Evergrande and Market Volatility
We have had a few clients recently ask the question:
How could an Evergrande collapse and contagion affect our portfolios?
This is a great question.
We have been attempting to protect our portfolios from a Chinese property crash/correction for many years. We do not own any Chinese companies. A number of our companies such as Google and Facebook are banned in China. We have always been cautious on economically sensitive companies in Australia, such as our banks and iron ore miners that have benefited immensely in the last few decades from China’s demand for resources.
We have been warning of the heightened risks to the excessive debt growth in China for nearly a decade. To be honest, we are surprised that they have managed to kick the can this far down the road. The more they bail out companies like Evergrande, the greater the moral hazard. Much of the Chinese economy is structured with the idea they can take silly risks and the government would always have their back. As Einstein says,
“The difference between genius and stupidity is that genius has its limits”
The low interest rate environment, which seems to be prolonged further due to the Covid pandemic, has benefited the most leveraged companies due to it lowered lowering global borrowing costs. The weaker the global economy, the longer the excessively leveraged companies can may survive. Thus, the ironic situation we find ourselves in is one where those that have taken risks they shouldn’t have, appear to be doing better than they otherwise would. Or to paraphrase Buffett, the tide is yet to go out to expose those swimming naked.
China and Australia have some of the highest debt ratios in the world. China’s corporate debt is closely tied to property and development. Australia’s household debt is likely higher than it appears due to “Bank of Mum and Dad” and loans at multiples of gross wages not possible in the rest of the world. In Switzerland, you can’t borrow more than 4.5 times gross wages. Australia has large swathes of loans at above 6 times gross wages.
Most of China’s debt is off balance sheet and so it takes some work to calculated total debt levels. The estimates are in the range of $40 trillion to $90 trillion USD in debt. We have read the PBOC stability reports, investment bank reports, independent analysis reports and we have attempted to look at a number of the Chinese banks to estimate loan exposures. It is concerning that the low end of the estimates is some of the worst debt levels in global history. The highest end of the estimates are numbers that defy belief.
The good news for global investors is that most of the Chinese debt is onshore debt. This means that they have little global exposure to flow on the rest of the world. A debt crisis could be restricted to China.
With likely lower for longer rates, extreme debt levels can be worked over. The prime example is Japan over the last 32 years. The Japanese debt bubble of the late 1980’s was one of the largest in history. With zero to negative rates for 32 years, they have bumbled along just fine. A 32-year bumbling could be just what China needs to work through their debt excesses.
Negative rate settings have created some quite unusual economic conditions. Money has flowed from negative yielding countries to only slightly positive yielding China. In a scenario where foreign investors think they will have a return on capital and a return of their capital, flows from negative yielding countries to China could continue and their excessive debt levels may be fine. A return of capital has often not been the case for many offshore investors. Offshore Evergrande bond holders are the patsies in this game.
Our analysis of the situation is not one of knowing what is going to happen, but rather one of avoidance. The best pilots avoid flying through thunderstorms. There are some who think they can risk it and get through the thunderstorm simply to meet an arbitrary landing time. We far prefer to take the safer option of avoidance when it comes to thunderstorms and Chinese debt storms.
If you avoid offshore Chinese bonds, avoid Chinese banks, avoid Chinese real estate developers, avoid Chinese tech stocks with accounting irregularities and regulatory risk and avoid iron ore miners, then you should manage to avoid most of the Chinese credit issues.
In the most extreme situation, the Chinese banking system, which would probably not be considered solvent if they accounted for impaired assets correctly, could lead to worse global issues. We do not think this is the most likely outcome. The Japanese 1989 crisis and 1997 Asian crisis did not cause a global credit crisis. We suspect that the current Chinese credit issues are most likely to be contained as were as in these two historical examples, albeit the Chinese credit levels are far higher than the Japanese and pre-Asian crisis levels.
A meaningfully weaker Yuan could be the result of a significant Chinese credit event. If this were the case, it could make their exports even more competitive on a global scale. Having one’s own currency and most of your debt in that currency, is like having a keel on a ship which rights you in the event of sideways tipping. Any weakness in the economy and you have a significantly weaker currency to allow you to become more competitive to recover.
If the Chinese Yuan significantly weakens, we may find some excellent investment opportunities in China.
Capital Independence
Our ‘safety first’ investment philosophy leads to constant checking of the risk levels in our portfolios, just like a pilot is constantly monitoring his or her instruments and checking their fuel. It should bring some comfort to our clients that a very large part of our ‘safety first’ philosophy is preferring capital independent companies. Companies that will likely never be forced to raise capital under duress. It must be stressed that this level of safety on the balance sheet and cash-flow is not the norm. More than half of the companies on the ASX raised capital at the worst possible time in 2009, permanently impairing shareholder’s returns. We think we should avoid this folly more than most with our unique ‘safety-first’ style.
At present, 90% of our portfolio has no net debt and spare cash. The few companies we own that have moderate debt, such as Unilever and Reckitt, have less cyclical earnings than much of the market and we still consider them capital independent. We are very comfortable in saying that we think our portfolios are far better than the market in terms of permanent safety of capital.
Most talk of risk as volatility. This is like a pilot worrying about in-flight light to moderate turbulence and not being concerned with crashing into a mountain.
We view risk as the probability of permanent loss. We strongly believe that investing in companies with net cash, that form majority of our portfolio leads to lower risk of permanent loss.
Having said that, we have invested in companies that are not capital independent in the past after they raised capital. Sometimes, companies that have just raised capital can be safe investments for a number of years and they can sometimes be bought for cents on the dollar. We bought Bank of America in 2011 after it raised capital at a price of only 40% of its book value. It is important to know where you are in the cycle. We can assure you this is not the bottom of the cycle and so we have been moving further away from economically sensitive companies that are trading at less than 50c on the dollar.
Capital Dependent Boom
As Charlie Munger always says, “Invert, always invert”.
The opposite of capital independent, is capital dependent. This means that a business requires the kindness of strangers to keep the lights on.
There is a boom in capital dependent companies right now. The fad of loss-making, cash incinerating businesses at nosebleed valuations in today’s market is red hot. We don’t think this trend is permanent.
The last time there was a capital dependent boom was the dot com bubble. The heady days of pre-March 2000 have some eerily similar characteristics to today’s market. Companies with no profit were able to raise enormous amounts of capital with simply a promise and a website. It is important to note that the dot com bubble crashed during low interest rates. Capital for growth funding became very difficult to source.
Today’s capital dependent companies are slightly more sophisticated, yet far worse in terms of cash burn. It is not abnormal to see companies burning billions of dollars a year to “grow”.
The irony of the disruption fad is that those disrupting with huge capital needs are able to be disrupted themselves with an even bigger cheque.
There is no doubt that some of these businesses will be future leaders. We think that it is Hunger Games odds trying to pick which ones will survive.
To quote Warren Buffett again - “You only know who has been swimming naked when the tide goes out”. If you own lots of capital dependent companies, you are likely in your birthday suit at full tide. Some will be lucky. Most won’t.
Synchrony Financial
Synchrony financial is the largest provider of private- label credit cards in the US. It partners with other firms to market their credit products in their physical stores as well as on their websites and mobile application. It counts Amazon and PayPal as their customers.
We first initiated a position in Synchrony a few years ago in the mid $22 range after significant share price weakness when the company announced the loss of their biggest customer Walmart. On thorough analysis, we calculated that the Amazon and PayPal credit card contracts should significantly outweigh the loss of the Walmart contract and they were likely to grow over the coming years.
Fast forward to 2021 and we have more than doubled our money in a few years for our earlier clients.
With these excellent gains, we have decided to trim our Synchrony position. We still believe that Synchrony has potential upside over the coming years, however it is a highly cyclical business with large customer risk and at this point in the cycle, we feel that it is prudent to reduce exposure and crystallise some of the gains.
Yandex
A rally in Yandex’s share price to its near all-time highs has allowed us to trim our exposure. Yandex is growing very quickly in a number of areas that are less obvious to us. Their marketplace, Yandex-Taxi (Uber) and delivery businesses are lower margin and higher capital-intensive businesses. We expect Yandex to continue growing quickly, with significant upside if their European robot delivery service becomes popular.
The price of the company is now at a point where there is less margin of safety. There is a risk that management extend too much capital to one of their newer growth areas with no profits to follow.
Whilst there has been a recent trend of the market to favour loss making businesses, our focus on “cash cows” should provide more than acceptable returns with likely less risk of permanent loss. Yandex is now less of a cash cow and more of a future promise company. We have found that owning companies that are already winners with high return on capital employed (ROCE) is a much easier way to grow your wealth over time.
Magellan Financial Group
We recently added to our Magellan Financial Group position. Magellan is a fantastic business which is significantly undervalued in our analysis. We expect significant gains from the current share price over the coming years.
Whilst their main global fund has recently underperformed, they have a long track record of outperformance. We think that any market weakness should highlight the defensive nature of the Magellan portfolios and maintain their outperformance over the long-term.
Their Australia- focused Airlie fund management business is growing solidly, with a significant outperformance year last year. Their infrastructure fund management business is relatively steady. We also expect their lower cost Core Series funds and retirement income fund, which were rolled out last year to gain traction. Given their solid investing philosophy and track records we opine they will continue to attract funds from advisers.
Magellan is becoming a diversified holding company. With now over $1billion in non-core assets i.e. private investments in investment bank Barrenjoey, Guzman y Gomez and FinClear. These investments have great potential to yield positive returns over the long run whilst providing diversification to their core fund management business, we see Magellan growing for decades to come.
We estimate that it trades at closer to 12 times next year’s earnings for the fund management business once the non-core assets are backed out and it is currently trading with a grossed up forward dividend yield of approximately 8.5%.
Magellan Financial Group will remain a far smaller position in our portfolios than our core holdings in Berkshire, Alphabet, Microsoft, Amazon and Facebook. Our weighting of businesses dependent on their safety rather than their upside is one of our strengths for building permanent wealth independence for our clients.
We hope that everyone is safe and well. We are excited to be able to resume travelling and meeting our clients in person in the coming months once the lockdown is lifted soon.
From the Team at Valor
Performance of Model Portfolios as at 31 August 2021*+
