Investor Fears of 'Zombies' Creating Bubble in Companies with High Cash Flow
Investor concerns about so-called 'zombie' companies, which have survived due to low interest rates, are leading to a bubble in companies with high cash flow, according to Piper Sandler & Co. strategists. The uncertainty in the macroeconomic environment has driven equity investors in the US towards companies that can easily cover their interest expenses with earnings, resulting in high interest-coverage ratios. These companies with healthy balance sheets have been among the best-performing stocks in the Russell 3000 index this year. The Federal Reserve's decision to maintain high interest rates suggests that borrowing costs will remain elevated for some time, further incentivizing investors to gravitate towards companies that can bear these expenses.
Piper Sandler's analysis reveals a significant performance difference between companies with high interest coverage ratios and those with low ratios. While this outperformance could be viewed as a bubble, the strategists believe it is unlikely to deflate soon. They suggest that the bubble will continue until either zombie companies go bankrupt or interest rates collapse to keep them afloat. The difference in performance is even more pronounced among smaller companies in the Russell 2000, indicating that weaker balance sheets are more heavily penalized.
Overall, the Russell 2000 index has experienced a decline this year, with companies most likely to default in the next 12 months performing even worse. This performance disparity provides opportunities for active investors to select winning companies and avoid those with weaker financial positions. Bank of America Corp. has also advised clients to focus on companies with good cash flow, even if their growth expectations are relatively low, and to avoid non-earners with uncertain prospects.
The rise in interest rates has increased borrowing costs for companies and put pressure on profit growth. This environment could potentially lead to the demise of zombie companies that rely on promises rather than cash flow. As interest rates continue to impact businesses, the performance divergence between companies with strong and weak balance sheets is likely to persist.
Implications of 'Zombie' Company Bubble for New Businesses
The bubble in high cash flow companies, driven by investor fears of 'zombie' companies, could have significant implications for new businesses. The current macroeconomic environment, characterized by high interest rates and uncertainty, is pushing investors towards companies with high interest-coverage ratios.
Survival of the Financially Fittest
For new businesses, this trend emphasizes the importance of maintaining a healthy balance sheet. Companies that can cover their interest expenses with earnings are not only surviving but thriving in the current market. The ability to bear high borrowing costs is becoming a key determinant of business success.
The performance disparity between companies with high and low interest-coverage ratios could present both challenges and opportunities for new businesses. While companies with weaker balance sheets may face increased scrutiny and penalties, the situation also provides a chance for active investors to identify and invest in potential winners.
The strategists at Piper Sandler suggest that this bubble is unlikely to deflate soon. This could mean an extended period of high interest rates, putting further pressure on companies that rely on borrowing. For new businesses, this reinforces the need for sound financial management and the importance of generating good cash flow.
In conclusion, while the 'zombie' company bubble presents certain challenges, it also underlines the importance of financial resilience for new businesses. By focusing on maintaining a healthy balance sheet and generating strong cash flow, new businesses can navigate this environment successfully.