Hidden Risks Of Small Caps: Levered Zombie Company Impact On Bull Market Future
Summary
- There's been a lot of talk lately that we are in a "new secular bull market" that becomes driven by small-cap momentum.
- The problem I have with this is seemingly everyone is forgetting there are a lot of zombie companies that won't survive the longer rates stay elevated.
- A zombie company is a business that is unable to generate enough cash flow to cover its interest expenses.
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Humanity is mind-controlled and only slightly more conscious than your average zombie. - David Icke.
A secular bull market is characterized by a prolonged period of rising stock prices, driven by factors such as strong economic growth, low inflation, and investor optimism. It's during these times that small-cap stocks can experience significant gains, as investors are more willing to take on the higher risk associated with these smaller companies, in the hopes of achieving greater returns. There's been a lot of talk lately that we are in a "new secular bull market" that becomes driven by small-cap momentum. The problem I have with this is seemingly everyone is forgetting there are a lot of zombie companies that won't survive the longer rates stay elevated.
Defining zombie companies
A zombie company is a business that is unable to generate enough cash flow to cover its interest expenses and, as a result, is reliant on external sources of financing to continue operating. These companies are essentially "dead" in terms of their financial health, yet they continue to exist due to the availability of cheap credit, which allows them to roll over their debt and keep their operations running.
High debt companies, on the other hand, are businesses that have taken on a significant amount of debt relative to their assets or earnings. While these companies may not necessarily be "zombies" in the strictest sense, their high levels of leverage can make them more vulnerable to economic downturns, rising interest rates, and other external factors that can negatively impact their ability to service their debt.
Risks associated with rolling over debt at higher interest rates
One of the primary reasons that levered zombie companies have been able to survive in recent years is the availability of cheap credit, which has allowed them to roll over their debt at low interest rates. However, this dynamic could change in the future if interest rates were to stay elevated.
Datastream, Worldscope, DB Global Research
Warning signs for investors: identifying zombie companies in small caps
For investors looking to navigate the potential dangers of small-cap investments, it's important to be able to identify the warning signs of zombie companies and high debt businesses. Some key indicators to watch for include:
- High debt-to-equity ratios: A high debt-to-equity ratio can indicate that a company is heavily reliant on debt financing, which can make it more vulnerable to changes in interest rates or other external factors.
- Low interest coverage ratios: A low interest coverage ratio (i.e., the ratio of a company's earnings before interest and taxes to its interest expenses) can suggest that a business is struggling to generate sufficient cash flow to cover its interest payments.
- Persistent losses or declining revenues: Companies that consistently report losses or experience declines in revenue may be facing structural issues that could make it difficult for them to turn their business around.
Conclusion: navigating the hidden dangers of small caps
The presence of levered zombie companies and high debt businesses within the small-cap sector represents a potential danger for investors and the future of the secular bull market. Yes, small-cap momentum has been strong, and I don't discount the possibility that outperformance persists. But the reality is that we have yet to see the impact of higher rates on companies teetering on the edge. Be careful of narratives, the bear market may not be over.
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