Real estate developer China Evergrande has been a source of volatility in recent weeks, as the market gauges the economic fallout if the company defaults on its debt and the government doesn’t step in to help the struggling firm.
Like any investor, we hope the company’s problems are not a source of contagion for global markets. However, the firm is an example of the stocks we typically avoid, and its troubles reinforce the importance of several key tenets of our investment philosophy that lead us away from such companies. A few of those include:
Stay domestically focused: We believe its important to know management teams and understand the regulatory environment in which they operate. As such, our strategies are focused on U.S. businesses. We rarely venture into international markets where it is harder for us to know the business as well as we would a U.S. firm and management team.
Avoid leverage: Bloomberg has described China Evergrande as “the world’s most-indebted developer.” At Prospector, we don’t perceive high debt levels as a yellow warning light, but rather a screaming, flashing red. Over the long term, avoiding highly levered companies tends to pay off when liquidity evaporates and the company’s access to capital markets becomes more difficult, or outright disappears. This is exactly the risk China Evergrande faces and could continue to face in the coming months when more debt payments are due.
Always ask … What can go wrong? Our entire investment process revolves around limiting downside risk. We believe the path to outperformance over a full market cycle lies in minimizing losses so that we can compound returns over time. This is why we have tended to outperform in down markets.
On a stock-by-stock basis, we seek to earn $2 of upside for every $1 of downside in each investment and avoid stocks where we believe there is more than 25% downside. In short, our focus is first on what could go wrong with a company, not what might go right. And when a company is highly levered, and operates in an international market where we have less visibility and less access to management, we believe there is more potential for things to go wrong.
To learn more about how we invest, explore a Q&A from our portfolio managers. Topics include:
- Tips on avoiding Wall Street group think
- How we generate investment ideas
- Why our approach to equities is similar to high-quality bond managers