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Fund Manager on Evergrande: "Anyone Who Has Invested In The Equity Needs Their Heads Examined"

Evergrande’s enormous debt problems could trigger a broader sell-off across other financial markets.


I received the following commentary this morning from representatives at Aubrey Capital Management, a U.K. based boutique investment management firm that manages the Aubrey Global Emerging Markets Opportunities Fund. Rob Brewis, the fund's manager, has strong views on the property giant and I’m sharing those thoughts with you below.

Evergrande, now the world’s most indebted property developer, seems to be causing Hong Kong’s financial markets to plunge again today as investors weigh up whether the group’s enormous debt problems could trigger a broader sell-off across other financial markets.

“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.”

My Take

I was not familiar with Evergrande up until a couple of weeks ago, so I won't speak to if or how investors should have seen this coming (although 15 times levered with negative cash flow is generally a red flag).

I think the important thing will be not to overreact to this. Yes, this will be bad for the real estate and financial markets in China, but the big question is whether this is an Evergrande thing or a systemic financial system thing. Evidence at this point, I believe, suggests that this is an isolated incident within one entity.

The markets right now will overreact worrying if this is the first domino to fall in a larger global financial system contagion. I agree with the comments above that it will ultimately prove to be non-systemic. Sticking to high quality balance sheets, if you want exposure to this space, is the way to go.

If you look at sector ETFs focused on China this morning (there aren't many and the ones that do exist are thinly traded), equities aren't reacting too harshly. The iShares MSCI China ETF (MCHI) is down about 3% as I write this. The Global X China Financials ETF (CHIX) and the Global X China Real Estate ETF (CHIR) are down 3-4%. Big moves, of course, but not quite as large as you might see if investors believed there was a true systemic failure at play.

My opinion at this point would be not to overreact and focus on higher quality investments for your portfolio.


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