Zombie companies are proliferating here’s how to keep them out of your stock portfolio – MarketWatch

The Covid-19 pandemic has radically altered the dynamics of our global economy and capital markets. Before the recent selloff, markets had rallied to all-time highs despite the pandemics economic damage. This climb upward likely left investors feeling confused and curious, while so much uncertainty persists. Surely, there must be more to this story.

Digging deeper into this markets performance, its clear: Not all is as it seems.

There are investments lurking in portfolios today that, if left unaddressed, may wreak havoc on longer-term investment returns. Zombie companies those with excessive debt levels and failing business models are presenting new and unforeseen challenges for investors.

Read:Schwabs Liz Ann Sonders: Stock market today is a small handful of winners and a heck of a lot of pain

In the first half of 2020, the number of zombies more than doubled. In certain sectors, this trend has become even more pronounced: The tally of energy and consumer discretionary businesses that fell into the zombie abyss tripled over that same time period. Smart investors have already seen that across the entire corporate landscape, technological changes and shifting consumer preferences have rendered many business models obsolete.

Fortunately, there are ways to minimize the risk of ill-fated zombie businesses to ones portfolio.

First, with this pandemic-induced environment in mind, its worth putting into perspective the impact of zombies by simplifying the equity universe into three types of companies: runners, fighters and zombies.

Runners, in short, are growing companies in growing markets. The most visible examples are the mega-cap technology firms. But runners exist in other markets, too. They can grow in a Covid-19-infected economy and can do so profitably. Even as some runners risk growing too large and attracting attention from regulators, theyre making life worse for the zombies, with every percentage point of gained market share coming at the expense of these companies.

Fighters are those companies battling for, and winning, market share in flat or low-growth markets. Fighters may have growth-like characteristics or may trade at low valuations. Theyre not limited by geographic or size distinctions. Technology and a landscape permanently altered by Covid-19 are presenting new opportunities for these companies to reinvent themselves through innovative customer experiences, for example. Large retail brands featuring a direct-to-consumer relationship and omni-channel capacity are illustrative of fighters finding new life in a challenged space.

Which brings us to the zombies. Losing share, losing pricing power and being kept alive by debt servicing, zombies ultimately cannot cover their cost of capital. Fundamentally, zombies lack a path to profitability.

The pandemic has accelerated the zombies demise, and certain industries have become more infested with them. The energy sector, particularly exploration and production firms, are plagued by low prices, weak demand and leveraged balance sheets. Banking, already squeezed by a diminishing branch footprint, has been negatively impacted by the flattening yield curve, a record-low rate environment and stagnating loan growth. The communications industry is also a breeding ground for zombies, as shifts in consumer preferences for content, including more customized streaming options, have made legacy structures obsolete.

One obvious question arises about zombie companies: How long can they survive? It depends, but a zombies negative impact to your portfolio can last for years and the issue is exacerbated by todays monetary environment. Even as their fundamentals decay, zombies continue to shuffle forward, underperforming the market and introducing unhealthy competition to the real economy. The wave of monetary stimulus since the 2008-09 financial crisis has made access to capital historically easy, providing fresh food (cheap debt) to the business model with no future.

So, in this uncertain world, how should investors manage the risk posed by these fundamentally doomed companies? As policy decisions drive market performance and prop up failing businesses, investors must carefully assess the characteristics of their holdings to discern the living from the living dead.

First, go big. We believe an overweight to mega- and large-cap firms (Russell Top 200 Index, Russell 1000 Index) will shift equity holdings to a significantly safer neighborhood than the more zombie-populated small-cap universe (Russell 2000 Index) can provide. Certainly, there are plenty of large-cap zombies as well, but the likelihood of being exposed to a failing company is higher in small-caps.

Next, seek runners and fighters. Finding long-term winners in the current environment is a difficult undertaking, but rigorous analysis can help uncover fundamentally good business. For example, maintaining an equity bias toward growth characteristics could help limit zombie exposure. Even within the much-maligned value equity universe, looking for stocks that can grow profitably by gaining market share or by building brands often distinguish the runners and the fighters from their doomed peers.

Finally, play offense in fixed income. Yes, fixed income proved to investors in 2020 that credit can, and will, break out of its lower-volatility slumber quickly in response to new information. That said, weve seen a remarkable normalization in the level of volatility in fixed income markets, and we see opportunity in investment-grade and preferred securities as an effective means of driving additional risk-adjusted yield. Within high-yield fixed income, zombie risk is best addressed with an active approach that limits potential drawdown risk from zombie surprises.

Within the credit universe, to identify those industries with the highest incidence of zombie companies, we review several criteria including debt interest coverage. When examining this metric within the high-yield market, the consumer-discretionary and energy sectors show the highest prevalence of zombies, while in the investment grade credit space, energy and industrials show the most extensive occurrence of zombies.

By taking steps to minimize the negative impact of zombie companies, investors will be better positioned to navigate financial markets as this exceptional time unfolds.

Todd Jablonski is chief investment officer of Principal Global Asset Allocation at Principal Global Investors.

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Zombie companies are proliferating here's how to keep them out of your stock portfolio - MarketWatch

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