The Zombies Are Coming – The Absolute Return Letter December 2020

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Absolute Return Partners letter for the month of December 2020, titled, “The Zombies Are Coming.”

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Department stores are relics of the past. JC Penney has been stuck for years in permanent twilight, with changes in retail and the weight of its own balance sheet blocking out the sun. -- Robert Armstrong, Financial Times

I am married to a very keen shopper. As much as I enjoy a good game of football or ice hockey when I am not working, she enjoys the kick she gets from shopping (in all fairness, she loves her ice hockey too). Tired of COVID-19 and the lack of shopping it has resulted in, she is anxious to get back to the high street.

“Shopping online is just not the same” she constantly reminds me and, when I tell her that shopping the way she likes may never be the same again, she frowns. “Why?”, she asks. “Sooner or later, life will return to some sort of normal.” “Yes”, I say, “but that doesn’t necessarily mean that the high streets will ever look the same again.”

The issue at heart is that, to many retailers, the COVID pandemic has been the death knell. Already struggling from online competition, when the government closed the high streets of Great Britain during the first wave in the spring, many consumers who had never shopped online before were suddenly forced to do so and found it was actually quite convenient. According to at least one estimate (provided by, for the first time ever, over 50% of all Christmas presents in the UK will be bought online this year.

The net result? More empty square metres in already half-empty high streets up and down the country and, of those brick and mortar retailers that are still standing, many are struggling. With the industry (on average) being highly indebted, you would expect weak revenues to lead to a phone call or two from the local bank, but life isn’t always as simple as that.

There is even a name for companies that really should go belly up but that are allowed to carry on. They are called zombies, and the zombie culture is growing bigger by the day. As it grows, it does more and more damage to the overall economy, and that is what this month’s Absolute Return Letter is about.

What is a zombie company and why are there so many of them?

I have just provided my own rather casual definition of a zombie company. However, it isn’t difficult to find a more formal one. After doing a simple search on the internet, I settled on this one from

A zombie company is simply a company that is neither dead or alive. In other words, it is in so much debt that any cash generated is being used to pay off the interest on the debt […]. This means that there is no spare cash or capacity for the company to invest or grow. This means that is unable to employ more staff but on the flip side, as long as the company is not actually losing money on an operational basis, it does not need to make further redundancies either.

Bank for International Settlements (BIS) published a study on the phenomenon in September 2018 called “The rise of zombie firms: causes and consequences”. In the paper, BIS classified all those non-financial firms in the Worldscope database (which contains financial data on companies from 14 advanced economies) with an interest coverage ratio less than one for three consecutive years as zombie firms, provided they were over ten years old. BIS named this group of companies the “broad definition” of zombies.

BIS then calculated Tobin’s q on all those companies classified as zombies under the broad definition. (Tobin’s q is a measure of a company’s expected future profitability – see the precise definition underneath Exhibit 1.) All the broad zombie firms with a Tobin’s q below the median firm in the sector in a given year were then classified as zombies under the “narrow definition”.

BIS chose to distinguish between narrow and broad zombies as companies with great growth potential often have negative interest coverage ratios, but the growth potential is typically recognised by the stock market which is reflected in Tobin’s q. This also explains why BIS chose to only include listed companies in its analysis.

Zombie Firms

Exhibit 1: Interest coverage and Tobin’s q of zombies and non-zombies

Note 1: Based on data from 14 advanced economies over the period 1987–2016. Interest coverage ratio = ratio of earnings before interest and taxation to interest paid. Tobin’s q = the market value of total assets divided by their replacement cost, which is calculated as the book value of equity and debt.

Note 2: The broad definition of zombie firms include all those firms with an interest coverage ratio less than one for three consecutive years provided they are over ten years old.

Note 3: The narrow definition of zombie firms include the broad zombies that have a Tobin’s q below the median firm in the sector in a given year.

Source: “The rise of zombie firms”, Bank for International Settlements, September 2018

Quite interestingly, BIS found that, from virtually non-existent as recently as 30 years ago, by 2016, more than 12% of all listed, non-financial firms in the world had been zombified (Exhibit 2). At the same time they found that, whilst the prevalence of zombie firms is on the rise, so is the probability of them staying (barely) alive for longer.

Zombie Firms

Exhibit 2: Zombie firms in percent of all listed non-financial firms

Note 1: Based on Worldscope’s database with non-financial companies from Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.

Note 2: LH chart represents the broad definition of zombie firms: all those firms with an interest coverage ratio less than one for three consecutive years and over ten years old.

Note 3: RH chart represents the narrow definition of zombie firms: broad zombies with a Tobin’s q below the median firm in the sector in a given year.

Source: “The rise of zombie firms”, Bank for International Settlements, September 2018

The obvious two questions to ask are therefore – why do we have more zombie firms today than we did only a few years ago, and how does that affect the overall economy? Let’s deal with the simple one first – why? In the 2018 paper, BIS pointed to two reasons why it has become easier for financially weak companies to survive for longer.

Firstly, banks have been surprisingly accommodative. Rather than writing questionable loans off, many of those loans have instead been rolled over. Secondly, ever lower interest rates have made higher financial leverage more affordable, which many companies have taken advantage of, but the rising level of financial leverage has also driven more and more companies into zombification.

Let’s deal with banks’ behaviour first. Admittedly, this is a side of banks we have never seen before. Why this more gentle attitude? Have banks suddenly turned into Mother Teresa of the High Street, or could something else explain their behaviour? I am afraid to say that Mother Teresa didn’t suddenly turn up on the High Street. The explanation – or at least a significant part of the explanation – is the profound weakness of many banks’ own balance sheet (LH chart of Exhibit 3). Already bleeding quite badly from the Global Financial Crisis (GFC), banks simply couldn’t afford for all those companies to go bankrupt. In order to protect their own balance sheet, they allowed non-viable firms to carry on, even if one could argue that it would have been better not to.

Having said that, the global economy didn’t start to unravel until June 2007 (with the collapse of Bear Stearns), but the corporate world became zombified much earlier. This makes one wonder what else drove zombification higher in the years prior to the GFC, and I can immediately think of two reasons.

Firstly, as you can see on the left-hand side of Exhibit 3, although the GFC didn’t start in earnest until 2007, banks’ balance sheets began to deteriorate as early as 1998. Secondly, interest rates fell quite steeply for at least 20 years prior to the GFC, and there can be no doubt that the dramatic drop in interest rates during the 90s and 00s has played a role.

It is simple maths. When interest rates drop, more often than not, companies take on more debt. Why? Because they can afford to. Maybe not the family-owned business that has been in the hands of the same proud family for the last 150 years, but the flood of acquisition-hungry private equity funds and the omnipresent corporate mogul keen to grow his (her) business empire have most definitely driven financial leverage to new highs.

It has quite simply become so extraordinarily cheap to borrow that companies can afford debt levels that were unthinkable not that many years ago. As you can see on the right-hand side of Exhibit 3 below, in the last 35 years or so, there has been a noticeable link between the share of zombie firms and interest rates. Based on the two charts below, we can therefore conclude that, at least since the 1980s, the share of zombie firms has been linked to both interest rates and bank health (proxied by banks’ price-to-book ratios).

Zombie Firms

Exhibit 3: Drivers of rising zombie shares

Note 1: Price-to-book ratios, policy rates and zombie shares are simple averages from the same 14 countries as those listed in note 1 under Exhibit 2.

Note 2: Firms with an interest coverage ratio less than one for three consecutive years, over 10 years old and with a Tobin’s q below the median firm in the sector in a given year.

Source: “The rise of zombie firms”, Bank for International Settlements, September 2018

Let me make one more observation re the link between zombies and bank health. As you can see above, the correlation is not consistent. BIS found the link to be rather ‘episodic’ (their wording, not mine), meaning that the two tend to be more correlated during economic downturns and during periods of financial stress, such as the early 1990s, the early 2000s and the GFC – an observation I don’t find overwhelmingly surprising, given how banks often behave in difficult times.

The implications

It is relatively easy to understand why a combination of ever lower interest rates and a weak(ish) banking sector – a phenomenon we have experienced in the last 20+ years – could explain the rise in the zombie share. That said, the argumentation gets a bit more hairy when trying to explain what that means to the global economy. Again – let me try with the easy one first: It is not good for GDP growth. Those of you keen to start you Christmas shopping can stop here. The rest of you should hang on for a few more minutes.

Let’s begin with the zombie share’s impact on productivity. In a paper from 2017, researchers from OECD documented a link between the share of zombie firms and labour productivity when measured relative to labour productivity in non-zombie firms (Exhibit 4). OECD defined a zombie firm precisely the same way BIS defined a broad zombie some 18 month later, so the two studies are comparable in that respect.

Zombie Firms

Exhibit 4: The share of zombie firms vs. labour productivity (average across 8 OECD countries)

Source: “The walking dead? Zombie firms and productivity performance in OECD countries”, Economics Department Working Paper no. 1372, January 2017

Almost by definition, and as you can see in Exhibit 5 below, zombies are less productive than non-zombies, and productivity growth is a powerful driver of GDP growth. The problem is also that zombie firms crowd out many more productive non-zombies. Think for example of all the employees working for zombie firms. If those people made themselves available to more productive non-zombies, aggregate productivity would rise.

Zombie Firms

Exhibit 5: Labour productivity per worker (charts 1 & 2) Total factor productivity per worker (charts 3 & 4)

Note 1: Gross value added per worker, in constant 2010 US dollars.

Note 2: Broad zombies defined as firms with an interest coverage ratio less than one for three consecutive years and over 10 years old.

Note 3: Narrow zombies defined as broad zombies with a Tobin’s q below the median firm in the sector in a given year.

Note 4: In constant 2010 US dollars, based on Solow residuals from ordinary least squares regression estimates of sectoral production functions.

Source: “The rise of zombie firms”, Bank for International Settlements, September 2018

Furthermore, the more firms that are zombified, the lower new investments are (as zombies have little or no capital to invest), and productivity won’t improve much, if at all, unless you invest in productivity-enhancing technology. Zombie firms themselves obviously don’t invest much, but non-zombies are also negatively impacted. BIS found that a one percentage point increase in the narrow zombie share in a sector lowered capital expenditures of non-zombies in the sector by around one percentage point – equivalent to a 17% drop in capex relative to the mean investment rate.

There is also pretty strong evidence that employment growth is negatively affected by zombification. According to BIS, for every one percentage point increase in the zombie share, employment growth is 0.26% lower. Finally, zombies impact the pricing power of non-zombies by impacting total supply, i.e. the rise in the zombie share in recent years may at least partially explain why we have flirted with deflation more recently.

If you add up all those factors, it becomes evident that a rising zombie share does a considerable amount of damage to economic growth. BIS used a global database when it researched the topic and did not make any comments on geographical variations so, on the basis of the 2018 BIS paper, it is impossible to say whether certain countries are more zombified than others (more on this below).

One more observation before I move on. Is it possible that it is not falling interest rates that have led to a rising zombie share but the other way around? In other words, could a rising zombie share affect productivity negatively, which in turn causes interest rates to fall? The issue at heart here is the potential confusion between correlation and causality. Fortunately, there is a test for that – it is called the Granger causality test. When BIS tested for causality, they found that lower interest rates reliably predict an increase in the zombie share, whereas bank health does not. This may also explain why the zombie share has continued to rise more recently despite bank health having improved somewhat over the last few years.

Geographical variations

Various papers and articles on the zombie phenomenon argue that the zombie share varies significantly from country to country, but the only source on geographical variations that I have been able to find is the previously mentioned OECD paper from 2017. As you can see in Exhibit 6 below, the zombie share has risen much more in some countries (e.g. Spain and Italy) than in others (e.g. Finland and France). That said, according to OECD, nowhere did the zombie share drop between 2007 and 2013 – it was flat to up everywhere. I should also point out that major OECD countries like Japan, Germany and the US were not included in the OECD study, so my conclusion should be caveated by that.

Absolute Return Letter

Exhibit 6: The share of zombie firms over time (9 OECD countries)

Source: “The walking dead? Zombie firms and productivity performance in OECD countries”, Economics Department Working Paper no. 1372, January 2017

We know that, in recent years, productivity growth has been more modest, and interest rates have fallen more, in Japan and Europe than in North America. We also know that Japanese and European banks have, on average, been weaker than North American banks more recently. Therefore, one should expect the zombie share to be higher in Europe and Japan than it is in North America, but I can only provide limited evidence to support that claim.

COVID-19 and zombies

I have managed to find a recent study, conducted by Leuthold Group and presented in the Financial Times only a couple of months ago (Exhibit 7). The study includes the first half of this year when the first COVID-19 wave struck, but it includes only US companies, so no direct comparison to other countries can be made.

Leuthold’s definition of a zombie firm is precisely the same as the broad zombie definition in the BIS study from 2018, so the numbers are comparable in that respect, allowing me to make a few interesting observations. Having said that, the universe in the Leuthold study is the Leuthold 3000 index – a Russell 3000 look-alike – and I don’t know how similar that index is to the Worldscope database used by BIS in 2018. My conclusions will therefore have to be caveated accordingly.

If you take another look at Exhibit 2, you can see that the global zombie share under BIS’ broad definition was c.12% in 2016. Now, if you look at Exhibit 7, you can see that the US zombie share was c.10% in 2016 – a couple of percentage points lower than the global average as per the BIS study, which implies that the RoW zombie share (ex. USA) in 2016 was probably around 14-15%.

The other interesting observation you can make on the back of Exhibit 7 is that the COVID-19 pandemic has acted as fuel on an already existing fire. As you can see, from end-2019 to mid-2020, the US zombie share increased from 13% to 15%. Given that the economic impact of COVID-19 has been far more dramatic in Europe than it has in the US, I would expect the European zombie share post-COVID-19 to be approaching 20%.

Absolute Return Letter

Exhibit 7: Percentage of zombies in Leuthold 3000 universe

Source: Financial Times

Final remarks

As most of you will know, one of ‘our’ six megatrends is what we call the Last Stages of the Debt Supercycle. One of the classic characteristics of all late-stage debt supercycles is falling productivity growth, falling GDP growth and falling interest rates. Every single debt supercycle is the same in that respect, and it all ties back to the mountain of debt society has been saddled with in the latter stages of all debt supercycles.

In the early stages, GDP and debt grow approx. 1:1 but, as the super-cycle matures, the ratio drops fairly steadily. At the end of the cycle, it is always below 0.3, and I have noted that, more recently, GDP has grown less than $0.30 for every dollar of added debt in both the US and China. One of the world’s leading capacities on debt supercycles is Ray Dalio of Bridgewater Associates, and I can strongly recommend you read his book on debt cycles which is called Big Debt Crises.

One of the most important reasons GDP grows less and less for every dollar of added debt is the tendency for more and more capital to be misallocated (i.e. used for non-productive purposes) as the debt supercycle matures. In that context, capital sunk in zombie firms amounts to huge sums of misallocated capital which will hold back productivity growth. In Exhibit 8 you can see that Italy and Spain have been particularly guilty of ‘allowing’ zombie firms to deploy capital unproductively.

Absolute Return Letter

Exhibit 8: The share of capital sunk in zombie firms in 2013 (13 OECD countries)

Source: “The walking dead? Zombie firms and productivity performance in OECD countries”, Economics Department Working Paper no. 1372, January 2017

Going back to my earlier claim that we are fast approaching the end of the current debt supercycle, nobody knows precisely what will make the house of cards collapse this time and when it will happen, but collapse it will – it always does. If this is a topic that interests you, other than buying Ray Dalio’s book, I would suggest you subscribe to ARP+ where you will find much more information on debt supercycles.

Niels C. Jensen

1 December 2020