The Fed’s pandemic response has created a ‘zombie horde’ of crumbling companies, says $702 billion Principal. Here are 4 portfolio moves that minimize the risks posed by these firms, and the worst-hit industries to avoid.

  • The Fed's pandemic response, as well as the economic impact of COVID-19, have created a surge in "zombie" companies with limited future viability, according to Todd Jablonski,  a CIO at Principal Global Investors.
  • Jablonski laid out 4 portfolio shifts for navigating the zombie apocalyspe.
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As the US economy shut down in March because of the COVID-19 outbreak, the Federal Reserve took drastic measures to support financial markets, cutting interest rates to zero at an emergency meeting and committing to virtually unlimited quantitative easing as necessary.

But the actions of the US central bank, along with the pandemic's ongoing impact on the health of the economy and the sizable shift towards technology it's caused, have created a "horde" of zombie companies, or firms with limited future viability, Principal Global Investors argued in a recent note. 

"The global COVID-19 pandemic in the first half of 2020 radically altered the complexion of our global economy, our capital markets, and the outlook for many economic participants. For many companies, the associated lockdowns caused their transition from living business interest to fundamentally doomed enterprise," said Todd Jablonski, chief investment officer at Principal Global Asset Allocation, in the note.

He added: "Perversely, United States Federal Reserve (Fed) actions to support overall economic activity during the pandemic via low rates and credit purchases have had the negative side effect of providing life support for zombies."

Jablonski and his team at Principal, which has $702 billion of assets under management, labeled companies a "zombie" if they met one or more of five identifiers: 

  • If they had an interest coverage ratio of less than two
  • If their return on common equity spread is less than 4%
  • If their Altman Z Score, which predicts a company's likelihood of going bankrupt within two years, is less than 1.8
  • If they have sales growth under 3% year-over-year 
  • If they have an average sales growth of under 3% over the last three years.

The percentage of equities in each of these categories rose in the first half of 2020, most strongly year-over-year and based on three-year sales growth, where Principal now considers 69% and 51% of firms zombies.

In equities, the industries hurt most consistently across the five identifiers have been energy and consumer discretionary.

Even with the "mass zombification," Jablonski said that dead firms may be kept alive for a period.

"Notably, over the first six months of 2020, by all five of our metrics, zombie prevalence increased significantly. No doubt, part of the move is attributable to the economic impact of the COVID-19 crisis," Jablonski said. 

"Interestingly, the Altman Z score moved only slightly, while the other four identifiers increased significantly. The lack of increase in the poorly scoring Altman Z firms reflects another sign of the times—a growing cohort of zombie firms are still significantly distant from bankruptcy," he continued.

Nevertheless, no matter the short-term life-giving forces, zombie companies eventually will die, he said. 

He laid out four portfolio shifts to make to minimize risk posed by dead firms.

4 portfolio moves for navigating the zombie apocalypse

First, Jablonski recommended overweighting investment grade credit, since about three-quarters of the US investment grade bond market is "out of zombie risk." However, he warned that investors should be ready for the moment the Fed backs out of its support of markets, which could be brought on by fiscal stimulus, a vaccine, or trade regulation. 

"Monetary support equal to 29% of GDP is too powerful to resist. Zombies' debt issuers today are dependent on central action for 'fresh food.' And just as the Bank of Japan and European Central Bank provided a feeding frenzy for the Japanese and European walking dead via monetary policy, the Fed has newly opened another buffet line in the US," Jablonski said.

He added: "Active, open central purchases of corporate debt provide ample liquidity, attractive price discovery, and generally supports the IGC asset classes."

Second, he said investors might look to high yield bonds with a moderate risk appetite, but would want to take an active approach since zombie companies are more commonly found here.

Next, Jablonski recommended overweighting large-cap stocks, where companies are less likely to be zombies than in small-caps. He said this is especially true when it comes to being able to pay back interest on debt.

Finally, he said to look for firms that are "fighters" — those that are "fighting and winning market share" — and "runners" — those that are "growing companies in growing markets."

"Invest knowing zombies are out there and will be for a long time, given their inseparability from the general macroeconomic dynamic. In the current environment, maintaining a tactical bias toward reliable equity growth characteristics could help limit zombie exposure,' Jablonski said. 

"Even within the value equity universe, look for stocks that can grow profitably—by gaining market share, or by building brands—to distinguish themselves from their peers."

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