How to Spot a 'Zombie' Company

Regional banks take another big hit... A different kind of run... The unintended consequences of short-term decisions... The next debt crisis is ahead... How to spot a 'zombie' company... One number everyone should know...

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We'll get to the total 'zombies' in a moment...

But first...

We told you on Monday that JPMorgan Chase CEO Jamie Dimon claimed "this part of the crisis is over," meaning the failure of regional banks... and that, to us, it didn't look like the trouble was finished.

Regional-bank stocks were still selling off sharply, and there were signs the story could continue. Today, it did...

Yesterday, Federal Reserve Chair Jerome Powell said in a press conference when asked about all this, "I guess our view is that the banking system is sound and it's resilient."

"I guess?" Really?

Now it looks like a few more U.S. regional banks are destined for the clearance rack or the garbage bin...

The biggest losers in the small banks today were PacWest (PACW), a name we mentioned on Monday, and First Horizon (FHN). Their shares were down 51% and 33%, respectively, with speculation swirling that they could be the next to fail.

PacWest, a small-business lender with about $44 billion in assets, is reportedly exploring a potential sale, and the company said it is evaluating "all options to maximize shareholder value." Uh-oh.

And shares of First Horizon fell after Toronto-Dominion Bank (TD) called off its $13 billion takeover plan for First Horizon, citing concerns about regulatory approval.  

This TD Bank deal was actually in the works before the banking crisis began back in March.

A different kind of run...

Back in March, Silicon Valley Bank kicked off the turmoil in the regional-banking sector with a run on deposits. In these latest crises of confidence, investors are fleeing from the stocks more than depositors closing out their accounts.

In a public statement last night, PacWest said it had not experienced any unusual deposit outflows since the sale of First Republic Bank to JPMorgan Chase on Monday... Yet the stock has cratered, and short sellers betting against the company have racked up profits.

As global news service Reuters reported yesterday – before many of these regional-banking stocks took another large tumble today...

Short sellers have pocketed $1.2 billion in paper profits betting against U.S. regional lenders in the first two days of May, analytics firm Ortex said, as the third major regional bank failure in two months sparked a selloff in the sector.

The SPDR S&P Regional Banking Fund (KRE) was down more than 5% today and is off 43% in the past three months. So while Jamie Dimon may be hoping to talk the end of this crisis into existence, it still doesn't look like it's over just yet.

It might be close, though. Our Ten Stock Trader editor Greg Diamond's technical analysis suggests it. Mr. Market sure is a wild beast.

Regardless, this is the sort of thing we had in mind over the past two-plus years when we said there would be consequences of the Federal Reserve's rate hikes...

Of course, those rate hikes were a consequence of letting inflation run wild for about six to 12 months... which was a consequence of the economic stimulus in response to the pandemic... and so on.

We're seeing the influence of everything in 2023...

As we've also said, another likely outcome is the next 'debt crisis'...

Among other things, this will be when the many "zombie" companies in America – which can barely pay the interest on their own debt – go out of business.

Our Stansberry's Credit Opportunities editor Mike DiBiase recently joined Dan Ferris and me on the Stansberry Investor Hour podcast to talk about this. As Mike says...

A "zombie" is a company that can barely afford the interest on its debt. Zombies have no hope of paying off the principal of their debt when it comes due.

These companies are completely reliant on creditors to refinance their debt as it matures. It's like borrowing on one credit card to pay off the balance on another.

If or when the economy heads into a recession, the downturn will eat further into these struggling businesses' cash flows... And in a higher-rate environment where debt is twice as expensive as it was just a few years ago, many of these "zombies" will go bankrupt.

And at that point, many investors will be panicking...

Folks will rush to rescue some of their money before companies get completely wiped out. Counterintuitively, this will be exactly the time to put cash to work...

In this crisis, stocks and corporate bonds will go "on sale" – even the ones of good businesses that have little chance of defaulting on your debt. (In Credit Opportunities, Mike and analyst Bill McGilton recommend this type of bond investing. It's an approach they call "safer than stocks" because bonds offer a fixed return and legal protections that stocks simply don't have. You can learn more here.)

But how do you spot these "zombies" to avoid? How do you know if you have one in your portfolio? This is key to avoiding potential major losses. After listening to our recent Investor Hour episode, subscriber Terry L. wrote in and said he enjoyed the interview with Mike but wanted to know more...

Could you provide a short primer on how to evaluate potential zombie companies that are high risk in this worsening economic environment? This would be very helpful for me to make the right decisions in my portfolio going forward.

We got in touch with Mike this week and, good news, he agreed to share a how-to with everyone on precisely what to do... To close things out today, he will go into detail on how to spot the "zombie" companies you should avoid owning.

Here is Mike's advice for spotting a 'zombie'...

First things first, you have to know your way around a set of financial statements. I (Mike DiBiase) prefer to compare a company's "cash profits" with its interest expense on its annual 10-K forms and its quarterly 10-Qs. If that cash profit is less than its interest payouts, the company is a zombie.

Ideally, you want to see a company's cash profits measure at least twice that of its interest expense. That gives you a cushion if its earnings happen to fall.

In general, you'll want to look at more than one year or quarter. Note the trend. Is the company's interest coverage improving or getting worse over time?

You'll find "cash profits" in a company's statement of cash flows. It won't be called "cash profits," though, but "net cash provided by (used in) operating activities."

Companies already deduct interest costs to arrive at this number, so you'll need to add them back (you'll find the "interest expenses" line elsewhere in the financial report) and then compare the two figures.

(The "official" definition of a zombie uses a different stat called earnings before interest and taxes, or "EBIT." However, some companies have a lot of noise in their income statements like large noncash expenses, which is why I prefer the other metric I mentioned.)

Here's my simplest advice...

When credit is getting tight, like today, stay away from unprofitable companies.

Companies that failed to make a profit while debt was cheap will often struggle further when debt is expensive. The market is no longer pumping up high-growth tech companies with vague aspirations of future profitability... and for good reason.

Also, avoid highly leveraged companies. If a company's long-term debt totals more than 60% of its assets, stay away.

Unfortunately, there isn't a place where you can find a list of all zombies today. But one place you can do a kind of "zombie" stock checkup is on our website. When you look up a company by name or ticker, you can look at our Stansberry Score (available to subscribers who are signed in).

The Stansberry Score includes a "financial" score, which reflects the financial health of a company and predicts whether a company will default on its debt within the next year.

A higher "financial" score means a more financially sound company, with a score above 80 being ideal and a score of 50 being considered neutral. I haven't conducted in-depth research on every company that our automated system reports on... But I'd suggest avoiding any stock with a Stansberry Research financial-health score of less than 30.

New 52-week highs (as of 5/3/23): Alamos Gold (AGI), Eli Lilly (LLY), MYR Group (MYRG), Novartis (NVS), and Torex Gold Resources (TORXF).

In today's mailbag, giddyap... your suggestions for the name of a Fed-owned racehorse... As always, send your comments, questions, horse names, and other feedback to feedback@stansberryresearch.com.

"How about Running Deficit? Running on Empty would be nice but they'd probably get sued by Jackson Browne." – Paid-up subscriber George R.

"DEADBEAT!" – Paid-up subscriber Richard D.

"Runaway (as in budget deficit)" – Paid-up subscriber B.F.

"What immediately came to mind, especially after the comments about the relentless spending and the debt limit:

"Gotta Spend; Damn the Debt; Ain't no Limit; Drunken Sailor.

"Down the stretch they come!" – Paid-up subscriber Steve R.

"If the Fed owned a racehorse, it would be named Hardly Able." – Paid-up subscriber Patty G.

"We'll Print More." – Paid-up subscriber Todd L.

"Out of the Money, because this horse never needs to finish in the top three positions to earn its keep. Politicians will just keep feeding it my money." – Paid-up subscriber Roy B.

"If the Fed or any of those other clowns in office owned a racehorse, its name would be Forever in Debt." – Stansberry Alliance member S.G.

"Off the top of my head I can think of a few good names for the Fed's race horse. Let's start with Rate Hike or Bankrupt... and lastly Forever Printing." – Flex Alliance Member Kenneth S.

"KickTheCan, of course." – Paid-up subscriber Daniel B.

"If the Fed owned a racehorse...

"First of all, it would pay for the horse with 30-year bonds, paying more in interest over 30 years than the horse was worth and finally paying the principal note after the poor thing was dead.

"Then they would hire a jockey whose father knew someone who owed someone a favor, a jockey who went to Harvard or Yale, was 6'4", good-looking, and had always been chauffeured around in a Bentley.

"But it wouldn't matter if the horse (or the jockey or the taxpayers) won or lost.

"The horse's name would be Long Run. 'In the long run, we are all dead.' – Keynes." – Paid-up subscriber Jacqueline G.

"Easy Money" – Paid-up subscriber Michael B.

"Couldn't settle on just one. Here's a possible field:

"Dust in My Wind
Bubble Trouble
Pumper's Delight
Yellen in the Dark
Guttenberg Express
Jamie's Diamond
Too Drunk to Fail
Barnum and Bail Out
Print n' Sprint
Cart Before the Horse
Greenscam
Here's Your Mandate
Transitory Story." – Paid-up subscriber Gary S.

"I don't know about race horses, but if the Fed ran NASCAR it would go like this:

"Interviewer: 'You've raised the limit on horsepower 10 times in a row resulting in extremely hazardous conditions for everyone not just on but near the track. Are you oblivious to the consequences of your actions?'

"Fed: 'We are well aware that 4 of the most prominent cars drove into the wall this past month resulting in their complete destruction, so that's why we are only raising the horsepower limit by 25 this time.'" – Paid-up subscriber D.M.

Hi Corey, The horse's name should be In God we Trust because if the great masses lose faith in the dollar then it will be hell on Earth. But maybe Just Another Comma might be more descriptive." – Paid-up subscriber Jim H.

"If the Fed owned a race horse, it should be named Inflation. Then at the track they could cheer him on by saying 'Run away, Inflation!!'" – Paid-up subscriber Larry N.

Corey McLaughlin comment: Wow, how about these names? See what teamwork can do? Thank for sending in all the fun suggestions, though it might be more fun if every single one of them weren't so appropriately accurate.

It's hard to pick a winner, but in the spirit of betting and this weekend's Kentucky Derby – which subscriber Craig R. mentioned in yesterday's mail to spur this whole conversation – here's my trifecta from all of your great nominations...

Down the stretch they come... Forever Printing, Yellen in the Dark, and Running on Empty (even though Jackson Browne may sue). I can imagine a track announcer yelling: "... and it's Forever Printing by a nose!"

Jamie's Diamond also made me laugh out loud, but we'll save that for a horse owned by JPMorgan Chase, which there also has to be – at the very least indirectly – somewhere in the world.

All the best,

Corey McLaughlin and Mike DiBiase
Baltimore, Maryland
May 4, 2023