With the FOMC beginning to bring interest rates back toward a more neutral stance, there are few places in the market that will “heal”. One of the most misunderstood parts of the market are the so-called zombies. These companies tend to be smaller, and leveraged to the shorter end of the interest rate curve. Zombies (by the definition used here) have earnings that do not cover their interest expenses over a 3-year average. For a while, the question was “how long can they hold on?” Maybe, they have held on long enough to make it to the other side.
More than 50% of the Zombies exist in 3 states – California, Texas, and New York. And that is not coincidental. Those states tend to have a higher concentration of start-ups (which usually “run in the red” until reaching sufficient size) as well financial companies, technology and industrials. These characteristics are not coincidental. They are part of the reason for the development and survival of the zombies over the past 3 years. The areas the zombies populate are accustomed to loss making entities with highly engrained cultures of innovation and a venture capital mindset. It does not “bother” them to be a zombie for an extended period of time.
Not to mention, the revenue equation for many of the zombies has not been nearly as bad as expected. The prospect for a continuation of a good US economy and lower interest payments could be quite the powerful 1-2 punch. Simply, the zombies could be much healthier – much more quickly – than many anticipate. And the whiplash from “sick and dying” to “healthy and running” is something to pay attention to going forward.
And there are places to hunt for these zombies. Again, they tend to be smaller capitalization companies. This limits their ability to tap capital markets for longer term debt, and puts them largely at the whim of bank lending. There is also a concentration in the industrials and consumer discretionary categories with financials and real estate not far behind. Those are good places to look for the zombies as rates begin to moderate. Many of them do not need a better economy. Many simply need lower interest rates on the front end of the curve to be interesting from an investment perspective.
And the zombies are not dying. Bankruptcies are not abnormally high. They did pick up in 2023, but not to levels that would be considered elevated by historical standards. Not to mention, bankruptcies have been slowing through 2024, and are now sitting at subdued levels. That should not be ignored.
The zombies survived. Maybe the zombies are about to thrive.