One of China’s biggest companies and second largest domestic real estate developer is on the brink of collapse. The news is slow to reach the Western world but I expect we’ll be hearing more about Evergrande in the coming days as things go from bad to worse.
Real estate development is a very difficult business and long intervals between acquisition, construction and project sales upon completion have led to a long graveyard of failures. Nothing new here.
What is new is the scale of the blow up and the possible spillover effects into the Chinese economy. I think it's likely that Evergrande will be bailed out in some way, shape or form. The company is just too big to fail.
I don’t know how, but the Chinese government is likely to ring fence domestic issues to prevent home owners and employees from further social unrest.
For those who haven’t been following the story, I suggest you check out this great summary fromThe Guardian here. In a nutshell, Evergrane can’t make repayments on around $300bn of debt.
Interest payments won’t be made this week and the bondholders owed the debt are now scrambling to see what they can retrieve. The share price, which trades in Hong Kong, is down 84% this year and last traded at around $2.54 per share.
According to the company's 2020 annual report, 674B ¥ (35%) is interest-bearing debt, which means it incurs new interest liability of 180+M ¥ every day! Comparatively, it only has 158B in cash to repay all its short term debt + interest which means defaults are inevitable.
What we don’t know is what else happens upon this default for obligations that are on the company’s books. We don’t know who else is exposed and what spillover effects there will be on other Chinese or global companies for that matter.
In the same way that a virus can spill across borders and cause contagion, so too can defaults of this nature.
Debt can blow up overnight
Debt is like a nuclear reactor, it can blow up and cause widespread damage overnight. Allegedly, Evergrande spends ¥1-2B on football every year. And in the last 10 yrs, it burned >¥20B.
But it didn't just stop at football. The real estate developer also established an entire subsidiary for electric vehicles ("Evergrande Auto"), another for streaming media ("Hengten Networks"), an amusement park ("Evergrande Fairyland") & health chain ("Evergrande Spring").
When times are good, nobody can see the consequences of debt. It’s only when things turn overnight, for whatever reason and often not predictable, that vulnerabilities are exposed.
There’s a valuable lesson for ordinary investors here and that is, think about debt very carefully and never hesitate to step back when times are good. Rising markets make us feel great, whether its stocks, real estate, crypto etc. We feed into the hysteria and often over indulge in debt. The smart money meanwhile is treading cautiously, not blind to the risks that lie ahead.
It’s hard to go against the grain (read my note here). Investing is a marathon, not a sprint. When the leading pack is sprinting ahead, it's tempting to catch up to them. But the smart athletes will always pace themselves out, leavin enough gas in the tank to complete the race.
Keep an eye on Evergrande this week and if you are in a position to take some debt off the table (particularly if you are stretched relative to your income), perhaps do so as asset prices are good.