We rarely write on specific stocks: for allocators running large portfolios, often across different asset classes, it is just too granular. And when on occasion we do, it is even more rare to report on a stock that we do not even own. We are making an exception with Evergrande for a couple of reasons. First, because this company is causing concern about the Chinese market as a whole over and above the impact its demise will have on its share and bond holders. Secondly, because our process screens out companies with such egregious business models.
For those of you who have not heard of Evergrande it is a property company that has just announced the sales of its apartments is no longer sufficient to service its massive debts. We suspect this has been the case for some time (brokers we know have ceased coverage of the stock for some time – not a good sign for the second largest company in the sector) and that past deposits paid by unwitting customers (it is estimated that there are around 1.5m of them and close to 800 unfinished projects) have gone long ago to keep the show on the road. Their fate has been widely debated on an online forum set up by the People’s Daily over the past couple of months.
Beijing has been well aware of Evergrande’s rising debt ratios for several years and has been trying to cajole the developer into de-gearing. Unfortunately, for want of the means, the founder of the business, Xu Jiayin, has continued down the “I am too big to fail” route. This has finally come home to roost. The Company’s debt is huge – some put it at $300bn – and will take a decade or more to unravel. We will, no doubt, be bored talking about it in a few months. The government’s priority is to manage the process without creating too much of a stir. The last thing the new “Common Prosperity” initiative needs is the distraction of large numbers of people who have put down deposits on unfinished projects or have invested in some bank wealth management products with exposure to the group being left penniless. Much of the debt will be with government banks who will, no doubt, manage the bad debts down over many years. It will be a massive headache, but not in any way a systemic risk. We would have seen that in broader bond markets, or indeed the currency, but there has been nothing. For many, the financials of this beast have been in plain sight for years. Sadly, as so often, the rating agencies have been slow to react.
The equity is clearly worthless, and the bonds not worth very much. In fact, anyone who has invested in the equity (15x leveraged, with negative cash flow in 8 of the past 10 years) needs their heads examined. We suspect it is/was in all sorts of indices so ETF buyers have indeed been invested in it.
As you know we focus on the EM consumer and the Chinese consumer is in rude good health. Though we are growth investors we are also mightily keen on cash flow generation. This necessarily attracts us to companies that have the wherewithal to fund their own growth without resort to lashings of debt. Note that none of our China holdings, excluding a couple of financials, have net borrowing.
Fraud is very often difficult to spot and despite confidence in our process we are never complacent about corporate chicanery. This one however, was a sore thumb with bells on it. Will it have any impact on our profitable, well managed and growing businesses with strong balance sheets? No.
Please click here for a pdf version
This document has been issued by Aubrey Capital Management Limited which is authorised and regulated in the UK by the Financial Conduct Authority and is registered as an Investment Adviser with the US Securities & Exchange Commission. You should be aware that the regulatory regime applicable in the UK may well be different in your home jurisdiction. This document has been prepared solely for the intended recipient for information purposes and is not a solicitation, or an offer to buy or sell any security. The information on which the document is based has been obtained from sources that we believe to be reliable, and in good faith, but we have not independently verified such information and no representation or warranty, express or implied, is made as to their accuracy. All expressions of opinion are subject to change without notice. Any comments expressed in this presentation should not be taken as a recommendation or advice. Please note that the prices of shares and the income from them can fall as well as rise and you may not get back the amount originally invested. This can be as a result of market movements and of variations in the exchange rates between currencies. Past performance is not a guide to future returns and may not be repeated. Aubrey Capital Management Limited accepts no liability or responsibility whatsoever for any consequential loss of any kind arising out of the use of this document or any part of its contents. This document does not in any way constitute investment advice or an offer or invitation to deal in securities. Recipients should always seek the advice of a qualified investment professional before making any investment decisions.
