Evergrande - just a storm in a teacup?

Chart of the Week

Source: Google Trends, 23.09.2021

The Google search engine often shows more than many think. With the tool Google Trends, you can see how often certain search terms are searched for. So you can also see what worries the investors around. 1-2 months ago, many investors were worried that inflation would come back. Even the word hyperinflation made the rounds. Now, almost nobody talks about inflation anymore.

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Why this is important:

Inflation is currently the biggest risk on the investment markets. High inflation would force central banks to raise interest rates. Especially now, when many companies are still suffering from the Covid restrictions, an increase in interest rates could lead to a global recession. The fact that inflation risks are decreasing is therefore very good news for investors.

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Evergrande - just a storm in a teacup?‍

At the beginning of the week, the markets came under strong pressure, as many market participants feared the imminent bankruptcy of the real estate company Evergrande, could trigger a global financial crisis like the bankruptcy of Lehman Brothers in 2007. 

A good explanatory video, about the business model and the problems of Evergrande, can be found here.

We consider the panic as exaggerated. The bankruptcy of Evergrande will certainly have an impact on the Chinese stock market, but will not lead to a global crisis. The Chinese government will have to cushion the social impact of Evergrande's bankruptcy in some way to avoid social unrest. The stock markets then also quickly calmed down and recovered.
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Positive surprise from the Federal Reserve meeting in the U.S.

The main driver of the strong stock market boom since last March has been the ultra-expansive policy of the U.S. Federal Reserve. If the central bank changes its policy, this will have a major impact on the stock market. Until now, it was assumed that the Fed would start changing policy in November and end its expansionary monetary policy in March 2022. Currently, the Fed buys USD 120 billion of bonds per month. A reduction in the amount is called "tapering". At the central bank conference on Wednesday, Jerome Powell, the head of the U.S. Federal Reserve, has confirmed the start of tapering for November. However, this should be in very small steps of no more than USD 15 billion. So the completion should not be in March 22, but at the earliest in September 2022. This is very good news for the equity markets.

In the two days following the announcement, interest rates nevertheless rose. So bond market investors are more skeptical than equity investors.

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Life cycle of companies

Investment success comes from investing in the right companies at the right time. The following chart shows how professionals go about this:

The chart shows the different phases through which companies move. At the beginning, many companies have very strong profit growth, but this fades over time. They change from stormy growth stocks to dull substance stocks. Many investors focus on published earnings and earnings growth when selecting companies. What many fail to consider is that companies can heavily influence this number with things that have nothing to do with the company's business. These include tax tricks, write-offs or acquisitions. It is much more helpful to focus on CFROI (cash flow return on investment). This valuation measure shows the success of a company from its operating business. 

An investor is now well advised to buy companies that are in the stormy growth phase (green circle) or have a consistently high CFROI (light green circle). 

Value investors, like Warren Buffett, focus on companies that have been around longer and are trading at a discount to the competition (orange circle). Their hope is that a change in strategy or chief executive will return the company to square one and begin a tumultuous period of growth.

All companies that lie between the three marked circles should rather be avoided as an investor. These companies are often well-known, but regularly disappoint with their published business results. The return is usually somewhat worse than the overall market. However, the return is always too good to sell, but too bad to be truly satisfied. Learn more about Cash Flow Return on Investment. ‍