Zombie Companies

Zombie Companies (also known as 'the living dead') are businesses that are so heavily indebted they are effectively insolvent, yet manage to continue operating. These firms typically generate just enough cash to cover their day-to-day running costs and, crucially, the interest payments on their debt. However, they don't earn enough to pay down the principal amount of the debt itself, which means they can never truly free themselves. This traps them in a perpetual state of financial limbo, unable to invest in new projects, innovate, or grow. They are essentially shuffling along, kept alive not by a healthy business model but by a combination of record-low interest rates and lenient creditors who would rather “extend and pretend” than write off a bad loan. For a value investor, these are not misunderstood bargains but dangerous traps that can devour capital.

Zombies don't just crawl out of the ground; they are created by a specific economic environment. The primary culprit is a prolonged period of ultra-cheap money. When central banks hold interest rates near zero for years on end, the cost of borrowing plummets. This acts as a form of life support for weak companies. In a normal economic cycle, poorly managed or uncompetitive businesses would fail, freeing up resources for healthier firms. This process is known as creative destruction. However, with access to nearly free debt, otherwise unviable companies can keep refinancing their loans and stagger on, sometimes for decades. Lenders, such as banks, can also be complicit. Rather than foreclosing on a struggling borrower and booking a significant loss on their own balance sheet, they may find it easier to keep extending credit, hoping for a miraculous turnaround that rarely comes. This combination of cheap money and creditor forbearance allows the corporate graveyard to fill up with the living dead.

Spotting and avoiding zombies is a critical skill for any prudent investor. They pose a threat not only to your portfolio but to the health of the entire economy.

It's easy to look at a company whose stock has fallen 90% and think you've found a bargain. With zombies, this is almost always a mistake. They are the classic definition of a value trap—a stock that appears cheap for a reason. Here’s why they are so dangerous:

• No Margin of Safety: Their survival is entirely dependent on low interest rates. A small increase in rates can quickly make their interest expense unbearable, pushing them into bankruptcy. This dependency on external factors they cannot control means there is no buffer for error.
• No Fuel for Growth: Since every spare cent of cash goes to servicing debt, there is nothing left to reinvest in the business. They can't fund research, upgrade equipment, or expand into new markets. With no growth prospects, there is no logical reason for the stock's value to increase over time.
• Negative Free Cash Flow: They are often “cash burn” machines, meaning their operations consume more cash than they generate. This is the opposite of the cash-generative compounders that value investors seek.

Zombies don't just shuffle around in isolation; they actively harm the economy. By surviving when they should have failed, they hoard valuable resources. Capital, skilled labor, and equipment are all tied up in these unproductive firms, preventing them from being reallocated to more innovative and efficient companies. This “misallocation of capital” acts as a drag on economic growth, slows wage gains, and stifles productivity. The most infamous real-world example is Japan's “Lost Decade” of the 1990s, where the government and banks propped up a vast number of zombie companies, leading to more than a decade of economic stagnation.

Luckily, zombies have some tell-tale signs that a diligent investor can spot by digging into a company's financial statements.

While no single metric is perfect, a combination of these red flags is a strong indicator of a zombie company:

1. The Classic Test: The most common definition, used by institutions like the Bank for International Settlements, is a publicly traded company that is over 10 years old whose EBIT (Earnings Before Interest and Taxes) has been less than its interest expense for three consecutive years.
2. The Interest Coverage Ratio (ICR): This is the direct way to apply the classic test. The formula is: ICR = EBIT / Interest Expense. A ratio below 1.0x means the company isn't generating enough operating profit to even cover its interest payments. A persistently low ICR is a major warning sign.
3. High Leverage: Look for a consistently high debt-to-equity ratio. While acceptable levels vary by industry, a company piling on more debt while its earnings stagnate is a classic zombie move.
4. Stagnant Growth: Zombies don't grow. If revenues have been flat or declining for years, it suggests the underlying business is fundamentally broken.

It’s important to apply context. A single bad year doesn't automatically make a company a zombie. Young, high-growth companies in their investment phase or a business in a highly cyclical industry (like oil or mining) might temporarily have an ICR below 1.0x during a downturn. The key difference is the prolonged nature of the problem and the absence of a clear path back to health. A true zombie has a permanently broken business model, not just a temporary cold.