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Industry Voices

Commentary: Walking dread: Avoid zombie companies to protect your investment portfolios

From a distance, they seem normal. But look closer. Their movement seems uncoordinated, almost shambling. They stumble forward, unwitting victims of their surroundings.

Beware ... the zombie companies. For long-term survival, your investment portfolios must be able to identify and avoid them. Technology coupled with the return of market volatility is creating more of them than ever, putting pressure on tried and true business models of the past. The wise investor learns to read the signs.

The term "zombie companies" initially referred to struggling, debt-riddled Japanese firms of the 1990s and again resurfaced as U.S. companies surviving on bailouts in the wake of the 2008 financial crisis. But today, the definition is due for an update. Now, as 10 years of global growth synchronization and easy central bank policy come to an end, technological change is magnifying the creation of a new strain of zombie company. Developments across mobile technology, e-commerce and cloud computing are putting pressure on slow-adapting business models across industries. And it's infecting some big names of the past.

While firms mired in extreme debt spawned the term, technological progress has always had a role in creating zombie companies. What's different now is the scale, speed and scope of that tech disruption combined with an end to an era of easy money. And now, zombie companies could be lurking in almost any industry, sector or region.

To spot the herd of these slow-to-adapt companies, look closely at sectors and industries that are dependent on access to cheap capital for viability. Energy, particularly the fracking industry, for instance, is a place to watch. If oil prices stay low while interest rates rise, we could see more zombies coming out of the ground than oil or natural gas. Also look for business such as asset managers, which have been able to grow revenue through a "rising tide" of market gains rather than share or pricing gains — a telltale sign of the undead.

Investors may want to also pay attention to corporate bankruptcies, which experts project increasing in their frequency in 2019. Bankruptcy data last year hinted at another worrying trend that may help identify zombies: serial filers. Over the years, several major retail companies filed for Chapter 11 protection more than once. New Generation Research Inc.'s bankruptcy data showed that almost 25% of 2018 filers were on their second or third bankruptcy filing. With these types of serial bankruptcies, we're seeing businesses where even debt restructuring may not be able to save them.

Add in the impact of technology — where the fundamental viability of companies' business models is in question — and the risk for equity investors is that a zombie's future value doesn't just drop. It can zero out. For fixed-income investors, downgrades and eventually outright default are the dangers.

The rise of e-commerce makes retail companies particularly easy prey — almost a quarter of 2018 bankruptcy filings were retailers. Companies that fail to adapt to consumer buying behaviors risk being left behind. Consumer companies are vulnerable too, especially those that have increased margins by cutting costs. The energy sector is another potential hotbed. These companies risk "zombi-fication" if they're not able to grow their business to stay profitable, rather than relying on further cost cutting.

High-dividend yield companies are another group that are susceptible to a zombie takeover. As a sector, they have performed well in the period of high liquidity and low inflation since the financial crisis, and garnered institutional assets through their low-volatility profile. Yet, some dividend yield stocks are often at-risk business models — profitable, no-growth, cash flow-generating enterprises sustained through a distribution or other localized advantage. Technology is then deployed to improve the business model and eat the margin. From an investment standpoint, the current environment favors dividend growers more than dividend payers. The firms surest to avoid the zombies are those that can grow — their top lines, their bottom lines and their dividends.

A long-horizon active management approach with an emphasis on quality is the best weapon to defend against zombie risk. Spotting and avoiding poor balance sheets and business models requires the deep fundamental research of active managers that understand a company's business model and the disruption environment in which it exists. The evaluation of an investment in a business over the next 60 months is quite different than the evaluation of a stock investment over the next 12 to 18 months. Turnover, a proxy for average holding period, is a helpful evaluation tool for this useful investor mentality.

Within fixed income, the zombie menace means there's value in pursuing durable income over max income. A thorough re-evaluation of positions in speculative credit and re-embracing of active credit selection makes sense, too.

Avoiding zombie companies is easier said than done in investing. For the asset owner and asset allocator evaluating late-cycle investment potential, it's clear a combination of technology, innovation and low rates has endangered a tremendous array of companies trying to hold on to out-of-date business models. Active asset allocation and active issue selection can help.

Todd Jablonski is chief investment officer of Principal Portfolio Strategies, the asset allocation boutique of Principal Global Investors, and he is based in Seattle. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.