Not long after the Fund was launched, we initiated a short position in Evergrande. This was done via our risk screening to offset a net long position in Chinese property stocks.
Since the start of this year, the size of the short position has declined in proportion to Evergrande’s share price fall. In other words, it has declined significantly.
We don’t initiate short positions or increase existing short positions if the cost of borrow exceeds 10%pa. Our view is that shares with structural or solvency issues that result in a cost of borrow which exceeds this threshold are best analysed by high conviction fundamental managers.
The rise in Evergrande’s cost of borrow occurred over several months. Similarly, the decline in Evergrande’s bonds – which even at par value had a coupon which was indicative of high risk – started earlier this year. Chart 1 shows the price of Evergrande’s USD 9.5% coupon 2024 bonds. It is worth noting that low risk companies don’t issue bonds with a 9.5%pa coupon and the bond was trading below par for a prolonged period.
Chart 1: Evergrande’s USD 9.5% Coupon 2024 Bond Price
Source: Bloomberg
Investors already knew that Evergrande was extremely risky. Its business model is akin to a Ponzi scheme, requiring prepayments on unbuilt apartments to fund its business expansion.
Given this, it is surprising that the market reacted with such shock and awe to Evergrande’s demise. It had been well telegraphed.
What does the negative sentiment associated with Evergrande mean for the Fund?
The impact thus far has been negative. The Fund has a small net long position in Chinese property stocks and, as we’ve flagged in previous market insights, a net long Chinese equities position (largely offset by a net short position in US futures).
With regard to the first issue, numerous Chinese property stocks satisfy our Long Value screen. They look cheap based on numerous valuation factors and several stocks – not Evergrande – satisfy the certainty and quality criteria.
As part of our “micro” non-systematic overlay, we have favoured stocks which comply with the “3 red line” limits mandated by the People’s Bank of China and the Ministry of Housing. Our longest position – China Overseas Land and Investment (688 HK) – comfortably exceeds each limit and is a potential beneficiary from distressed property sales which may occur due to forced deleveraging.
A collapse in Chinese property prices would adversely impact all property stocks but this is unlikely to occur. The Chinese government has been attempting to reign in property prices and can relax the restrictions which have been imposed. A measured decline in property prices would likely be welcomed, but a sharp decline would destabilise the economy and likely be met with an aggressive policy response.
Of more concern is the Fund’s net long exposure to Chinese equities. It has materially detracted from the Fund’s performance and is at the outer limit of what we will tolerate from a risk perspective. Given this, we are constantly reviewing and assessing the positions in our Chinese equities portfolio.
Since Evergrande has dominated market sentiment, we have reduced our net long exposure to Chinese stocks which rate poorly based on our debt protection factors and increased our exposure to Net Cash Alpha stocks which have been dragged down by the anti-China sentiment. (For more information on interesting stocks which satisfy this screen, refer to https://www.oqfundsmanagement.com/post/net-cash-alpha-stocks).
In the short term, the negative sentiment associated with Evergrande will weigh on all Chinese stocks. Even if this doesn’t improve, investors will become more discerning and we believe the portfolio is well positioned to benefit from more rational price discovery.
It is also worth noting that despite the extreme underperformance of Chinese equities over the last few months, the Fund has been able to withstand the performance impact. Stock selection has generated significant alpha and our investment process is generally working well.
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