Saturday, August 1, 2009 8 comments ++[ CLICK TO COMMENT ]++

Is shipping attractive for contrarians?

Reader Plan Maestro suggested, in a comment to the shipping post I made, that shipping companies are attractive to contrarians. I thought I would examine the shipping industry because it is a good indicator of everything that has happened in the last decade. (BTW, Plan Maestro probably knows a lot more than me about shipping so this isn't necessarily directed at him.)

Shipping companies, for those not familiar, are companies that lease or transport items ranging from grains or iron ore (dry bulk), to oil (tankers), to diverse items such as clothing, electronics, etc in containers (containerships—railroads refer to this as intermodal transport).

I agree with Plan Maestro that shipping companies are contrarian. But it is also very dangerous and one needs to be pretty good with their bottom-up analysis. In some sense, investing in shipping companies is similar to investing in banks—or monoline bond insurers—last year. But the best comparison is to technology, media, and telecom companies after the bust in, say, 2001.


Similar to Dot-Coms of Yester-year

Similar to the tech companies, the shipping companies were in a massive bubble. The bubble has now burst and many of them are down 70% to 90%. Anyone investing in this industry needs to separate out the survivors from the rest. Just like how the boom in the late 90's attracted thousands of technology companies, and hence depressed the economics for all, a similar thing has occurred in shipping. Unlike a dot-com, it is not easy to start a shipping company so you didn't have thousands of new shipping companies. Instead, you only had a few new entrants it seems (I'm not an expert on shipping and don't follow the industry so this is just my impression.) However, the ones that did operate in the sector signficantly expanded capacity and purchased many new ships. As The Economist article in my prior post alluded to, some of the orders may be deferred or cancelled, but I still think we are looking at massive overcapacity. Given how ships are expensive, companies won't get rid of them easily (it's the same problem as factories in China.)

I think if you can pick out a few survivors with strong balance sheets—make sure debt is manageable—you may do well. It would be like trying to separate suvivors like Cisco and Juniper from also-rans such as Nortel, Lucent, or 3Com; or, for those more into service companies, it's like trying to pick Amazon or Ebay from the countless others who looked just as promising as Amazon but went bust.

Macro Bet is Another Possibility

You can also make a macro bet on shipping. This would entail buying numerous shipping companies (or an ETF if available) on the basis of a recovery. Any recovery in shipping would dependent on growth in China (probably needs to maintain above 7%), growth in USA (probably needs to be above 2.5%), or re-leveraging up of consumers in America and Europe—basically, anything to boost world trade.

I think I'm in the minority but I am bearish on the macro outlook. As I have said numerous times, I am still very concerned about China. Edward Harrison of Credit Writedowns recently picked up a story where Marc Faber is quoted as saying Chinese numbers are fake and are more likely to be 2%. Marc Faber says a lot of crazy stuff just for show but, ignoring the magnitude of the number (even a bear like me does not see 2% as being realistic), we should pay attention to him. As long-time readers of this blog know, I respect Faber, even if I disagree with his politics :), and he has been write more often than not (you may recall this June 2008 blog entry where I quoted him saying that stocks, real estate, and commodities were overvalued and he favoured US$). So the China situation is a huge risk for anyone going long shipping companies.

As for the US, which is the largest economy on the planet and drives most other countries, I do not expect strong growth. I think we would be lucky if we get 2% real growth for the next few years. It is always possible that growth may end up being high, but I view any such move as artificial and vulnerable to a downturn. For instance, if the US government transfers taxpayer money to bank employees and owners; or if it prints a ton of money or keeps guaranteeing the debt of questionable firms; or if it enacts further fiscal stimulus spending; it will see high growth (as much as maybe 4%). But that is all temporary. Overall, I think USA will see low growth.

Admittedly, I have been wrong on China for at least 3 years now, and based on the way the stock market is rallying, my outlook for USA may turn out to be wrong as well. In fact, shipping indexes have bounced strongly this year based on expectations of green shoots everywhere. So the above two points, although key, is something you need to figure out on your own.

But there is another reason I am bearish on the macro outlook for trade, and consequently shipping, and it has to do with the shipping itself.

How big was the trade boom and hence the shipping boom?

One of the problems for anyone taking positions in shipping companies is that the trade boom, and hence shipping boom, was once-in-a-century events. It seems hard to believe but I feel that the trade boom in the last decade (or maybe two decades if you want to stretch it out) is rare. I think the last time anything similar occurred was in the late 1800's or early 1900's. Obviously the world changes and it's hard to compared across a century but it does seem like the current situation is very rare.

One of the things Plan Maestro suggested was that China was growing near 10% for the last 30 years so what happened in the last decade may not be that different. We need to separate out the trade boom from China's growth.

Although China was growing strongly for many decades, the boom in trade only occured in the last decade. You need to get the timing right. Growth may be strong but if trade doesn't boom then shipping won't do well. This is similar to how, Jim Rogers has been correctly bullish on China since the early 90's but, even if you were Chinese and investing in the Chinese stock market, you made no money until 2005 (the Shanghai stock index actually declined until 2005).

To see how massive the shipping boom was, consider the following chart of the Baltic Dry Index (BDI) (courtesy wikinvest). The BDI provides just one frame of the picture. It tracks dry bulk shipping and may or may not be representative of other types of shipping. Nevertheless, I think it provides a good idea of the shipping boom.



China, as well as the world, had seen strong growth all throughout the 90's yet the index only skyrocketed in the last few years. The implication being that trade only boomed in the last 5 years.

On top of attracting more capacity, the spectacular rise in shipping costs probably kept afloat uneconmic or poorly-run businesses. I mean, it's like any other boom. There are many commercial real estate that was built in the last few years with pricing that makes no sense whatsoever—actually, if you assume money was cheap for decades, which it never is, then it made sense.

The difficulty I see with shipping is that one needs to figure out if a company is viable with rates that were prevalent pre-2005. Unlike the washed-up technology companies after the dot-com bust, shipping companies operate in perfect competition and it is possible that the worst shipping company sets the price for the industry. What's the competitive advantage of one particular company over another? I just don't see how one can pick off the survivors easily (apart from the balance sheet).

Anyway, good luck to Plan Maestro with his investments in shipping companies. It's certainly not for the faint of heart :) The P&F chart is not logarithmic so each box is equal to each other, so the collapse in dollar terms is spectacular.






SIDE NOTE:

I am not into technical analysis but I ran across the following daily P&F chart for the BDI index (from stockcharts.com). I have never seen anything collapse so quickly in my life :



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8 Response to Is shipping attractive for contrarians?

Daniel M. Ryan
August 2, 2009 at 11:57 PM

Myself, I saw several tanker companies in the low P/E, high yield set of stocks I watch. They've been pretty volatile, and I burned my mock fund with one of them.

On the other hand, oil never went through a shipping-boom bubble. Tanker rates have little to do with the Baltic Dry Goods Index, and most tankers are on long-term contract.

I found out the hard way, though, that being selective is crucial. So is exiting when things go wrong.

Sivaram Velauthapillai
August 3, 2009 at 4:56 PM

I remember some people investing for dividends (these companies pay as much as 10% in dividends) a few years ago, which is a huge mistake with these companies. I know you do a lot of work with low p/e stocks and maybe you should set up a cyclical p/e portfolio where you add cyclicals with very high (or infinite) p/e ratios. I following the thinking that cyclicals at very high P/Es are more attractive than when they have low P/Es.


Like you and StockmanMarc said, being selective and stock picking matters a great deal going forward. Two or three years ago, a blind macro bet would have worked (same with a blind bet on financials a few years ago) but the future is likely to be different.

As for your comment about oil, I'm far more bearish than you are. I have no idea if I'll be right but it is possible that oil set a long-term peak last year. If so, that would be a major top. Although the oil tankers may not have had the same size bubble as dry goods or containers, I still think there may have been a bubble. Even if capacity did not enter the market, it is possible the valuations are too high. If you look at something like Frontline (FRO), which I believe is solely in crude oil and related tanker shipments, its stock price certainly was in bubble territory last year. It's off about 66% from the peak but it's hard to say how cheap it is right now.

I also wonder about "long-term contracts". One needs to read through their official documents and make sure they are as solid as they appear. I don't follow the industry and have no idea how solid the contracts are. Let's not forget that if oil companies go bankrupt then the contract may be breakable in bankruptcy court. But even outside bankruptcy, I wonder about these contracts. I don't know about these contracts, but in completely unrelated businesses, I have seen capital goods orders and backlogged purchases, which seemed like solid contracts, dissapearing in the last year. I remember reading articles in newspapers in past years talking about the bullish backlog orders without ever pointing out how they can easily be cancelled under various conditions.

One thing I'm learning with this crisis is that a lot of what was taken to be "true" is not what it seems. Backlog orders may look good but they can easily dissapear. Contracts that were thought to be solid often end up yielding little, especially if the other party goes into bankruptcy.

Plan Maestro
August 3, 2009 at 6:45 PM

Sivaram (first name or last name?)

You can see the CSAV and Hapag-Lloyd cases for the difficulties in getting out of charters. These are very similar situations to Delta vs Pinnacle (they could not get out of those charters either). However, to sleep well at night is better to check the financial health of the clients.

Also, not all debts are the same and not all revenues are the same so you have to do a very good bottom-up analysis to invest in this sector. I am pretty confident (I hope not overconfident) with GSL. The REFI discussions are relative to the timing of the resumptions of the dividends and the reception of the Berlioz: not to bankruptcy. The banks are probably going to get a pound of flesh in exchange of achieving this goals but the cash flow potential has not been impaired. All the while the company keeps accumulating $0.23 per share PER QUARTER and when they resume revenues that would be a 65%+ yield at current price (!) .

Regarding revenues safety, 50%+ of CMA CGM charters end this year so they have A LOT of flexibility to adjust their capacity, flexibility that their competitors do not have. This pair is a clear winner in this environment. If you add that one of my all time idols bought at the reverse merger last year at prices closer to $7 just last September... George Soros that is a contrarian.

The stock jumped 33% the last 3 days on very high volume (4 times the average) and the news from the refi look very good.

PD: thanks for the nice EBAY, YHOO and AMZN memories. Three of my four buys in 2002. Sold them all right after the GOOG IPO. (2005?). IPOs are good sell signs and dividend cuts are good buy signs.

Sivaram Velauthapillai
August 3, 2009 at 9:28 PM

Sivaram is my first name so you can use that :)

How much debt does GSL have? I don't know if the Yahoo numbers are right (it seems different from Morningstar) but if they are correct, this is a dicey play. Yahoo reports debt of $590m while GSL's market cap is $86m and I'm not sure what its cash flow is.

On top of all the macro issues, debt is a risk with all the shipping companies. Frontline (FRO) has debt of $3billion vs market cap of $1.88b and equity of $700 million.

Having said all that, Frontline, just to use a standard example, has an unbelieveable ROE of 90%. So, if things work out, shareholders are going to make a killing. It's just that it is very risky IMO...

Plan Maestro
August 4, 2009 at 1:07 AM

Have not checked Yahoo or Google (and it to late to check my notes) but all the shipping companies have high debt. It is part of the business model and a driver of the booms and busts. Much more important is the qulity of the debt and the cash flow stability. The way I put it in Gurufocus:

"I am going to ruffle feathers, but I believe that leverage is part of the value equation when you have STABLE cash flows. If you can juice your ROE increasing your leverage WITHOUT COMPROMISING the sustainability of the company that is part of the competitive equation. Media and newspapers were the usual example, but fixed contract long haul pipelines, chartered shipping companies, hedged MLPs are other examples.

However, when I invest in that kind of companies I much rather get dividends than reinvestment and growth. Given the high ROE juiced by leverage, those are sectors prone to over investment and bubbles specially when there are no barriers to entry. So I much rather invest alongside management that is more conservative with the uses of cash flow given the aggressiveness of it sources (just check commercial real estate)"

Daniel M. Ryan
August 4, 2009 at 1:32 AM

Yeah, that's why I got into them in my Marketocracy mock fund. I had three more than now, and did get stuck in a couple of value traps, but the one I aim to keep is a dividend play. Its financials are hairy, but my interpretation of them suggests to me that this company will scrape up enough to keep paying its dividend. If you're interested, it's Ship Finance International [ SFL .] I should also add that I've plowed only imaginary dollars into it: no real money.

There were five tanker-shipping stocks I've bought for that mock fund; I've sold three. Here's a quick scorecard:

Of the three I sold:
- One got me a quick profit, of about 15%
- One got me a large loss, of more than 15%
- One got me a small loss, of about 8%. That one was Frontline.

Of the two I kept:
- One's got a small profit, of about 3%, but was well into 20%-loss territory at its low point.
- One, bought recently, has gotten me a decent profit of about 7%.

All in all, I just about broke even (in imaginary-dollars terms.)

I also got valuable lessons about doubling down in an industry, about how underdiversification develops, and about looking before leaping...

Sivaram Velauthapillai
August 4, 2009 at 10:50 AM

I am not a fan of debt but I dont' see any fault with your thinking. If you have stable cash flows, levering up a little bit may be ok. However, I'm not really sure shipping companies have stable cash flows. I think MLPs and othe rresource companies are more stable. You did your homework so maybe you did pick off a company with stable cash flows but it remains to be seen.

I don't know the business dynamics of shipping but one problem I can see is that the prices may be set by the worst company out there. Prices may fall simply because all the struggling companies are literally giving away their ships. Some of you have suggested that some companies have guaranteed contracts.

Plan Maestro
August 4, 2009 at 3:37 PM

Very interesting conversation Sivaram. Do not want to push the marginal costs beyond the marginal benefits, but here is other interesting issues about investing in shipping.

http://www.covestor.com/mbr/planmaestro/blog/34506

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