Zombie Companies in a Zombie Economy
There was a large strip mall built out along the highway corridor back in 2007. It was at the far edge of the city. A frontage road had been run through a wetland to provide access, an apparently justifiable encroachment on nature, given the prime location. At considerable cost, all city utilities had been extended, the public all-in on this bet as well. An anchor restaurant—a Famous Dave’s—assured all that success was to come.
Of course, the market took an abrupt shift in the years immediately following construction. Except for the restaurant, the strip mall would sit completely empty for a decade. I was told that, if someone agreed to sign a five-year lease, they could get the first year free. Or the first two years. The rumored numbers changed while the vacancies didn’t.
Ultimately, Famous Dave’s closed, and to my surprise, was replaced by a Boulder Tap House. Some tenants started to creep in. A number of businesses opened and closed, seemingly misjudging the value of highway frontage. They probably figured it out within the first twelve months before the lease payments kicked in. More than a dozen years later, the little mall is about 50% occupied at any given time, though I don’t drive past it much anymore and can’t report on the ebbs and flows.
I was out there recently, however, and was surprised to see a new strip mall being built further up the highway. That is to say, I didn’t expect to see it, but once I did I was not surprised at all. I’ve actually grown used to the insanity. You see, I’ve accepted that I live in a world where things don’t make sense, and don’t have to make sense, and so I’ve stopped worrying about it.
A new strip mall next to the failed strip mall? What could be more natural.
Catastrophic Capital
Let’s imagine there are three entrepreneurs seeking an investment for their business and one investor in town with that kind of money. Entrepreneur A has a great business plan, loads of experience, and has been running the business profitably for a number of years. Entrepreneur B seems like a good person, has a great idea, but is short on experience and has only done a small model of the business. Entrepreneur C has some crazy dreams, talks a good game, but it’s clear that they have no clue what they are doing.
If the investor can only partner with one of these three, it would surprise nobody if they pick Entrepreneur A. The two will work out a deal that will balance the aggressiveness, desperation, and risk of each party and translate that into an ownership stake and projected rate of return. In that scenario, Entrepreneurs B and C are going to be left to struggle without additional capital.
Let’s now assume there are two investors, not one, and they are both equally disposed. Both will want to work with Entrepreneur A, and that business owner is likely to now get better terms than if there was only one investor. Whatever investor loses that courtship now has to choose between Entrepreneur B and C. Maybe B gets a shot now, hopefully with a partner that can provide some guidance (along with patience).
Now, instead of two investors, let’s assume there are five. Or ten. And all of these investors have made promises to their backers that they must keep, and rates of return that they are expected to meet.
Entrepreneur A is now getting great terms. So good in fact that it’s likely that whoever wound up making that investment did so with an over-inflated sense of future returns. The best investment has now become a bad investment, or at the very least a very risky investment.
Entrepreneur B is now also getting an amazing deal with unbelievable terms as investors fight each other over the remaining opportunities. This drives it into the high-risk category, as well, with the winner overpaying for an opportunity that, in another market, would not have been funded.
Entrepreneur C now goes from being completely on the outs to being easily funded, with yield-starved investors fighting each other to make that investment. In fact, despite the enormous risk, Entrepreneur C can get as much capital as they need at rates that are ridiculously low.
So, Entrepreneur C goes and builds another strip mall right next to the one that has been sitting mostly empty since 2007.
Zombie Companies
Publicly traded companies report their earnings each quarter. Those reports include their operating income as well as the amount they paid on interest. A “zombie company” is a business that does not earn enough to pay the interest on their debt. Not only do they require more debt to pay off their existing debt when it comes due, they need to take on additional debt just to cover the interest.
There are legitimate reasons why this might happen for one or two quarters (a sudden and unexpected drop in earnings, for example), but this is not a situation that should persist for any length of time. The market should kill off such a business. After all, who would loan money to a business that had little to no chance of making enough money to pay them back?
Your crazy uncle would.
Last year, way before any kind of pandemic discussion, there was concern in some financial circles with the growing number of zombie companies. More than a decade of near-zero interest rates meant that every investor—every pension fund, every hedge fund, every insolvent Baby Boomer with hopes of retiring—was fighting to invest in anything that could potentially pay a return. After the good investments were all driven recklessly bad, what was left was junk debt and a lot of zombie companies.
In March of 2019, CNN reported that 13% of public companies in the world’s advanced economies were zombies. An interesting Twitter thread at the beginning of the year listed a score of them and then dove into the financials of some. These are truly wretched companies, yet they don’t go away.
To those of you who think that Apple or Google are the smartest companies in the world (they might be): consider that they are sitting on tens of billions of dollars in cash earning essentially nothing. Same with Warren Buffett’s Berkshire Hathaway. There are so few decent investments that these titans of capital choose to earn nothing on billions rather than put that money to work, even in the case of Apple and Google, in their own companies.
Are you following your broker’s advice and buying S&P 500 index funds? Congratulations, you’re purchasing a whole bunch of zombie companies, driving up their stock price, allowing them to linger on even longer. (For the record: I don’t own any S&P 500 index funds.)
And this was before the pandemic. This was before huge hits to earnings, before Congress started borrowing trillions to bail out corporations, and before the Federal Reserve started printing trillions of dollars, buying everything on sale in a desperate attempt to keep inflated the multiple financial bubbles that we now consider normal. Here’s how CNBC described it last week:
Some of the biggest [zombie companies] have actually found it easier to raise more debt during the present crisis, as a Federal Reserve intervention has breathed new life into the corporate bond market. Their stock prices have also rebounded aggressively.
Get used to crazy, but not too much.
Even though it makes no sense, we’re going to get another strip mall out on the edge of town. We’re all going to get a lot of crazy stuff in the coming months and years. I’m taking the time to explain all of this today because we run the risk of normalizing this kind of condition, of coming to believe that this is how things actually work. Don’t let that happen.
This is how things are working right now. I’m not happy with it, and I don’t support anyone who is putting forth these policies (which, if you want to get political, means both major political parties here in the U.S., since this is one of the few consensus policies we have). I’ve accepted that this is the insane way things are going to work for a while and I can’t do anything about it, but I’m not ever going to think this is normal.
Strong towns need local entrepreneurs, so we have to carve out space for them. We must have small businesses, so we have to work alongside them. They are all being crowded out in an unfair game. The easy returns go to their zombie competitors while the local businesses struggle every day for survival.
Our economic policies make our cities weaker. They make our country weaker. And, ironically, they make the economy we are pretending to save even weaker.
The only way we fix this is from the bottom-up. We can start that right now by working to build Strong Towns.
Get the Local Leader’s Toolkit: A Strong Towns Response to the Pandemic right now for free.
Editor’s Note: Chuck expanded even further on this article in the podcast below.
Reopening a neighborhood store that was a fixture in its community for decades shouldn’t be this hard.