One such consequence of the financial crisis was the economy falling into a deep and drawn-out recession, which had a far reaching impact on many of the 2.5 million businesses in the UK.
Company Watch – a group that monitors financial health of business – published a report stating that one in 10 companies in the UK are treading water, and have evolved into so called ‘zombie’ companies that at best are generating enough cash flow to service their debt.
In such companies, liabilities outweigh assets, and significantly they employ collectively circa 500,000 people, yet have a combined negative net worth of about £70bn. This perhaps reminds me of Japan 10 or 15 years ago, whereby good money stagnated in bad companies.
Companies in such distress often adopt ‘suicide pricing’ – i.e. heavily reducing the cost they charge for their product or service, impacting competitor profits who then try and compete with such pricing models. It is worth at this point bearing in mind the rapid rise we have witnessed in the stock market compared to a modest rise in the rate of earnings.
Performance of indices since 2008 Lehman crash
Source: FE Analytics
Additionally, when and if the economy as a whole begins to improve, and pressure mounts on the Bank of England to adjust interest rates, the consequences will be grave for such companies and we would expect to see the insolvency rate increase considerably, along with the rate of unemployment.
In a separate survey, it was expected that up to a third of ‘zombie’ companies would be driven into liquidation if we witness normalisation of interest rates. This also adds to our argument that domestic inflation will be hard to come by within the UK, despite the best intentions of the BoE monetary policy.
British banks in particular appear content in keeping these companies alive in order to avoid taking potentially large losses onto their balance sheets – remember ‘a rolling loan gathers no loss’ – which is perhaps restricting the issue of new credit growth on the other side. This is something we’re told the politicians and bankers are keen to see.
Speaking with a number of our underlying managers, I’m told that a number of European banks, and in particular German banks, have not been afraid to cut losses – perhaps evidence further that the UK banks remain perilously positioned as far as their balance sheet strength is concerned.
Of course this predicament is not going to significantly impact those companies with pricing power and a global reach – the ilk of company we tend to own in our portfolios – but it is worth considering what area of the market is going to impacted most by this phenomenon. A generalisation perhaps, but many of the falling knives remain in the lower reaches of the index or indeed are private, and have a focus towards construction, property and the service sectors. If one is tempted to allocate to such an area of the market, it is certainly worth employing a talented stock picker who has a proven record of avoiding the dead cats.
James Sullivan (pictured) is manager of a number of portfolio at Miton, including the CF Miton Special Situations and CF Miton Total Return funds.
He has signficiantly outperformed his peer group composite since he started running funds in June 2008, but his cautious stance of late has seen him underperform many of his rivals, who have been more willing to cash in on the steep rising market.
Performance of manager and peer group composite since June 2008
Source: FE Analytics
To read more of Sullivan’s views on the global economic recovery, click here.
