Beware of the zombie: viability concerns for high-debt companies as rates rise

Editor’s Note

Holding onto highly speculative, unprofitable growth stocks in the current environment is akin to buying a lottery ticket, says Lazard’s chief market strategist Ron Temple.

The global financial advisory and asset management firm – which celebrates its 175th anniversary this year – takes a long-term view to investing strategy. Fundamentals are key. That means having a deep understanding of each individual company, the team behind the business, and its intrinsic value.

This approach helped Lazard’s asset management arm take out the title of Morningstar’s 2023 fund manager of the year. Its gold-rated Select Australian Equities fund – which has a strong concentration on value stocks – was awarded the domestic large cap equities title after delivering total returns of 26.6% in 2022.

It’s exposure to gas producers and insurers bode well in a year where growth stocks were smashed. Of course, value investors had largely underperformed in recent years, with ultra-low interest rates and stagnant inflation driving growth stocks to dizzying highs.

Rising inflation and interest rates have brought growth stocks back down to earth, but Temple says bundling all of growth into one category is a mistake that not only leads to missed opportunities, but also comes at a great cost to those seeking to buy the dip.

I sat down with Temple during his visit to Australia this week from New York to get a sense of where he sees opportunities, and perhaps more importantly, where he sees the pitfalls.

Further down, we identify three undervalued investing opportunities on the ASX.

Rising interest rates to bring out the zombies

When debt is cheap, unprofitable companies are given more leniency. Growing market share was prioritised over profits.

But the landscape has vastly changed. Inflation is running at 7.8% annually in Australia, underlying inflation – which is far more sticky – is at 6.9%. The RBA doesn’t expect inflation to return to the top end of its 2% to 3% inflation target until 2025.

Investors know many of these highly speculatively growth stocks are a long-term play – high risk and (hopefully) high reward. Highly speculative implies these companies don’t make money, and may not make money for the next five years. But they have an interesting idea that people are willing to bet on.

Growth as a whole was sold off sharply in 2022, but Temple says speculative growth companies have been driving some of the sharpest year-to-date rebounds in the sector.

He warns zombie companies – those borrowing money to stay alive – may eventually run out of sources of capital.

“The most vulnerable part is speculative growth, the highly unprofitable companies in the growth bucket,” Temple says.

“There's a viability risk for some of these companies. If they're burning cash year after year, there's no guarantee the credit markets are always going to be willing to give them another loan or to buy the next bond.

“So I think there's a lot of risk in these stocks. And people would be better off not trying to buy lottery tickets, but instead focusing on those core fundamentals and companies that make money now.”

That means focusing more on profitability, he says, and less on trying to find the exciting story of two years ago.

As of September 2022, Coolabah Capital estimates around 13% of ASX companies are ‘zombies’ – that is, they haven’t earned enough income to repay the interest on their debt for three years in a row.

Since September, the official cash rate has jumped a further 1 percentage point to 3.35%. Financial markets expect that to rise to 4.25% by November.

New entry points for quality stocks

So, where does this leave the opportunities, I asked.

Temple says growth names shouldn’t be completely avoided, pointing to opportunities among some of the highly profitable big US tech stocks.

“They traded up to 20, 25, 30, sometimes 35 times earnings. But those have come back down to earth quite a bit in some cases and I think there could be really interesting opportunities there.”

But as the impact of higher interest rates wash through the economy, Temple says markets could retest the October 2022 lows, offering attractive entry points for high quality names.

“That would imply a 10% to 15% downside than where we are right now,” he says.

“I think right now, the best place to be invested in the market is quality, and when I say quality, these are companies with high returns on capital that can be sustained, at attractive valuations.”

“I think any [portfolio manager] you would speak to would say that they generally have a list of stocks they're looking at that they really want to own and they're waiting for the right price point, and I think it'll we'll get there in the next few months as the market sells off.”

3 undervalued stock ideas

With reporting season largely out of the way, we identify three undervalued stocks with an economic moat and 4- or 5-star rating.

A narrow or wide economic moat signals a company has a competitive advantage that should keep rivals at bay for at least the next decade or so. Things like brand loyalty, the network effect, cost advantages, and economies of scale.

These stocks all rate on Morningstar’s global best equity ideas list, available in full to Investor subscribers.

WiseTech Global (WTC)

Morningstar raised its fair value estimate for narrow-moat WiseTech by 2% this week to $90 per share following its first half results this week.

The company, which provides logistics companies the technology to digitize, accelerated growth in its core international freight-forwarding solution during the period, with organic revenue growth coming in ahead of Morningstar forecasts.

Wisetech is trading at a 33% discount to Morningstar’s fair value estimate.

Brambles (BXB)

Wide-moat Brambles beat expectations in the first half, as a continuing global pallet shortage allowed the company to increase prices by 15% year on year.

Brambles is the only scale provider of pallet-pooling services operating globally.
The company is trading at a 14% discount to Morningstar’s fair value estimate of $14.00 per share.

AGL Energy (AGL)

Narrow-moat AGL is trading at a whopping 46% discount to Morningstar’s valuation of $12.80 per share following a disappointing first half earnings result.

AGL management downgraded full-year EBITDA guidance by a few percent due to weaker wholesale electricity prices, following the federal government's price caps for domestic coal and gas sales.

“First-half earnings were heavily affected by power station outages in July 2022, which forced the firm to source electricity from wholesale markets at very high prices,” says Morningstar senior equity analyst Adrian Atkins.

“The market may also have been concerned by weak underlying operating cash flow, which was just AUD 105 million. But we think this was mostly caused by temporary factors and should significantly improve in the second half.”