We wrote about zombie companies a year ago – companies that survived the COVID-19 lockdown, but that are not profitable enough to service debt and invest for the future at the same time. The inflation story has played out pretty much as expected, which continues to depress their margins. Now they face rising interest rates, which makes funding their businesses increasingly expensive. In many cases, these companies are no longer able to cover their interest expense, much less turn a profit. After a decade of an extraordinarily accommodative Fed and cheap money, they now face an existential threat.
According to a recent Bloomberg report, zombie companies make up about a fifth of the country's largest 3,000 publicly traded companies, saddled with $900 billion in debt. They were shock absorbers to inflation, and now face higher borrowing costs and more difficult credit conditions. They also make up a significant part of passive indices. For instance, we estimate zombies account for about a third of the Russell 2500 Value.
In addition to crosscurrents from inflation, a war in Ukraine, rising interest rates (falling bond prices) and contracting equity multiples, investors now face the increasing risk of zombies. As an equity investor, the question of whether they survive (many will not) is less relevant than the question of equity value impairment. Citing the same Bloomberg report from above, 620 companies in the Russell 3000 index failed to generate enough operating profits over the last 12 months to cover their interest expense. We believe that list grows over the next year as the Fed raises interest rates.
We are already seeing this problem escalate in the debt markets. For example, cruise line operator Carnival recently sold $1 billion of 8-year debt at a 10.5% yield. Their debt has swelled to $36 billion vs pre-pandemic levels of $11.5 billion. The good news is revenue is expected to jump 660% this year. The bad news is analysts still expect them to lose $2.5 billion. If analysts are correct and they grow another 52% in 2023, they are expected to finally turn a profit – a profit of $1.6 billion – for a company with an Enterprise Value (market cap plus net debt) of $45 billion. In their best year ever, they only earned $3.1 billion. Since the book value of that debt does not change, guess who gets left holding the bag? The equity holders, of course. If we get a recession, “Katy bar the door.”
Medical professionals take the Hippocratic Oath, “First, do no harm.” That is how we feel about investing – first, own no zombies. (Second is own no airlines.) Although there are certain periods of a business cycle that owning an inexpensive, passive index fund makes sense, we strongly believe this is not one of those periods, especially in SMid and Small Cap areas. We believe there are simply too many global risks and crosscurrents to blindly throw money at stocks at the moment. We focus on owning businesses that can fund themselves (and their growth), with strong management teams able to operate and, more importantly, quickly adapt to the rapidly changing landscape.
Below is the linked to the Bloomberg article we referenced: https://www.bloomberg.com/news/articles/2022-05-31/america-s-zombie-firms-face-slow-death-as-easy-credit-era-ends?srnd=premium&sref=vfD06998
For more information, please visit: www.ballastam.com
Investors should carefully consider the investment objectives, risk and charges and expenses of the Ballast Small/Mid Cap ETF. This and other important information about the ETF are contained in the Prospectus, which can be obtained at www.mgmtetf.com or by calling (866) 383-6468. The Prospectus should be read carefully before investing. The Ballast Small/Mid Cap ETF is distributed by Northern Lights Distributors, LLC, member of FINRA/SPIC. Northern Lights Distributors, LLC and Ballast Asset Management are not affiliated.
Important Risk Information
The Fund (MGMT) is a new ETF and has a limited history of operations for investors to evaluate. The Portfolio Manager has experience managing a mutual fund. However, the Adviser has not previously managed a mutual fund or ETF. As a result, investors do not have a long-term track record of managing an ETF from which to judge the Adviser and Adviser may not achieve the intended result in managing the Fund. Market risk includes the possibility that the Fund’s investments will decline in value because of a downturn in the stock market, reducing the value of the individual companies’ stocks regardless of the success or failure of the individual companies’ operations. Securities of companies with small and medium market capitalizations are often more volatile and less liquid than investments in larger companies. Small and mid-cap companies may face a greater risk of business failure, which could increase the volatility of the Fund’s portfolio. The Fund is actively managed and thus subject to management risk. The Adviser will apply its investment techniques and strategies in making decisions for the Fund, but there is no guarantee that its techniques will produce the intended results. The Fund faces numerous market trading risks including the potential lace of an active market for Fund shares, losses from trading in secondary markets and periods of high volatility and disruption in the creation/redemption process of the Fund. The net asset value of the Fund will fluctuate based on changes in the value of U.S. equity securities held by the Fund.
ETFs are subject to market fluctuation and the risk of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at the market price, which may be higher or lower than their NAV and are not individually redeemed from the Fund. 5547-NLD-06292022