A huge number of 'Zombie' companies are drowning in debt. This CEO sees a reckoning as interest rates soar




 

Zombies are real. Well, at least "zombie companies" are real.

Loosely defined as economically unviable firms that need to borrow to stay alive, an era of cheap money and high-risk investing has fueled the rise of the walking dead in the business world over the past decade.

David Trainer, the CEO of the investment research firm New Constructs, believes there are now roughly 300 publicly-traded zombie companies.

And with interest rates soaring, money isn't as cheap as it used to be, which means zombie companies are facing a reckoning that will affect both investors and the economy as a whole as recession fears mount.

"When economic reality hits these companies, and they do go to zero or close to it, which we're going to see in spades, a lot of investors are going to get crushed," Trainer told Fortune. "We're going to see a potentially huge impact on consumer demand…there's going to be a lot of people that are ticked off."

What is a zombie company?

What exactly makes a zombie company, and how many there are in the U.S., is a matter of debate.

Goldman Sachs recently estimated that some 13% of U.S.-listed companies "could be considered" zombies, which it called "firms that haven't produced enough profit to service their debts."

But in a study last year, the Federal Reserve found that only roughly 10% of public firms were zombie companies in 2019 using slightly more rigorous criteria. And in an even more confusing turn,Deutsche Bank Strategist Jim Reid conducted a study in April 2021 that found that over 25% of U.S. companies were zombies in 2020.

For comparison, in the year 2000, only about 6% of U.S. firms were in the same situation, according to Reid's findings.

Trainer, who has made his name with a few prescient predictions about zombie companies in recent years, also believes that the number of these failing firms in the U.S. has risen dramatically over the past few decades.

But he defines zombie companies using a more holistic method. In Trainer's view, zombies are firms with less than two years of "lifeline" available based on their average free cash flow burn that also struggle to differentiate themselves from competitors, have poor margins, and lack options for future profitable growth.

"So there's a very low likelihood that the cash burn is ever going to get better," he said.

Trainer and his team have built a list of roughly 300 publicly-traded zombies that they closely track, and while most of them are smaller firms, some have been in the public eye of late.

Stocks like the online car retailer Carvanaand the once-high flying stationary bike maker Peloton made the list, along with the meme-stock favorites AMC and GameStop.

Carvana declined Fortune's request for comment. AMC, Peloton, and GameStop did not immediately respond to requests for comment.

In Trainer's view, many of these zombie companies will eventually see their stock prices drop to $0 as the market recognizes they can't survive rising interest rates.

The Federal Reserve has raised rates five times this year to combat near 40-year high inflation, leading to soaring borrowing costs for corporations. That affects zombie companies, who are already struggling to pay their interest expenses, far more than most.

But while the potential downfall of zombie companies could be painful for investors and the economy in the short term, Trainer made the case that it won't be the worst thing in the long run.

Instead, he argued it represents a necessary cleansing of the financial system.

The rise of zombies and their effects on the economy

How did this zombie invasion happen in the first place?

In the years following the Great Financial Crisis of 2008, central banks around the world were desperate to reignite economic growth and reduce unemployment. To do this, many decided to slash interest rates and institute other loose monetary policies designed to spur lending and investment.

It was the beginning of an era of "free money" that put cash in the hands of speculators, who quickly turned around and bought risky financial assets, sending them to new heights.

The S&P 500, for example, rose more than 545% between its post-GFC low in Feb. 2009 and its Nov. 2021 high. And over the same period, the average sales price of U.S. homes jumped nearly 110%, while cryptocurrencies transformed into a trillion-dollar-plus asset class.

The speculative era hit its peak in 2021, after stimulus checks fueled a boom in retail investing, according to Trainer. At the time, cryptocurrencies like Bitcoin were soaring, the IPO and SPAC markets were on fire, and meme stock traders were pushing zombie companies' stocks like AMC and GameStop ever higher.

Trainer believes that this era of speculative investing increased the number of zombie companies in the U.S. dramatically, hurt productivity, and made the economy more vulnerable during recessions.

"I think, long term, zombies have caused a meaningful reduction in growth and prosperity," he said. "Because effectively, what a zombie stock is, is a waste of capital. To the extent that the capital is wastefully employed in these businesses that have actually never produced any real economic value, we are losing the opportunity to invest that in more productive areas."

Echoing Trainer's comments, Deutsche Bank Strategist Jim Reid said last year that zombie companies weaken economies by minimizing the growth of firms in the industries in which they operate.

"The survival of zombie firms is likely a drag on productivity growth as these firms congest markets and divert credit, investment, and skills from flowing to more productive and successful firms," he said in his 2021 study, referencing data from the BIS.

Trainer goes a step further than Reid, arguing that the survival of zombie companies is a threat to the U.S. in an increasingly competitive global economy.

"If we don't have efficient and productive capital markets, we lose probably one of the biggest competitive advantages that we have as a country, which is our ability to allocate capital more efficiently and rapidly to its highest and best use," he said. "And that's part of the problem. People forgot that this is what the capital markets are about. They're about allocating capital to its highest and best use, period, end of paragraph."

The fall of the zombies and lessons for investors

The era of zombie companies may be coming to an end as interest rates rise, forcing unprofitable firms to burn more and more cash. But according to Trainer, the downfall of zombie companies will ultimately be beneficial for the economy and help teach younger investors who have lived through an era of speculative excess about the importance of risk management.

"There's been an environment where people have grown up and they don't understand risk. Take meme stocks for God's sake," Trainer said, referencing the Reddit favorite AMC. "You're buying a movie company whose biggest competitor just went bankrupt…Then you see all of the competitive forces squeezing margins, and management is talking about buying a goldmine and how they're going to sell popcorn at grocery stores? Yeah, I'm sure they're gonna build a competitive advantage around popcorn."

The CEO went on to make the case that the young investors who pumped zombie stocks during the pandemic would benefit from understanding the difference between speculating and investing, which was so eloquently laid out by Warren Buffett's mentor, Benjamin Graham, in his 1949 book "The Intelligent Investor."

Graham distinguished between investors, whose "primary interest lies in acquiring and holding suitable securities at suitable prices," and speculators, who merely care about "anticipating and profiting from market fluctuations."

He also warned, over 70 years ago, of the dangers of allowing speculation to run rampant in the stock market.

"The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise, the stock exchanges may someday be blamed for heavy speculative losses, which those who suffered them had not been properly warned against," Graham wrote.

Trainer argues we are seeing the impact of ignoring Graham's warning today with the rise (and coming fall) of zombie stocks.

This story was originally featured on Fortune.com

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