The US Federal Reserve's battle against inflation this year is bringing the era of easy money to a close. While monetary tightening may be painful for most companies, it will prove fatal for some.
The changing economic environment could spark an existential crisis for hundreds of so-called ‘Zombie firms.' These unprofitable companies have been artificially kept alive by borrowed credit but could be about to meet an untimely end. Savvy investors will heed the warning signs and pull their funds out from their life support machines. Amid market turmoil, diversification is the key to survival.
Die Another Day
Since the 2008 Global Financial Crisis, governments have slashed interest rates to near-zero or even negative territory. These super-low rates made borrowing cheap and easy. This, combined with a fairly loose monetary policy and quantitative easing, kept capital flowing freely throughout the economy.
As analyst Andrzej Rzońca writes, “Focused on boosting demand, policymakers forgot about supply and started zombifying the economy.”
This encouraged unprofitable firms to keep borrowing from creditors. The low interest rates meant they faced little pain in perpetually delaying repayments, even as their balance sheets got worse.
Their prolonged death disrupts the next iterative phase of “creative destruction” that innovates industries and boosts productivity.
Yet these overleveraged corporate behemoths could now be quashed under the weight of their debt.
According to Goldman Sachs, as much as 13% of firms listed on the US stock market could be zombies. The investment bank said it classified such zombies as those “firms that haven't produced enough profit to service their debts.”
Research Frim New Constructs put out a list earlier this month of the corporate walking dead, including the infamous meme stocks AMC and Gamestop.
Investors looking to shore up their positions in this volatile market must zoom in on the zombies. This may involve looking closely at the fundamentals of the company's business model and combing over the quarterly earnings report for any red flags.
For instance, the Debt-to-Equity (D/E) Ratio reveals to what degree a firm may be financing its operations through debt rather than its own resources. It can be useful for gauging the company's default risk.
Diversification can take different forms. Investors can go for intra-industry diversification by spreading their holdings across players within an industry (for instance, buying up Pepsi as well as Coke or Samsung as well as Apple). This minimizes the risk of being overexposed to any one particular firm and prevents a collapse in its value from ruining your portfolio.
Another is diversification across industries. For instance, if one were overly invested in tech stocks (which suffered sharp losses last month), they may consider defense or healthcare stocks.
Economic headwinds may blow hard but, depending on what is happening in the world, may batter specific industries and propel others. Defense stocks, for instance, boomed earlier in the year amid the geopolitical fallout from Russia's invasion of Ukraine.
A third form is across assets. This could involve an investor buying gold and other hard commodities instead of just holding cryptocurrencies or diversifying into Real Estate Investment Trusts (“REITs”) instead of just holding bonds.
Every investor's risk tolerance differs. This reflects their personality, time horizon, current financial circumstances, and other factors.
For some, the current investment climate is untenable. Rather than liquidating into cash, pivoting to lower-risk assets may be the best option.
Some invest in what are known as “recession-proof stocks,” which have a track record of performing better during downturns.
Many of these companies offer products at lower prices, such as McDonald's and Walmart, and keep generating strong revenue throughout a recession as consumers turn toward discounts as they tighten their belts.
Gold is another favorite for hedging during recessions. Gold enthusiasts (or “gold bugs”) laud the timeless metal for its resistance to the effects of inflation. The reason is that the supply of gold is more stable than most currencies, which can fluctuate yearly depending on quantitative easing, stimulus measures, and other policy decisions.
This is why the price of gold is often driven, in large part, by inflation.
“A rise in inflation or inflationary expectations increases investors' interest in purchasing gold and, therefore, drives up its price; in contrast, disinflation or a drop in inflationary expectations does the opposite,” a 2021 report by the Federal Reserve Bank of Chicago on gold prices stated.
Zombies firms remind us that all firms are beholden to the seasonal nature of the macroeconomy and market forces. Like living organisms, companies evolve their own competitive advantages to adapt to certain ecosystems. Different firms perform very differently under different economic conditions; for some, a dramatic change in their habitat spells disaster.
Ultimately, zombie firms are an important reminder to investors of the importance of diversification. We can only keep a portfolio from cracking by spreading one's eggs across a number of proverbial baskets.
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This article was produced and syndicated by Wealth of Geeks.