The Federal Reserve knows a lot of “zombies” walk among us…
In fact, as I explained yesterday, the central bank estimates that around 10% of all publicly traded companies are zombies. These companies have unsustainable levels of debt.
Most importantly, the Fed is about to go zombie hunting. It’s about to raise interest rates. That will make it even more difficult for these companies to maintain their debt.
You want to stay as far away from these companies as you can. And right now, keeping them out of your portfolio is more important than ever. But… how do you do that?
Today, we’ll look at some tools you can use to cut the zombies out of your portfolios. When a company grades poorly on these tools at the same time, it often spells trouble…
It all comes down to debt…
We need to make sure a company generates enough money to cover the interest payments on its debt. And we must make sure that it can continue to make those payments.
To do that, start with the debt-to-equity (D/E) ratio. It weighs a company’s debt against the value that shareholders hold.
In other words, this factor measures “leverage” – how much the company has borrowed versus how much it’s worth in the market.
A high D/E ratio means the company is in a risky position. Even a small change in the company’s financials may influence its ability to afford its bills.
I trust our Power Gauge system to do this work for me…
It has decades of data and analysis built into it. And the ratio of a company’s long-term debt to equity is one of the 20 fundamental and technical factors that the system analyzes.
If the Power Gauge rates a company’s D/E ratio as “bearish” or worse, I count that as a strike against it. But if you’re looking for a rough measure, it’s best to stay far away from companies with D/E ratios of more than 2. They’re in the riskiest spots.
Next, we must figure out how easily companies can afford their debt. Companies with high levels of unaffordable debt are at higher risk of defaulting.
To do this, you can use the interest-coverage ratio. This factor isn’t tracked directly in the Power Gauge. But it’s a great added layer for hunting down zombie stocks…
The interest-coverage ratio tells an investor how many times a company’s earnings will cover its debt payments (interest). If this ratio is below 1, it means the company doesn’t make enough money to pay its interest. That’s a darn risky position.
It’s going to get even riskier in the coming months, too…
Remember, the Fed is going zombie hunting by raising interest rates as soon as next month. So it’s best to avoid companies with interest-coverage ratios less than 2.
In addition to these two metrics, don’t forget to look at a company’s earnings growth. That’s another factor built into the Power Gauge. If it’s “bearish” in combination with the other factors we covered, you should definitely avoid investing in that company.
Simply put, the cost of borrowing is going up. That means many zombie companies won’t be able to cover the cost of their debt moving forward. So as an investor, your mission is clear…
Whether you use the Power Gauge or not, avoid packing your portfolio full of zombies.
Good investing,
Karina Kovalcik
