Editorial –The Meaning of Cash

Wouter Klijn, Director of Content at the Investment Innovation Institute [i3]

A World at the Crossroads

A Tale of Zombies and Innovation

When we spoke to Nathan Fabian, Chief Responsible Investment Officer of the Principles for Responsible Investment, for the [i3] Podcast, he told us the world is at a crossroads.

We could use the current economic malaise to set some climate change-related conditions to the broad stimulus packages and subsidies governments are providing to companies.

Or we don’t, and face a world where we end up with a raft of unprofitable materials and energy companies that simply continue to exist because of subsidies and access to cheap loans.

Are we comfortable propping up companies that ultimately will not survive the energy transition?

It is a pertinent question, but this dilemma doesn’t relate only to the energy sector. More and more investors are worried about the creation of a ‘zombie economy’.

After a decade of unprecedented monetary stimulus, the percentage of zombie companies – those firms that are unable to cover debt servicing costs from current profits over an extended period, usually 18 months or more – as part of global stock markets has increased significantly.

Now, with the COVID-19-induced economic malaise and subsequent new rounds of monetary and fiscal stimuli, that problem is likely to be exacerbated.

Yes, it is important to provide support for people experiencing hardship due to the global pandemic. There is no arguing about that.

But the combination of government support to businesses over individuals, combined with a decade of monetary stimulus and low interest rates, has created a situation where a great number of companies continue to teeter at the edge of existence, rather than failing swiftly and freeing up capital and resources for growing companies.

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The problem of zombie companies is real and has been brewing for years. Increasingly investors are showing concern that the world is facing a Japanisation of its economy, facing prolonged low economic growth, low interest rates, government sector leveraging, private sector deleveraging and many crises

According to volume seven of KPMG’s “Distance to Default (D2D)” report, released in june, 38 per cent of companies listed on the Australian Securities Exchange showed signs of distress, reporting a D2D score of less than 1, at the end of 2019. Half of those companies can be considered ‘zombie companies’. That is almost one out of every five public companies.

A closer look at the sectors that are most heavily affected shows the materials and energy sectors harbouring the most zombies.

Now, these numbers are distorted by the fact the materials sector – which makes up 55 per cent of all companies with a score below 1 – is home to a large number of small exploration companies that are speculative in nature and will never be profitable.

So this is not necessarily an indication the sector is gaining zombie companies because of the energy transition or the deterioration of the economy, but what the report does make clear is the situation worsened at the onset of the pandemic.

KPMG gave some preliminary figures on the situation at the end of March. The number of companies with a D2D score lower than 1 had increased from 38 per cent to 60 per cent. Pretty much all sectors experienced a decline in their score, meaning their ability to service debt deteriorated.

Of course, the period covered does not include the recovery that followed in May and the situation is bound to be a bit rosier today.

But the problem of zombie companies is real and has been brewing for years. Increasingly investors are showing concern that the world is facing a Japanisation of its economy, facing prolonged low economic growth, low interest rates, government sector leveraging, private sector deleveraging and many crises.

Can we avoid this sombre future?

Traditional economics will tell you economic growth is driven by an increase in productivity, but the majority of economic growth is actually driven by technological innovation. The innovations of steam power, electricity and more recently the internet have been the real drivers behind leaps in productivity.

To get out of the current malaise, we need further innovation. An acceleration of the energy transition from fossil fuels to renewables could provide one avenue of new growth as it would spark the creation of numerous sectors facilitating this transition.

Or perhaps the coronavirus pandemic-inspired move to online working, online learning and cloud computing could herald the next phase of growth.

But whatever drives the next phase of growth, it won’t come without some significant, and likely disruptive, changes to the status quo.

So buckle up for the next phase. It’s going to be a wild ride.

Wouter

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.