Struggling To Find Value In The Market? Think Shipping

(Photo by Morris MacMatzen/Getty Images)

In a world where nearly every asset class is expensive by historic standards, the dry bulk shipping sector stands out as an exception. A spectacular industry collapse in 2015-2016 led to a fall in benchmark shipping rates of 98% from the previous high. Asset prices declined by more than 90%, and publicly traded dry bulk shipping company stock prices declined by 95-99%. That is what a bear market looks like.

Source: Fearnleys Shipping

Source: Chart and chart data provided by Fearnleys Shipping. “Dry Bulk Shipping Rates” is the Baltic Dry Index for Panamax class vessels. The Baltic Dry Index is the market standard for indexing dry bulk shipping rates. “Vessel Price Index” is the market value of a 10-year old Panamax vessel.

But times they are a changin’. This industry sector was recently brought to my attention by a Swiss-based value investor, and former Fidelity fund manager, Darren Maupin who points out that certain dry bulk shipping stocks offer a compelling value proposition. His firm, Pilgrim Global, helped to recapitalize New York-listed Genco Shipping & Trading in 2016 and also owns shares in Eagle Bulk. Maupin also set up a private investment vehicle last year with highly regarded UK investor Tony Mallin to take further advantage of the distressed industry conditions by directly purchasing vessels.

Maupin’s research shows the dry bulk value unfolding as in prior similar circumstances. It’s really a perfect storm for the industry. Conditions like this only occur once every couple of decades in shipping markets, and in fact, dry bulk today is similar to the oil tanker stocks in the late 1990’s. The tanker recaps that Maupin participated in during that time while he was at Fidelity, led to truly spectacular returns over the ensuing 5-7 years.

How did the dry bulk industry collapse?

On the back of the commodities boom and China growth narrative of the early 2000’s, dry bulk shipping enjoyed an epic bull market. Cheap credit and loose lending standards added fuel for what also became a historic ship construction boom. This construction boom ultimately doubled the size of the global fleet and led to vessel supply far outstripping more moderate demand growth. So, supply overwhelmed the fairly stable demand growth. The ensuing bust left many ship owners in violation of debt covenants or in outright default.

So what is the current attraction?

Asset prices are trading well below replacement cost and orders for new vessels have declined to the lowest level in decades. Scrapping activity – where vessels are cut up and sold piecemeal for their steel and equipment – has also been robust over the last 2-3 years. This has removed some of the excess capacity.

Many of the publicly traded companies have cleaned up their balance sheets by reducing leverage and restructuring their debts. Corporate overhead expenses have also been cut and corporate governance is improving. As a result, managers like Maupin are buying stocks at 1-2x normalized cash flow and at big discounts to replacement cost without taking a lot of balance sheet risk.

Source: Fearnleys Shipping

Source: *Chart and chart data provided by Fearnleys Shipping. “Dry Bulk Shipping Rates” is the Baltic Dry Index, the market standard for indexing dry bulk shipping rates. “Equity Price Index”, is a basket of dry bulk shipping stocks which consist of GOGL, DSX, and SBLK.

Even though the industry has gone a long way towards cleaning itself up from a corporate governance perspective, even Maupin extends a word of caution that there are still some questionable, self-dealing management teams. Investors need to be very discerning when allocating capital to the sector.

The story becomes even more interesting considering the significant capital constraints facing the industry.

Dry bulk shipping is a capital-intensive business. With more than 10,000 vessels in the global fleet and average useful life of 25-years, between 300-500 new vessels per year are required just to offset natural attrition. Growth in demand adds to this figure. Orders over the last 2-years have averaged just 50 vessels per year.

Traditional sources of industry financing are unavailable. European banks have been the primary lenders to the industry for much of the last century, and now are either completely exiting shipping finance or are reducing their loan books. Under Basel IV regulations, shipping loans will become much more capital intensive for banks. In practice, instead of the minimal down payment and 90%+ loan-to-value construction finance schemes of the last decade, prospective new vessel orders might require as much as 40% equity financing. And many owners will not be able to secure financing at all from the dwindling pool of available construction finance.

Lending restrictions are just one constraint on future vessel supply. The shipping industry is also facing a one-two regulatory punch with requirements to install costly ballast-water treatment systems beginning in 2018 to be followed by low-Sulphur fuel requirements that take effect in January 2020. In an industry reeling from years of losses, another $5-20bn of mandatory capital spending for the existing fleet will absorb capital that could otherwise go to reducing debt or ordering new ships. These new regulatory requirements will also encourage financially strapped owners to send more vessels to the beaches in Pakistan and India to be scrapped, rather than install these expensive systems in old vessels.

Supply constraints are likely to persist for several years, and the world is still hungry for dry bulk commodities. A recovery in charter rates would seem to be a question of, “when, not if.” In fact, charter rates have quietly started increasing over the last 12-months to levels where vessels can generate positive cash flow for the first time in two years. Stock prices have begun to move up, but in many cases, remain more than 90% below previous highs. Some dry bulk stocks even continue to trade at discounts to their private market liquidation values.

There are two other intriguing characteristics adding to the allure for me. First, shipping has historically been uncorrelated with financial assets. And secondly, shipping has also afforded investors an unusual form of geopolitical hedge. Shipping rates have benefited from wars and conflicts on the world’s seaways, including an occasional canal closure. In today’s uncertain geopolitical world, that might prove useful indeed.

Finally, historically-minded investors – which I count myself among – may consider Martin Stopford’s industry-standard text, “Maritime Economics” (3rd Edition), where no fewer than 23 shipping cycles dating back to 1743 are described. So here is your key history lesson for the shipping business: Bear markets have been the authors of bull markets. We suspect this time will be no different.