Welcome to the Terminal Value Podcast. So the topic of today’s conversation is going to be a thinking Thursday episode. And what we’re going to talk about is zombie companies. Now, for anybody who hasn’t heard the phrase before,
a zombie company is a terminology that is used to refer to a company where their annual cash flow or their regular cash flow is not enough or is either just barely enough or not quite enough to pay the interest on their debt.
And where the phrase zombie company comes from is it means the company is essentially what they call undead. It’s sort of alive, but not really. And I want to talk about why this is important and what it means. Okay. So, of course, what happens is when a company has debt that’s accumulated and the interest is more than its annual free cash flow. Well, it is very hard for that company to make further investments. And so what ends up happening then is that they become very highly dependent on rolling over debt and having low interest rates in order to persist. But in this case, they can’t really continue to be competitively viable because there will be other companies who are out in the marketplace that can make investments and can go out and either add capital, add labor, can invest in efficiency projects.
These zombie companies can’t really make any of those investments or if they try to cut costs in order to be able to generate net profits, that will almost certainly eat into their operational ability, which will further erode their competitive positioning.
And so the reason why this is really important is because the latest numbers I’ve seen are that right in the US, right? Around 20% of all publicly traded companies are what the Federal Reserve calls zombie companies. And this is something that’s really critical to think about, which is that if one out of every five publicly traded company is only barely able to pay the interest on its debt, that means that their debt values aren’t decreasing. And so that means that whenever their debt payments come due, they have to do what’s called rolling it over, or they basically have to issue new debt to pay off the old debt that comes due. But what are we seeing? Interest rates are going up. Okay.
So what is going to start happening if interest rates go up and you have zombie companies out in the economy? What’s going to happen is that as those companies go through the process of rolling over their debt, they are going to have to roll it over at increasingly higher interest rates because inflation it’s here.
People have been talking about whether inflation was transitory or permanent. It’s not transitory. It’s not going away. Prices are escalating. Hopefully, at some point they’ll invert back down to some point that’s more reasonable for people to handle. But prices are definitely escalating. And as prices escalate, of course, in order to try to keep that inflation under control, because one of the things that drives price escalation is the increased availability of money. Well, the government, depending on which set of books you look at through the pandemic, either borrowed or printed somewhere in the magnitude of $6 trillion. So there is a ton of capital that has been flowing into the economy, and it’s been driving up prices. It’s been creating inflation. And so in order to restrict that, one of the things that needs to happen is the amount of money that is outstanding. And by the way, I’ll record another episode on this concept. But one of the things that I want everybody listening to wrap your head around is that
money and debt are the same thing.
The idea of an M one M two money supply with checking account balances and hard currency, that’s irrelevant in the 21st century. Effectively, debt serves the purpose of money because the total amount of debt outstanding in the United States, I think based on the latest report that I saw from the St. Louis Fed, is around 85 to just over $85 trillion. That’s all sources, all debt, everything. And so that effectively is the money supply in the United States. About 85 trillion is probably going to be getting close to 90 trillion here pretty soon. Okay. So now
what needs to happen is the interest on that debt has to be paid. Otherwise, it goes into default. And whenever debts go into default, that tends to be when very bad economic situations manifest.
And let me just walk through how this happens and why it comes back to zombie companies. Okay. So if you have an interest situation on a set of bonds that companies pay and they get to the point where they can’t pay it anymore, they do what’s called a default, which is they default on their payment, they can’t pay it. Okay. So now once those bonds go into default, now the people who own those bonds were assuming that they were going to get all their money back plus interest. Well, now it turns out that they’re going to get nothing back or only a portion back, because in a lot of cases, when companies go into default, it’s usually because they’re going through bankruptcy because they’re insolvent and they don’t have enough capital to pay off all their debts. And so what they end up having to do is they end up having to sell their assets or recapitalize somehow. And then there’s a negotiation of what percentage of that debt gets paid back. But the point is that
whenever there is some kind of default, the people who own the debt will get paid back less than they invested, which whenever that happens for something that is not an equity, it makes financial markets really jittery and they get really upset.
And particularly because what ends up happening is that as the debt portion of portfolios, if it gets marked down because you start having defaults, what will end up happening is that if you have accounts that have been using debt that have margin loans against them to purchase those debt assets, now they can get into what’s called a force deleveraging. So
whenever you have margin loans on a financial account to purchase other financial assets, if the value of those underlying assets starts going down, you have to sell off those underlying assets in order to clear your margin loans.
That selling off is what they call deleveraging. And in this case, what happens is when deleveraging happens, it drives prices down really, really fast. Anybody here who lived through the 2008 financial crisis had a front row seat to this. I had a front row seat. I watched my 401K balance cut in half over the course of about two or three months. And of course, just as a little bit of an aside, a part of my financial education was when 2009 rolled around and the price real estate was at fantastic values, equities were at fantastic values. My money had all been burnt up in the crash, and so I didn’t really have a lot of liquid capital to invest. And so that was what I was saying. Okay, the next time this happens, I’m going to be positioned differently. But anyway, getting back to the idea of deleveraging and what ends up happening with defaults is that when you start having debt defaults, it creates a knock on effect of portfolio deleveraging. And how this all comes back to the zombie companies is that there are now one out of five. One fifth of publicly traded companies do not have enough free cash flows to pay down the principal on their loans at today’s low interest rates. So that means
as interest rates start going up, they can be systematically forced into what’s called a debt spiral. And a debt spiral is where you’ll have a company, or the same thing can happen with a person.
But let’s say you have a company, for example, where the amount of interest that they owe is significantly higher than their annual free cash flow. So they have to go out and borrow more in order to stay in operation. Well, then the next year they have to borrow even more and the interest expense gets higher. The next year they have to borrow even more and the interest expense gets higher. Eventually they get to the point where people say, hey, wait, we’re not loaning you any more money. And then their operations implode because they can’t afford to pay all their obligations. They have to default on their debt. And then in a lot of cases, their assets will have to be sold in order to try to clear at least some of that debt. The equity holders and the equity holders will be left with usually nothing. Every now and then it works out to where when you have a liquidation, then the equity holders end up getting stuff. Now it’s not very often though, but anyway, here’s the thing to think about and here’s an idea that I really just want to get a chance to land in everybody’s mind for a little while, which is that with
20% of publicly traded companies not being able to pay down principal on their loans, as interest rates continue to move up to address inflation, then more and more and more of these companies are going to start going into a debt spiral. And as more of these companies start going into a debt spiral, there will be defaults. And as defaults happen, you are going to start seeing increasing amounts of volatility, particularly in debt and bond markets.
Now, as far as what this means for your personal financial portfolio, that is beyond the scope of this podcast because I am not licensed to render financial advice. Although I would most definitely say that you want to be very conscious of your debt exposure, particularly because when there are disruptions like this in debt markets, it will have an impact in equity markets. Because historically one of what’s believed to be the bedrock financial planning principles is the idea that bonds and stocks are not very tightly correlated. So in other words, when equity markets are weak, bonds will tend to do well. When bond markets are weak because of rising interest rates will be offset by equities, et cetera. Now what’s been happening recently is that in the permanent low interest rate environment, your bond prices have been going up very rapidly. And so equity prices well, recently equity prices have been experiencing more volatility. They’ve dropped from the peaks. But what you could see is that if you end up having a forced portfolio deleveraging from defaults, that result out of these zombie companies that are having to deal with increased interest rates due to the debt spiral. Now you could potentially see a markdown of debt assets that could drive the leveraging, that could also drive a simultaneous markdown in equity assets because a lot of portfolios will have to sell their equity positions in order to meet margin calls on their debt positions. And so what all this really comes up to is that there is a whole lot of potential volatility that’s brimming underneath the surface of corporate and financial markets right now that I personally don’t believe is fully priced in. And so as far as what that means that you should do, I would definitely talk with the person who handles your finances and think about how you want to address that. If it’s a conversation you’d like to have with me, of course I’m more than happy to have a 15 minutes conversation. Just go to my website www.meetdoug.biz that’s meetdougbiz and you can put something on my calendar and we can talk about what it means for you. But bearing all this in mind, understand that I am not a licensed investment adviser. I am simply a person who has seen a lot of stuff, who reads a lot of books and is sharing some of the things that I’ve learned with you. So anyway, thank you very much for listening and I’m looking forward to talking to you tomorrow.