Rising tide of zombie stocks coming

The market is carrying companies that would never make the grade under normal conditions.

As much as the RBA and the government tries, until we correct the misallocation of resources that artificially supports zombie corporations. Photo Naomi Jellicoe

Remember riding the Ghost Train as a child? I feel like that’s the ride today’s investor is aboard: and if you remember when you were on that train, the big scares came from the side.

One of the scares investors anticipate is the growing number of Zombie corporations. Ultimately, zombie businesses are reliant on the altruism of shareholders and lenders to survive, so many will perish when that altruism tires.

According to CreditWatch, the number of Australian businesses falling into administration rose in September. It’s the first time administrations have risen since June. Meanwhile, business defaults also rose for the first time since May.

Those increases immediately follow the reduction of JobSeeker payments to $1200 a fortnight and the introduction of a quarterly turnover eligibility test.

As we see a rising number of businesses falling into the hands of administrators, stockmarket investors are being invited to fund a veritable tidal wave of IPOs. In October (month-to-date), more than $700m has been raised from investors for companies including Cleanspace and Adore Beauty.

To put the quantum of October’s raising in perspective, a total of only $1.2bn has been raised for IPOs this year.

Many of 2020’s batch of IPOs are joining a growing list of profitless hopefuls. With a significant amount of the money raised being employed to operate these businesses, the ­period of “profitless prosperity” is extended. This, of course, has the consequence of possibly crowding out other businesses that were profitable and sought funding but were considered too “boring”.

What’s more, the “propping up” of profitless new entrants and competitors to incumbent businesses puts pressure on the margins of those incumbents, reducing the ­opportunity for wage growth and investment that would lead to productivity improvements.

This chain reaction is perhaps the most underappreciated consequence of the fad that is investing in “profitless hopefuls”.

While low rates are supposed to dampen the desire to save and increase the willingness to invest, the lack of “road blocks” to direct that investment means that we get misallocations to “moonshot” projects. 

As a recent report from the Productivity Commission (February 2020 Productivity Insights) put it: “The result is that the labour and multifactor productivity performance of the market sector where measurement of performance is most accurate, has continued to ­deteriorate.”

I have seen enough booms and busts over the past 30 years to be ­absolutely certain that not every business can succeed and not every business will make it through.

You wouldn’t know that, however, looking at today’s market. The optimism and financial support surrounding almost every e-commerce player would have you believe they’re all going to win. If you add up the aggregate revenue being forecast for these companies and compare it to the actual money available in the wallets of Australians, you would probably discover little remaining in those wallets for the electricity and gas bill.

It might seem counterproductive for a fund manager to be questioning the laissez faire approach that defines fundraising in Australia and elsewhere in the developed world. The fact is the only regulation is one of disclosure.

As long as you are told the company has virtually no hope of ever making money, you are free to “invest” in it. But the long-term consequences of allowing people to blow up their money on “NoHope” Mining NL or Buckleyschance.com.au is that productivity is set back.

At this point it is worth noting, coincidently of course, that Australia’s GDP over the past decade and a half has only been growing on an ­aggregate basis thanks to massive immigration.

On a per capita basis, our GDP has been going in reverse. Part of the reason, however, must surely be that zombie companies are being propped up by a tidal wave of private equity and public money in the vain belief that market share will be won from profitable incumbents or that wallet spend will be redirected from those same hitherto profitable incumbents.

Under the survival-of-the-fittest mantra, capitalists applaud from the sidelines but the wealthiest beneficiaries are those who founded these ultimately hopeless enterprises. In the end, wealth is directed from the many to the few, entrenching a widening of the inequality gap.

As much as the RBA and the government tries, until we correct the misallocation of resources that artificially supports zombie corporations (something that perhaps only a crystal ball or higher interest rates can do) we will have to live with productivity setbacks.

Zombie companies are a plague on society and a blight on capitalism with vast economic consequences that have yet to be fully felt. And the rising tide of zombies is something regulators should consider when framing long-term policy settings unless it is their intention to keep everyone riding the Ghost Train.

Roger Montgomery is the founder and chief investment officer at montinvest.com