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Zombie Companies – Trading the Walking Dead

Amidst the Corona Virus Pandemic there are hundreds of listed companies that cannot effectively exist on their own cash flow. Now relying on finance to keep their businesses alive. These Zombie Companies can’t even meet the interest payments, let alone the actual debt itself. These are what we call the walking dead and here’s why they are so important:

What is a zombie company?

Quite simply – a zombie company is a business that does not have enough cash flow. To stand on its own two feet. Amidst global shutdowns of economies and the halt of economic activity. Many businesses have struggled to keep the wheels turning and thus have reverted to financing through debt to keep themselves alive. As host Andrew Baxter explains, these companies who can’t exist on their current cash flow have gone to the Bond market for financing.

The Bond market (or debt market) is a place where companies can receive a loan to be repaid back to the investor in due time. All the while having to make interest or ‘coupon’ repayments over the life of the contract. That alone doesn’t sound too bad, but what if we told you that these businesses didn’t even have the cash flow to service the interest payments? Yes, that’s correct – these businesses aren’t even making enough cash to cover the interest payments on the debt, let alone the debt itself. Essentially – they are the walking dead in a negative cash flow position.

Why are Zombies Companies so dangerous?

We’re in an environment where interest rates are at an all-time low. Which really highlights how little cash flow these businesses are actually generating given they are failing to even make interest repayments of 2-3%. The reason why zombie companies are so bad, explains host Andrew Baxter, comes down to the scale of the borrowing.

Co-host Mitch Olarenshaw takes the US as an example where zombie companies have managed to accrue debt of over $1.4 trillion this year – compared to that of the GFC where it was merely only $0.6 Trillion in debt. Taking more specific examples – Boeing has loaned $32B just this year, Carnival Cruises $14.2B and Delta Airlines in $24.2B in debt just to name a few. Unfortunately, a lot of this money has been loaned by the Federal Reserve acting as the buyer of last resort in order to avoid recession, putting the vitality of the economy at risk alongside this.

What does this mean for the stock market?

Forgetting the grim story of zombies for a second here, let’s take a look at the stock market. Over in the US, the DOW Jones recently surpassed its crucial level of 30,000 points and is up 12% YTD. The Russel 2000 is now up 20% YTD and quite frankly mostly everything has been off to the races. Little do people know, 527 companies out of the Russel 200 Small Cap index fit into the category of a zombie company.

The danger here – getting FOMO on the market and adding value stocks to your portfolio without doing your research. Yes, the car may look nice from the outside but when you open the bonnet it’s a totally different story. These stocks that have very shaky balance sheets will run up with the market in times of optimism. However when the music stops these are most likely the first to fault. Andrew Baxter’s advice is to make sure you do your due diligence through fundamental analysis before pulling the trigger, so you don’t end up holding a zombie company. This is what he likes to call the “Litmus Test of Relevancy” and is something he teaches specifically through Australian Investment Education.

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How to trade a zombie company

Now this is where the fun begins for a trader as there is always money to made in the market. On these kinds of companies. For an investor, yes, these companies may look ‘undervalued’ at this point trading at extremely low prices so buying these would make sense. However, its important to take a look through these company’s balance sheets. To make sure they are in a position to be able to survive long-term. You have to ask yourself, says host Andrew Baxter. How big is the tail or head wind for the stock and how relevant is this business in the future?

This as an investor will keep you from investing in the perennial dogs that come about from situations like this. For a trader however, this is a completely different story. A trader has the ability to finesse their strategy accordingly to be short or long, or maybe even capitalise on an announcement with the expectation of poor quarterly earnings. Being nimble and across your fundamental analysis are two crucial skills needed to profit in these difficult situations. These are strategies that Andrew teaches through Australian Investment Education.

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