There are zombies among ASX All Ord shares. How I'd avoid my wealth being devoured

This type of zombie wants to eat your wealth. Here's how I'd barricade my portfolio.

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A businessman holding a cupof tea chats to a zombie in the office.

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Zombies are not only reserved for gruesome and grizzly movies. Investors can find them within the ASX All Ords — inflicting harrowing tales of a different type. These ASX shares won't feast upon your natural form, but on your net worth instead.

The truly ghastly fact about zombie companies is how pernicious their capital destruction can be. Rather than presenting a problem in plain sight, these undead entities can wander along for years without their detrimental deeds being detected.

Half of the mission in investing is to make money, the other half is trying not to lose it. That's why I believe it is critical to understand what a zombie share is and ways to avoid them. Being able to distinguish a horde from a haven could help rule out an especially deadly part of the market.

What is a zombie company?

If there are ASX All Ord shares that meet the conditions of a zombie company, what are those conditions?

Well, the technical requirements differ depending on who you ask. However, the general principle is a company that generates inadequate cash earnings from its operations to cover the interest on its debt — let alone pay it down.

Typically, these businesses will make use of additional capital raises and/or more debt to sustain themselves. It might work for a time, but the reality is unless the company can substantially improve its operational earnings, there's a good chance it will eventually collapse.

Right now, some ASX All Ords shares that are emblematic of zombies are Audio Pixels Holdings Ltd (ASX: AKP), Mesoblast Ltd (ASX: MSB), and Magnis Energy Technologies Ltd (ASX: MNS).

TradingView Chart

Mesoblast is a prime example of a zombie. The regenerative medicine company has dialled up its debt over the past five years, as pictured above. During that time, more funds have been consumed by research and development (among other expenses) than what has been generated by its operations.

Before you go deleting a bunch of companies from your watchlist, there are a few benefits of the doubt that I believe are worth giving:

  • Companies can have a challenging year where they become unprofitable. It may turn out to be a temporary sickness, rather than a full-blown zombie awakening
  • Sometimes a zombie can return to the land of the living under a successful strategy
  • Certain stages of select industries necessitate a period of zombification e.g. drug development and mineral exploration

Unfortunately, the risk that ASX zombie shares pose to shareholders is more prominent now than at any other time in the past decade. This comes down to the cost of capital ballooning amid the face-melting rise in interest rates.

How to dodge ASX All Ord shares with a nasty bite

If staying far, far away from anything that holds any resemblance to a zombie is more in tune with your investing style, there are several fundamentals I'd zero in on.

Firstly, a good place to start is a high EBITDA margin. The higher the margin, the more cash is available to pay interest and fund growth without additional debt. Keep in mind, though, a company can be profitable on an EBITDA basis and still lose money on the bottom line due to non-cash items.

Secondly, and perhaps a no-brainer (pun intended), is to search for ASX shares with minimal debt from the get-go. If the company never takes on debt, it's open ocean ahead — but if it does, you have ample time before it runs aground.

Lastly, a large swathe of ASX zombie shares can be avoided by steering clear of pre-revenue companies. Whether it is a drug developer, mineral explorer, or chip designer, if they are yet to generate meaningful revenue, there's a fair chance they're a zombie in the making (if not one already).

Some of these companies will go on to succeed and reward their investors handsomely. Many others will consume shareholder wealth before fading into oblivion.

If you don't mind going toe-to-toe with zombies, here's my final word. Rule number 22 of Zombieland: when in doubt, know your way out.

It's easy to start making excuses and loosen your standards when a company in your portfolio starts to turn. I personally think it is important to set the goalposts for selling early and don't be tempted to shift them.

Motley Fool contributor Mitchell Lawler has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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