The markets are on edge and trend followers are running for the exits. Woe be to the firms that need to raise money while fear stalks the land. They risk becoming zombie stocks that shamble around a bit before keeling over.
Even in good times, firms with negative earnings fare poorly and are, as a group, best avoided. But today I’m going to focus on stocks that are, potentially, in much more dire circumstances.
To find them I use a measure that’s colloquially known as earnings before the bad stuff. More formally, I’m talking about earnings before interest, taxes, depreciation and amortization, which goes by the handy acronym EBITDA.
You can start to see why it might be called earnings before the bad stuff. It’s bad enough to fall into the red after paying normal and recurring business expenses such as interest and taxes and other expenses; it can be deadly having negative earnings even before these essentials are paid for. After all, the expenses matter. Firms that want to avoid bankruptcy should pay their taxes and the interest on their debt. Depreciation and amortization account for the maintenance required to maintain a firm’s assets. Putting maintenance off is generally a bad idea. It’s sort of like burning the office furniture to heat the place.
Companies with negative EBITDAs are in a particularly precarious position and may be zombies. Matters get worse when the markets tumble and it becomes next to impossible to borrow money or to sell stock.
The accompanying chart presents the picture. It highlights the returns of the S&P/TSX Composite Index, which generated compound annual returns of 6.8 per cent from the end of 1996 to the end of November, 2018. The second line shows the trajectory of what I’ll call the zombie portfolio, which contains stocks with negative EBITDAs. It lost an average of 4.4 per cent annually over the same period. Each dollar invested in the zombie portfolio decayed to just 38 cents whereas each dollar invested in the index grew to $4.26. (The returns include dividend reinvestment but do not include frictions such as fund fees and commissions.)
The zombie portfolio tracks stocks on the Toronto Stock Exchange with negative EBITDAs over the trailing 12 months. It is reformed at the end of each month, weighted by size (or market capitalization) in a manner like the index, and its returns calculated using the local Bloomberg machine.
The frightful results compelled me to take peek at the current list of stocks with negative EBITDAs. The 15 largest stocks can be found in the accompanying table.
Shopify (SHOP) is the largest zombie candidate. It’s particularly interesting because it provides a glimmer of hope for zombie stocks while highlighting some potential risks.
Shopify is based in Ottawa and helps other businesses run online stores. It is far from dead. Its stock advanced smartly on the TSX from $35.60 per share at the end of 2015 to a recent price near $210 a share.
The firm generated negative EBITDAs each year since going public while it spent money in an effort to grow its business. The idea being to spend now with the expectation of making it all back – and hopefully much more – when customers beat a path to its door in the future.
It highlights the potential rewards and risks of trying to grow aggressively. If the customers show up as expected, it’s all gravy. If they don’t, the firm’s money might have been spent in vain.
In this case, industry analysts believe that Shopify’s plan is working and the firm should become EBITDA-positive next year. If it does, it’ll have successfully escaped the clutches of the zombie portfolio and be an exception to the trend.
While doom doesn’t always come to negative-EBITDA firms, they deserve extra scrutiny. It’s important to figure out what’s going on behind the numbers and explore whether there are any significant anomalous expenditures. After all, as a group, they tend to be miserable investments and have a history of putting portfolios six feet under.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
Editor’s note: A column in Monday’s Globe Investor used figures from Bloomberg to include Tricon Capital Group Inc. in a list of TSX stocks with negative EBITDA, or earnings before interest, taxes, depreciation and amortization. The Bloomberg figure did not include US$255 million of investment income that Tricon generated in the past 12 months from owning and operating approximately 17,000 single-family rental homes in the U.S., developing over 3,000 multi-family apartment units in Toronto, and managing a portfolio of for-sale housing assets in the U.S. Including this figure would make Tricon’s EBITDA positive and would exclude it from a list of negative-EBITDA stocks.
Norman Rothery