Global stock markets have been fragile recently. Over one month, the S&P 500 index is down 3.8% and the FTSE 100 index has lost 1.9%. One worry for investors is the potential for a global economic slowdown, especially in growth engine China. For the past fortnight, China has been rocked by fears surrounding Evergrande Real Estate Group (SEHK: 3333). The bonds and shares of the property giant have plunged lately, on fears that the group may collapse. Here are five lessons for all investors from the fall of China’s biggest real-estate developer.
1. Evergrande’s debt is a crushing burden
Evergrande is one of the world’s most heavily indebted companies. It had total liabilities (debts and other obligations) of $305bn at mid-2021. As a leading property developer, it also has massive assets (totalling almost $357bn at the end of June). Nevertheless, the developer is close to default and last month missed a scheduled interest payment to overseas bondholders. Worryingly, October could bring one of the largest debt defaults since the collapse of Lehman Brothers in mid-September 2008. Unfortunately, even cheap debt can become hard, unforgiving, and a double-edged sword.
2. Liquidity is king
In many corporate crunches, problems caused by excessive debt can be solved by cold, hard cash. When times get tough, liquidity — the availability of cash and highly liquid assets — is crucial. Without cash at hand, a cash crunch can quickly spiral into a liquidity crisis where liabilities go unmet. When this happens, shares and bonds of cash-crunched companies can crash spectacularly. For example, Evergrande’s Hong Kong-listed shares are down more than five-sixths (-85.1%) over the past year and are currently suspended. So look out for liquidity problems within your portfolio’s businesses.
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3. Diversification can be ‘diworseification’
In its efforts to become a global giant, Evergrande undertook an immense spending spree. The real-estate developer became a conglomerate, acquiring dozens of unrelated businesses. The group has invested in electric vehicles, theme parks, food and beverage businesses — and even a football team. In 2010, it bought the club now known as Guangzhou Evergrande FC and then spent $185m building a vast soccer school. It’s also building the world’s biggest soccer stadium for $1.7bn. For me as an investor, lavish spending on non-core businesses has always been a red flag.
4. Evergrande’s asset sales become fire sales
With huge debts to service, Evergrande is raising cash by selling whatever assets it can. Right now, the company is in discussions “about a major transaction”. But when desperate, ailing companies rush to sell assets in a hurry, they have little room to negotiate. As a result, sale proceeds can be considerably lower than anticipated. Hence, in times of company or market crisis, it’s important to realise that panicked or sustained selling can trigger significant falls in asset prices.
5. All booms end in busts
Over the past 30 years, China enjoyed a massive construction and housing boom. Today, real estate contributes almost three-tenths (29%) of Chinese economic output. And house prices in China — as in many other leading nations — have soared this century. In the five years to 2020, house prices soared by roughly half (50%) across China. But with Evergrande now on the brink, worries about contagion are hammering China’s property market. What’s more, with empty properties with room to house 90m people, China’s housing market could be heading for a crash in 2021/22.
