ISTR - Latest U.S. Zombie Firms With The Highest Potential Credit Risks Plus 6-Month Update

2023-09-11 07:19:20 ET

Summary

• This article provides a follow-up study reviewing the 6-month performance of the top "zombie" firm portfolio selections based on Federal Reserve metrics.
• Three different model returns from March are reviewed, with sample stock portfolios down -23.4%, -29.9%, and -32.2% on average over the past 6 months.
• The study identifies high-risk companies that are considered economically unviable and rely on borrowing to stay alive, from over 1,300 at-risk stocks identified.
• New top zombie selections are provided using four different high-risk parameters to continue the evaluation period as interest rates are reaching 22-year highs.

Introduction

This six-month follow-up study reviews the performance of the top "zombie" firm portfolio selections released back in March based on the Federal Reserve metrics from their commissioned research. In addition to a review of the worst-scoring firms from March, I am releasing new sample zombie selections from each of the models for another test of the Federal Reserve's parameters.

As a reminder, this zombie label was used by the Federal Reserve researchers to assess market risks during the Covid-19 pandemic to determine the level of high-risk "firms that haven't produced enough profit to service their debts."

As interest rates rise to the highest levels in 22 years this may be a good time for you to check your own portfolios for strong credit-worthy stocks with low debt default risk. Even the US sovereign credit rating has been downgraded this year for the first time in more than a decade, there may be strong value in reviewing some of the most at-risk stocks again.

March Selection Models 6-Month Returns

This article reviews three different zombie models tracked from selection in March. The following portfolio sample returns can be benchmarked off the major indices for the past 6 months.

In the first Zombie model, the sample stocks are down -23.4% with Signature Bank no longer a going concern after their collapse on March 12th. The first model took the top firms sorted by the highest negative Altman Z-score for probability of bankruptcy within 2 years with at least 4x debt leverage ratio. These stocks also had to have an adverse Ohlson score.

The five worst-performing stocks so far are: USD Partners LP ( USDP ), Investar Holding ( ISTR ), Dime Community Bancshares ( DCOM ), Provident Financial Services ( PFS ), and OceanFirst Financial ( OCFC ).

In the second Zombie model, the sample stocks are down -29.9% on average the last 6 months. These firms were sorted by the highest negative Ohlson O-Score for probability of bankruptcy within 2 years with at least 4x debt leverage ratio. These stocks also had to have a negative Altman score.

The worst-performing stocks in this group have significant overlap with the Altman sorted portfolio. Additional five worst performers include: HomeStreet ( HMST ), First Foundation ( FFWM ), Blue Ridge Bankshares ( BRBS ), Banc of California ( BANC ), and HarborOne Bancorp ( HONE )

Combined Federal Reserve parameters and Forensic Algorithms

Finally, in the last screen, the sample stocks are down -32.2% using the combination of the Federal Reserve parameters and the forensic algorithms sorted along the Altman Z-score for bankruptcy risk. Selections are also limited to high debt leverage ratios for firms with over $1 billion market cap. One exception is that back in July, Biogen ( BIIB ) purchased Reata Pharmaceuticals ( RETA ) for $7.3 billion in its largest recent acquisition and a major distortion to the zombie measures that saw RETA gain +102.9%. Without excluding the unusual RETA acquisition event, the small sample portfolio is down -18.7%.

Some of the biggest decliners so far have been popular short-squeeze meme stocks like AMC Entertainment ( AMC ) and Virgin Galactic ( SPCE ) with large short positioning against the stocks.

Compared to the benchmark indices the last 6 months these small sample portfolios look to be statistically significant indicators of at-risk firms. Acquisition events and other outliers can impact the results and I am doubling the portfolio sample sizes for the next 6-month selections posted below.

The U.S. Zombie Firms Study

In the wake of the Covid-19 pandemic, the Federal Reserve commissioned a study of Zombie firms to evaluate how many of these firms may "crowd out lending to productive firms and erode the strength of the U.S. economy."

A team of scholars evaluated the risks for the Federal Reserve and went about building a model to identify high-risk companies that are considered unable to generate enough profits to cover debt-servicing costs and must borrow to stay alive.

There is no formal definition of a zombie firm , but it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets (Caballero, Hoshi, and Kashyap 2008). Accordingly, we identify zombie firms in U.S. data by requiring that they are highly leveraged and unprofitable. - (Favara, Minoiu, & Perez-Orive 2021).

A comprehensive list of more than 1,300 at-risk stocks is available using the broader Federal Reserve measure from the study but may be impractical for inclusion in this article. More zombie stocks are available to members of my investing community. In addition to the separate Federal Reserve study, I have applied forensic bankruptcy risk models by Altman and Ohlson to identify smaller sets of potential zombie firms. Many stocks that we may expect to be Zombie firms like research biotech companies with no revenues, may in fact not qualify to borrow and attain the required high debt levels. Instead many research firms rely almost exclusively on issuing shares to raise operational capital.

Methodology

Because there is no official standard to define a Zombie firm, scholars and analysts may have widely differing sets of high-risk firms. Rather than try to determine which model is best, I will rely on the screens used in March that rely on the Fed study parameters as well as long-established forensic bankruptcy models from Altman (1968) and Ohlson (1980).

Forensic models including Altman and Ohlson are used regularly in my long-term portfolio selections with statistically significant results. My sample mid-year forensic selection portfolios are available here .

We also want to consider which firms may be most at risk from the record high and rising interest rates. This requires a focus on firms with high debt levels, not just a focus on low profits at risk of not being able to cover debt-servicing costs.

The Federal Reserve study from Favara, Minoiu, and Perez-Orive, defined the parameters of a Zombie firm as:

We require that zombie firms have leverage above the sample annual median, interest coverage ratio (ICR) below one, and negative real sales growth over the preceding three years. High leverage and low ICR help identify firms that cannot cover their debt-servicing costs, while negative sales growth identifies firms with low growth prospects, as sales growth is a good predictor of firms' future performance.

In 2021 Goldman Sachs reported that some 13% of U.S.-listed companies "could be considered" zombies, which it called "firms that haven't produced enough profit to service their debts." The Federal Reserve study found that only roughly 10% of public firms were zombie companies in 2019. Finally, a Deutsche Bank study by Jim Reid in 2021 that found that over 25% of U.S. companies were zombies in 2020.

In my March screen for 2023 using Federal Reserve parameters I found that approximately 14% of public firms in the database met the standard, up from 10% in 2019.

Current Zombie Companies Based On Altman and Ohlson Bankruptcy Scores

1. The Ohlson model predicts bankruptcy risk using a multi-factor financial algorithm developed by Dr. James Ohlson in 1980. Any percentage values above 50% indicate the risk of a firm's bankruptcy within 2 years.
2. The Altman model is used to predict whether a firm is likely to go into bankruptcy within 2 years and uses many variables from the income and balance sheets for this analysis. Distress is considered high with a value below 1.81.

The Debt Leverage ratio represents a company's ability to pay debt obligations from annualized EBITDA and all companies above a high 4x debt leverage ratio were included. Again keep in mind that companies unable to qualify to carry large debt levels may be zombie firms but would not be on this list.

Sorted by the highest negative Ohlson O-Score for the probability of bankruptcy within 2 years with at least 4x debt leverage ratio. These three sample stocks out of the 20 stock portfolio also had to have a negative Altman score.

1. ( NAAS )

2. ( GOL )

3. ( PB )

Sorted by the highest negative Altman Z-score for probability of bankruptcy within 2 years with at least 4x debt leverage ratio. These four sample stocks and two different stocks out of the 20 stock portfolio also had to have an adverse Ohlson score.

1. ( TGTX )

2. ( BBIO )

Current Zombie Companies Based On Federal Reserve Parameters

According to the Federal Reserve study:

[A]mong publicly listed firms those in zombie status are smaller in size, have lower return on assets, hold less cash and have lower investment opportunities than their non-zombie counterparts.

According to published research the average size of a zombie firm is $374.6 million and has a negative -3.4% return on assets. In this selection, the companies below $100 million were excluded to favor more widely traded selections. Larger firms may perform better than some of the excluded micro-cap firms. The current list sorted in descending order from the worst interest coverage ratio is shown below:

1. ( STRS )

2. ( FTCI )

3. ( SCWX )

Current Zombie Companies Based On Federal Reserve Parameters and Forensic Algorithms

Finally, the last screen uses a combination of the Federal Reserve parameters, and the forensic algorithms sorted along the Altman Z-score for bankruptcy risk. 20 final selections were limited to high debt leverage ratios for firms with over $250 million market cap. Though not the highest on the list, some of these names are familiar stocks like Groupon ( GRPN ), WeWork ( WE ), and Beyond Meat ( BYND ).

StockRover and Morningstar Grades

The stocks above are listed here with their associated scores in descending order by Financial Safety score where available. Morningstar Profitability Grades also indicate the risk levels.

Conclusion

These screens are intended to sort through over 1,300 high-risk zombie companies with large exposure to rising interest rate risks. The data may have errors and companies are always finding new ways to improve their financial conditions that may not be reflected in these numbers.

You should continue to do your own due diligence in assessing which firms may be at risk. As I stated at the outset, there is no firm definition of a zombie company, but the Federal Reserve study asserts, "it is generally agreed that (zombie) firms are economically unviable and manage to survive by tapping banks and capital markets." (Caballero, Hoshi, and Kashyap 2008)

I trust this research and stock selections will give you added value to your investment goals and returns in 2023!

JD Henning, PhD, MBA, CFE, CAMS,

References

Altman, E. I. (1968). The Prediction of Corporate Bankruptcy: A Discriminant Analysis. The Journal of Finance, 23(1), 193-194. doi:10.1111/j.1540-6261.1968.tb03007.x

Caballero, Ricardo J., Hoshi, Takeo, and Kashyap, K. Anil. 2008. "Zombie lending and depressed restructuring in Japan." American Economic Review , 98(5): 1943-77

Favara, Giovanni, Camelia Minoiu, and Ander Perez-Orive (2021). "U.S. Zombie Firms: How Many and How Consequential?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, July 30, 2021, U.S. Zombie Firms: How Many and How Consequential?

Ohlson, J. A. (1980). Financial Ratios and the Probabilistic Prediction of Bankruptcy. Journal of Accounting Research, 18(1), 109. doi:10.2307/2490395

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

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