Reporting season has certainly been the roller coaster we were expecting.

The market ran hot through January 2023 as investors seemed to momentarily forget the broader macroeconomic challenges that largely remained unchanged from 2022.

Australia – and the rest of the world – is amid an inflation and interest rates cycle that is looking to purposefully slow the economy. We have repeatedly said this is a temporary disruption that will ease once interest rates peak – but we are not there yet.

Inflationary figures remain stubbornly high, and this, along with cost pressures and higher interest rate expectations, remains a key market risk. That is why seeing the market run so far in January was surprising.

The zombie company epidemic is growing

As reporting season has progressed, the market has retreated somewhat, but market moves have been less to do with underlying financial results and more about broader market sentiment. CBA was a prime example, on the day it reported a record $5.2 billion net profit, its shares tumbled 5.7%.

Rising interest rates have only just begun to bite. Economic growth is slowing. Consumer retail spending has further to fall. These will be challenges not just for the current reporting season but also for the Full Year reporting season in August.

In this environment, we, again, are warning investors to beware of the zombie company epidemic and zombies lurking in their portfolios.

What are zombie companies?

Zombie companies are businesses that are unlikely to be able to repay their debts based on current forecast earnings. We fear the rally in markets in early 2023 could lead to complacency from Australian investors who may believe a rising tide will lift all boats. That is certainly not the case.

The link with bankruptcies

Analysing the underlying financial health of companies you invest in remains critical. We know that bankruptcies in Australia have returned to pre-Covid levels (see chart 1 below). With interest rates rising and government stimulus drying up, poor-performing, indebted companies have nowhere to hide.

When we overlay our proprietary Financial Health model – which considers 12 key accounting ratios – across the results of all 2000 ASX listed companies, shockingly we see that 75 per cent of all ASX listed companies are in either Early Warning, Marginal or Distress Financial Health and are therefore at risk of failure.

Our market analysis shows a concerning vulnerability across the Australia Stock Exchange (ASX). Overlaying Stock Doctor’s proprietary Financial Health model with an analysis of every company’s interest coverage ratio (i.e. a company’s ability to meet interest payments from forecast earnings) and its net debt to EBITDA ratio (i.e. how long it will take a company to pay off its debt based on its current earnings), we have built a model that identifies likely zombie companies.

Our model shows that 24% of ASX listed companies, that is, 106 stocks, may be zombie stocks.

In the United States, this increases to 27% of stocks at heightened risk. In other words, investors may need to avoid a quarter of all stocks in the Australian and U.S. markets as they are at risk of failure.

As these companies face a higher cost of debt, coupled with likely lower earnings due to a slowing economy and increased cost of living pressures, they will only become more vulnerable.

Warren Buffet’s oft-used quote is once again apt.

“Be fearful when others are greedy, and greedy when others are fearful.”

While it is nice to see markets push higher and portfolios recover somewhat from a challenging 2022, it is important to keep a long-term perspective, stay true to your investment strategy and most importantly, continue to invest based on fundamentals, not market speculation.

Using the proprietary Stock Doctor quantitative analysis, our team of analysts run near real-time quantitative analysis over all 2000+ ASX listed companies, giving unparalleled reporting season insight within 48hrs of the companies releasing their results.

Be informed to identify and avoid the zombie company epidemic this reporting season.

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