Investing

'Zombie' stocks are at an all-time high: Here's how to avoid investing in one

“Zombies” are firms without enough earnings to pay off debts. Here’s why you should avoid them.

Twenty/20

People will dream up all sorts of scary get-ups for Halloween this year, from the standard vampires and mummies to more modern and terrifying figures, like "Tiger King" star Carole Baskin. But if you're an investor, you should be more afraid of zombies.

No, not the folks at your party wearing green paint and fake blood. "Zombie" companies are cash-poor firms without sufficient earnings to pay off their debts. For now, experts say, ultra-low interest rates are keeping these firms alive, or at least undead. But with a record number of undead firms walking among the living, investors should beware of zombies' potentially blood-curdling impact on the economy and their portfolios.

The 'zombie' outbreak is spreading across the market

The term "zombie" was first used to describe debt-laden firms struggling to stay afloat during Japan's "lost decade" for stocks from the early '90s to the early 2000s, during which the Japanese central bank urged financial firms to make loans to unprofitable companies despite those firms' meager prospects for growth. The term gained popularity stateside during the late 2000s to describe companies surviving on government bailouts in the wake of the Great Recession.

In 2020, the outbreak continues. As the Covid-19 pandemic has shuttered or significantly limited operations across large swaths of the U.S. economy, firms are seeing major hits to earnings. The Federal Reserve policies that keep interest rates low have made it easier for financially threatened firms to continue borrowing inexpensively. As a result, a record number of U.S. firms have been zombified.

As of mid-October, nearly 15% of public companies with market capitalizations of at least $300 million are considered zombies, according to research from Arbor Data Science. (A company's market cap is its share price multiplied by the number of its shares outstanding — essentially, this tells you a company's size. A company with a $300 million market cap is considered very small.)

Definitions for zombie status vary but in simple terms a zombie can be thought of as a firm whose EBITDA (a measure of corporate profitability) is less than their interest costs, says Liz Ann Sonders, chief investment strategist at Charles Schwab. When firms don't earn enough to cover their debts, the next step is either to regain profitability or declare bankruptcy, she says.

"Or," she adds, "the third option is hang on by your fingernails."

The proliferation of zombies may eventually drag on the economy, according to Sonders. "When a large number of poorly run businesses are kept afloat, it puts a strain on economic growth," she says. "I'm not suggesting what the Fed has done has been with the express purpose of keeping zombies afloat. That wasn't the goal. But it was a consequence."

Avoid adding zombies to your portfolio

Owning zombies can have a major impact on your returns. "Unsurprisingly, zombie firms are usually bad investments," wrote analysts at Principal Global Investors in a recent note. "[They] often carry excess volatility due to their distressed business models."

To avoid the chances of running into a zombie, avoid buying stock in heavily indebted firms altogether.

"It's never a good thing when people or companies spend beyond their means," says Sam Stovall, managing director of U.S. equity strategy at investment research firm CFRA, adding that firms that pay a dividend greater than the firm's earnings per share should be avoided.

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In comparing a firm's profitability to its indebtedness, read a company's earnings releases and guidance to get a sense of the future trajectory of profitability, Stovall says. "You shouldn't only be looking in the rearview mirror," he says. "GDP has bounced back sharply this quarter in a V-shaped move. We haven't gotten back to breakeven, but this is a unique situation. Some of these firms may only be zombies on a temporary basis."

If avoiding debt-laden, struggling firms sounds intuitive, take a look at Kodak. The stock jumped from a couple bucks a share to nearly $33 after news broke that the firm had received a loan to produce pharmaceutical ingredients, despite considerable concerns about the firm's financial health. Sonders admits she doesn't know exactly what happened there. "I can't get in the mind of day traders," she says. "Maybe they thought the low prices were attractive, but then you got this momentum play on bankruptcy stocks." The shares have since settled back down to $7.

To avoid falling into a trap, Sonders says, stick with companies with consistent earnings growth, robust free cash flow (cash left over after the company spends to maintain and expand its operations), and low ratios of debt to equity — metrics you can generally find in your brokerage's stock screener.

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