaller businesses, the US National Restaurants Association reported that nearly 100,000 restaurants have closed as a result of the pandemic, representing one in six locations.
Meanwhile, across the broader United States markets, according to Deutsche Bank, the share of listed firms, that are more than ten years old, with an interest coverage ratio less than one, for three years in a row is 19 per cent. In Germany the number is 15 per cent, in the UK – 8.5 per cent and in France 17 per cent. And in each jurisdiction the number has been steadily rising for the last 30 years.
Despite these weakening business conditions, we have stunning multiples being achieved for profitless companies. Consider the recent listing of the virtual cloud service provider Snowflake. The company generated revenue in FY20 (year end is January) of $265 million and lost it all as well as another $349 million. The IPO price was three times higher than the last capital raising round just six months ago. The pricing started at $75-85 per share, was then raised to US$100-110, and it was finally priced at US$120 per share, or 75 times the current revenue run rate. Upon listing the share prices nearly doubled and the company now trades at more than 130 times revenue.
And it is these statistics that have prompted many investors to variously describe the current market as a ‘joke’, a ‘bubble’, a ‘ponzi scheme’, a ‘casino’ and a ‘lottery’.
Most value investors, like me, find it difficult to shake many decades of experiencing mean reversions. Anyone who lived through the ’87 crash, the ‘Recession We Had to Have’ in the early 90’s, the tech boom and bust or the GFC, are witnesses to capitalism turning long periods of market and economic steadiness into overconfidence, followed by excessive borrowing, then volatility and ultimately a crisis.
Rising prices for profitless companies reflects overconfidence, while the rising number of zombie companies must point to excessive borrowing. The ingredients that typify a bubble appear to be in place. Consequently, many value investors describe a ‘disconnect’ between the financial system and the real economy. And the apparent permanency of that disconnect, as well as the immediate rewards that have flown to investors who ignore value and pursue growth at any price, has resulted in a crisis of faith for value investors.
But while some value investors who predict an immediate crash and an emerging crisis could be right, they must also understand the same conditions also explain the concentration of money into those companies and business models that are actually winning.
While every economic contraction produces challenges for many businesses, there are others that win. Much of the market’s 2020 rally has been driven by a stampede of investment into just five giant technology companies, Facebook, Apple, Amazon Microsoft and Google (FAAMG). In the absence of these five the S&P500 would be down so far this calendar year.
These five companies collectively now comprise a quarter of S&P500 index’s market capitalisation and their market value is reported to be equivalent to the GDP of Europe. Apple’s market capitalisation alone is roughly the same as the market capitalisation of the entire 2000 companies in the Russell 2000 index. And over the last six years, while the famous five’s profits have increased by US$80 billion, their market value has increased by more than $4.4T – a multiple of over 55 times. Investors have simply been willing to pay a lot more for each dollar of earnings that these companies generate.
Many investors also believe that the performance of these stocks indicates a dangerous bubble, but perhaps these tech titans aren’t that expensive?
One argument is that their quality and prospects justify their current popularity and prices. You see, not only are the earnings of these companies growing at a rapid pace but as they grow, they are becoming more profitable. Returns on equity have increased for each of the five over the last four or five years. And in addition to benefitting from the network effect and flywheel competitive advantages, they have become monopolies in which inheres the most valuable of all competitive advantages – the ability to raise prices without a detrimental impact to unit sales volume. In a world of declining real rates of return, such pricing power and growth is scarce and highly prized by investors.
In Australia, a similar PE expansion has occurred and in both countries that has been a function of ultra-low interest rates.
The transmission mechanism works like this; Australian 31-year bonds recent sold at around 1.9 per cent. Adding on the equity market risk premium (ERP) of, say three per cent and you arrive at an earnings yield of about five per cent. If you divide 100 by five you arrive at the inverse of the earnings yield, which is the PE, of 20 times earnings. At the time of writing, the forward PE for the ASX200 is currently 19.85 times, suggesting it is about fair value and that is without factoring in growth. If long term growth is 2.5 per cent (and yes, that may yet prove ambitious) the fair multiple of earnings could be materially higher than 20 times.
And keep in mind that the US Federal Reserve has both articulated and demonstrated a desire to do ‘whatever it takes’. Indeed, central banks are aggressively buying an unprecedented range and quantum of listed and unlisted assets and securities. The consequence is the frustration of the traditional price signals that tell investors which businesses are weak and should fail. By keeping unprofitable and highly leveraged zombie companies alive and by eliminating the volatility that is associated with market-based economies, politicians appear to be protecting jobs.
Happily jobs aren’t doing that badly. In the US, nobody would have picked a severe pandemic would result in unemployment rising to only eight per cent. And in Australia, excluding Victoria, Seek’s Job Ads appear to be approaching pre-pandemic levels.
Investors are right to be cautious about the rise of Zombie companies as well as the risk of a bubble in technology and structural growth companies. But investors must also be careful not to underestimate the determination of politicians and central banks to save the world. And jobs data suggests their tactics might just be working.