Quick! Check your monthly statements! Your portfolio could be under attack!

OK, we admit it. Reading the words “zombie company” doesn’t exactly get your heart racing the way it might when watching a horde of undead bodies stagger across the movie screen. The term itself is not particularly scary, but these zombies do have the potential to create real-world consequences.

Financial zombies are corporations whose earnings are not sufficient enough to cover the interest payments on their outstanding debt. They are able to avoid bankruptcy by borrowing more money (issuing new bonds), liquidating assets, or refinancing existing debt. As a result, these companies survive despite being unhealthy.

If they can outgrow their debt, some might become success stories. Nothing, however, has the potential to crater a company’s stock price like unsustainable debt, which is why zombies pose an acute risk to investors.

Zombies are nothing new to the stock market. The difference is there are significantly more of them in 2019. the New York Times reported that 16% of public companies listed on US stock exchanges could be considered zombies, up from 2% in the 1980s.

A strong economy and low interest rates have created an environment in which zombies can thrive. Low rates make it easier for companies to refinance debt and borrow more money, and low yields offered by conservative investments encourage investors to chase higher-risk alternatives.

The rise of zombie companies is further evidence that many investors are ignoring the fundamentals. Reasonable valuations, strong growth outlooks, and healthy balance sheets used to be the attributes that attracted capital to certain stocks over others. Passive investing has made it considerably easier to avoid paying attention to those factors.

For anyone screening companies based on their individual characteristics – it is hard to imagine how zombie stocks would ever make the cut. When it’s only a matter of selecting an index, however, those details simply get overlooked.

What then is the best way to avoid the threat of zombie companies? Own high-quality individual stocks with relatively low debt. The historically long economic expansion will eventually end, and when it does, debt-heavy companies will be among the most vulnerable. Investors who prioritize strong fundamentals will ultimately be rewarded.