China Evergrande Disaster: Protecting Your Portfolio From Over-Leveraged Companies

After seeing China Evergrande (EGRN.F 46.15%) on the edge of financial collapse, investors may be wondering if any stocks in their portfolios are vulnerable to a similar risk. In this video clip from "The 5," recorded on Sept. 24, Fool.com contributors Brian Withers, Jason Hall, Neil Patel, and Demitri Kalogeropoulos discuss the importance of diversification and other essential strategies for long-term investors. 

Brian Withers: Question number 2, the China Evergrande auditor. If you're familiar, I don't know if, Jason, you've talked about this topic this week, I certainly haven't, but China Evergrande, what they call, got a little bit over its skis, got a little bit of aggressive with its debt and tried deduce its growth, and it got into a bit of a bind. It's in disaster mode and teetering on the edge of financial collapse, weighed down by almost $89 billion of debt and total liabilities in excess of $300 [laughs] billion. This is a disaster for investors. Let me just say that. Hopefully, none of our Fools out there are Evergrande owners. What's interesting is similar to other disasters, their auditor came in, and gave them, they said, "You guys are fine." Unless you were paying attention to the tea leaves and stuff, there wasn't necessarily a canary in the coal mine here. How should investors avoid this situation? Do you look at the balance sheet, cash flow and debt in your investing decisions? Jason, let's take you first.

Jason Hall: I think it's a good starting point. This is one of the reasons why I do invest so broadly. Because at the end of the day, Brian, you own what, 19 stocks now, or are you up to 20?

Withers: Twenty. I'm up to 20.

Hall: Wow.

Withers: I bought a REIT, dude.

Hall: Oh yeah, that's right. I knew that. I think it's one of those things unless you really have a pretty substantial amount of time, like a lot of us do, you spend your job is to do security analysis where you can really understand companies, the industries they operate in, spend the time to really get to know those businesses so then you can have a concentrated portfolio. Frankly, most of us can't do that. We just don't have the time. I think one of the best ways to think about avoiding that risk is by being diverse enough so that maybe a full position is one or two percent of your cost base is in a company. If things go badly, you still have 99 percent of your cost basis, so your downside risk is minimized by that.

But I think also you do have to look at it from business and industry. For example, I own a lot of real estate stuff, utility companies that have a lot of debt, they take on a tremendous amount of debt, but they own long-term assets, that the debt is often secured by those things. It makes it more palatable, because there's a clear cadence and usually they get favorable debt terms and it's long term before its maturity and that kind of thing. Now, a software company on the other hand, I wouldn't want to see a lot of debt because they should have a pretty lean profile, and they should have cash margins and their business should be pretty lean. They shouldn't need to take on the same kind of debt.

But with that said, you have to not let it be an excuse to buy a highly leveraged company in a leveraged industry, just because it's an industry that has a lot of leverage like AdLearn, for example, I know a lot of Stock Advisor members probably learn to with Seadrill, for example. Seadrill Limited was the offshore driller that went on a very aggressive building spree, took on a tremendous amount of debt to do it and then the oil market crashed. The company has actually gone through bankruptcy at least twice and I think is about to go through it a third time in a five-year period. A couple of things, so diversifying, and also thinking about industry within industry when it comes to leverage, and then not letting the excuse of this is a leveraged industry cause you to invest in a company that is too leveraged, so you manage it through those cadences.

Neil Patel: That's a good point, Jason. I also like to dive into the balance sheet and the financial flexibility of the business because you want to have a company that can handle what happened over the past 18 months. You want to company that can handle what happened in 2008/2009. One thing I really look at is the cash position of the business and compare it to the company's total long-term debt. I also like to look at the interest payments and if the company is producing enough cash flow where let's say there is a meaningful hit to revenue, would they still be able to cover those interest payments?

An example of a company that fits this description for me is Etsy. Etsy, they actually have a net debt position. They have 2.3 billion in debt on their balance sheet and only two billion in cash. The reason why I'm not turned away by that company is because if you look at the interest payment, it's trivial. All of Etsy's debt is convertible notes, so it's like less than 50 basis points of interest that they pay. If you look at their cash flow, Etsy producers 25, 30 percent operating cash flow margins, which is just ridiculous. That's a company that has more debt and cash on its balance sheet, but if you dig deeper into the financial statements, you'll see that they can whether whatever storm just on their way. It's because of that low interest rate on that debt, it's because of that high operating cash flow margin.

Conversely, I think if you would've looked at Netflix, let's say 10 years ago, you would see a company earning through cash, you'd see a company borrowing a lot of debt, but you might be turned off from that company, but that situation where taking on debt at historically low interest rates was a good move for Netflix. Like Jason said, if you understood and had the time to really dive into the business and understand what management's long-term goal is, you would know that taking on debt and creating content and acquiring customers was the right move. But it all comes down to how much time are you willing to put into this? How much volatility can you handle. If you can't do that then diversity is the way to go.

Demitri Kalogeropoulos: Yeah, Neil, I agree. I think there's a lot of examples of companies using debt in good ways. I was looking through the Evergrande's stuff recently, I'm no auditor or accounting major, but I'd like to think that I saw the stat here today, that 42 percent of their debt, that's $37 billion, was set to come due within one year. That's just pretty amazing to me, that's quite a debt burden that I would probably put on the front sentence of every quarterly release if I was a company like that. [laughs] I would say, "Oh, by the way, we have $40 billion of debt coming due within the next 12 months."

But get to your point there, that's a reminder to me that that's another reason to like we've been saying invest in companies you understand. There's so many I would stay away from. Before I go into an international business in a market, I don't quite understand what debt instructions and debt markets I don't necessarily understand regulatory, things that I'm not really clear on. I would stay close to an industry, I do know or when they makes sense to me, or maybe a company that I deal with personally.

A great example I like to have here is Home Depot. Obviously, everyone knows this, a huge retailer, the leading home improvement retailing giant. They've been taking on debt pretty steadily every year since 2014, a few billion dollars. But not because they need to. Home Depot, their earnings have been ballooning over all that time. Their margins are going up, their sales are going up, cash flow is amazing. But management has been prudently using debt at historically low rates, close to zero percent for a lot of that time to fund things like capital return programs and stock buybacks. Not super aggressive, but just in a balanced way and I call that just good effective capital efficiency, and that shows up in Home Depot's amazing metrics like return on invested capital. It's one of the highest in the entire industry, if not the whole stock market. Companies like that are great. Home Depot did not disappear then fold up during the Great Recession when sales dropped 40 percent for several years, and it's not likely to fold up using aggressive leverage. Now, you've got to trust the management team a little bit, but it's companies like that that I think I would start looking at before I branched into more aggressive plays.

Withers: Go ahead, Jason.

Hall: Brian, I just wanted to take a second and Neil was talking about Etsy. I just want to do a visual here of exactly what Neil was talking about, the cadence of how it's added dept to its balance sheets. Because it's easy to see these things and if you're not following Neil's explanation of the cash, thinking about their entire balance sheet and the expenses and the implications, it can make you walk away from things if you're too focused on the debt. This is just like looking at Etsy, how its debt has grown.

Again, $2.3 billion in debt, and then again to Neil's point, look at that, the cash has just grown essentially right along with it. If you were ignoring that, the fact that the company is raising debt, but its cash flows and it's retaining some of that cash at the same time, it would be easy to assume well, maybe this is a company that's, this is not necessarily in the right direction. Now, can you guys see this next chart? This is what Neil was talking about in terms of its interest expense, $22 million a year, roughly. That's nothing. Then the investments that the company is making into building out its platform and growing sales, this is what its operating cash flow is doing. Operating cash flow is surging. Excess cash that it's generating to service its debt is enormous. The company, again, Demitri, you were talking about those current maturities of debt over at Evergrande?

Kalogeropoulos: Uh-huh.

Hall: Guess what, Etsy doesn't have any debt that's maturing this year, so having a good ladder of managing its debt maturities is a really important part of it. Neil, I love Etsy, I think it's great. Then Home Depot too, what they're doing is essentially the exact same thing in a more capital-intensive business.

Patel: This ties perfectly into the previous question that we discussed, investors like us at the Fool, wondering who in their right mind would want to invest in Chinese Evergrande. But then you realize that these investors are playing a different game than you are. It's plain and simple. That somebody looks at that company, on every side of their transaction, there's a buyer and seller and so that's the perfect example of what we talked about previously, where people just have a different time horizon, have different goals and that applies to your investing decisions.

Withers: I also wanted to point out where our members can find out about this information. I pulled up Etsy's latest SEC filing and it's called the 10-Q, which is the quarterly one, and the 10-K, which is the annual one. Just show you a little bit, you search for the word debt and I get to this note 7 debt section and talks about the 2021 convertible debt. They have capped call transactions, their 2020 debt, their 2019 debt, and their 2018 debt, and then you can see a schedule here. This is what I was looking for, is when is things coming due and how is it spread out and you should be able to see that. Jason made a great point about comparing interest payments to cash flow and things like that are other good ways to see if the debt is sustainable.