Type of Companies best to stay clear.

Introduction

Low interest rate enviroment, couple with stimulus make accessing to money very cheap for buisnesses. Basically, unprofitable buisnesses can just borrow new debt to finance the old debt to keep the buisness running.

Zombie are companies that earn just enough money to continue operating and sevice debt but unable to payoff their debt. They do not have excess capital to spur growth, they are either dead or alive. In short, the have no profit and increasing debt despite of huge growth (or no growth) of revenue. Approximately, 20% of US companies are zombies as in 2020.

Typical Characteristic of a Zombie

A typical characteristic of a zombie, can be observed is that the revenue is growing at a very high speed, while the company continue to loss more and more money. Thus just by looking at revenue growth and ignoring other metrics to invest in a growth stock can be a bad idea. A zombie can be hyped up too. (the below financial statement is one of a very popular stock back in 2020).

While the company are growing, it needs funding to grow it buisness. The company can either rise it through debt or by issuing shares. It is perfectly alright to do that when the company during the growing phase provided the earnings growth exceed the share dilution rate. By issuing more shares, it will affect the EPS, which in turn will affect stock price.

When a company rise fund using debt. It is important to know if the company has the ability to pay off the debt. The company should have the capability to pay off, not necessary need to, but must be able to, just like AAPL. Having a negative cashflow is definitely an added risk during tough time.

Why do people invest in zombie? (Opinon)

Market had been on the longest bull run, investing had been very easy. We do got some small correction along the way but all just lasted less than a year. Maybe this time will be the same?

In my opinon, the reason is due to the rise of the personal finance/guru, most of our financial knoweldge are acquired online. When new investors are looking for information online, specifically youtube. The youtube algorithm will direct the audience to the most popular channel. These personal finance channel will often assert certain influence over the decision of the investors made.

Everybody wanted to invest in a stock that is the next Tesla or Amazon, during their infancy before it really take off and turn profitable, some of these financial influencers advocated a concentrated portfolio that consist of only one or two stocks, worst some of the recommendation are unprofitable companies. For new investors, in my opinon, is still the best to start out with a low cost index fund.

According to the study Do Global Stocks Outperform US Treasury Bills? The returns of 62,000 global stocks over 1990 to 2018 period was studied. 56% US stocks and 61% non-US stocks underperform one month treasury bill over the full sample. Top-performing 1.3% (811 out of 62,000) of the firms account for the majority (67.2%) of wealth creation of global stock market. 60.9% of the global stocks (37,195 out of 62,000) generate negative returns for investors. As it shown the probability of picking the next super star is astronomically low.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3415739

Stock Returns

There is 2 primary components of stock returns, the expected returns and unexpected returns. The stocks' value is theoritically the discounted price that the market willing to pay for the company expected future profit. The expected return is the discount rate applied to the expected future profit.

An unexpected return come from previously unknown information that get included into the calculation when it become known. Example if an company release its earning that are better than the expected may result in price incease to reflect a higher expectations for future profit or vice versa. In long term investing, it is not possible to predict the unexpected long term returns. Thus, in my opinon, it make more sense to focus on expected returns, somethings that already happened. Example Tesla FSD, Facebook metaverse.... those that is still work in progress and yet to take off, should not included in the valuation model.

The overvalue of a company can be explained by investors irrational extrapolating the high growth of a company too far into the future, leading to the prices higher than the buisness fundamental could reasonably justify. Any earnings misses will send the price tumble down 20% - 30%, as evidence to the recent facebook and Netflix. When the prices finally corrected back to a reasonable value, it reduced the investors returns.

A study (link below) shows evidence of the glamour effect of high price stock underperforming is relate to the reversal of erroneous expectations. Where the expectations in price are incongruent with current trend in firm fundamentals and the effect is the strongest during periods of high investor sentiment.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1757025

Cisco was once the most hyped and overvalued stock, before the dot-com bubble burst. Investors that bought at the peak had not recover until today. This is a result of overpaying for growth. But maybe this time is different?

Conclusions

• The expected returns of a zombie or weak companies are low or negative.
• Betting on future unexpected returns is a gamble.

• Based on the positive skew in stock returns, its a gamble with a negative expected outcome.