Boarding time approaches
For liquid investors with an eye on the medium term, investing in the maritime industry could be just the ticket, argues Marcel C. Saucy
The anticipated rebound from the shipping industry's 2008 crash has still to materialise. Four years later, however, market dynamics are improving, and an opportune time may have arrived to profit from a sustained rally of charter hires and ship values.
Shipping remains one of the least understood industries, despite its indispensable role in carrying 90% of all traded goods. At the market's peak, Chinese importers of Brazilian iron ore paid substantially more for transportation of their cargo than for the cargo itself.
Few institutions have meaningful exposure to the sector; fewer still understand its complexities. Shipping has therefore remained fragmented and controlled by private capital.
Demand for maritime transportation increases at twice the rate of world GDP growth, on average. The largest sectors are: dry cargo - currently 9,100 ‘bulkers' carrying ore, coal, agricultural commodities, fertilisers, or metals; liquid - 5,700 tankers transporting petroleum products from tar-like heavy crude to jet fuel; and container - 5,100 ships ferrying finished or semi-finished industrial and consumer goods in intermodal containers.
A misconception is that changes of charter rates, expressed through the Baltic Shipping index (BDI), reflect demand - thereby equating the BDI to the economic situation. In fact, supply is an equally important factor for pricing: current shipping lows are more attributable to excessive fleet expansion than to anaemic demand. This is primarily why the ClarkSea index of daily earnings of a broad array of ships crumbled from $47,000 per day in June 2008 to $8,732 in April 2009 ($10,600 by the end of April 2012).
Shipowners ordered too many ships in an uncoordinated fashion, encouraged by overly optimistic extrapolation of demand from emerging markets combined with excessively generous bank, bond and IPO funding.
Ship prices theoretically reflect the net present value of expected cash flows. A tendency to extrapolate frequently leads cash-flow projections made at the top of the market to overshoot reality, while higher confidence reduces the risk premium. Finally, even ships that have passed their normal trading life find employment in good markets, thereby extending the ship's projected life expectancy and theoretical cash flows. In poor markets these three net-present-value parameters are simultaneously adjusted in the opposite direction, causing highly pro-cyclical asset values.
The $103m price in December 2007 for a 10-year old capesize was 3.5-times the $28.8m paid in December 2002 for a five-year old. Along the way, significant earnings were also generated. Year-end daily charter hire for a capesize was almost $95,000 in 2007, versus operating costs of $6,500, producing more than $30m in net operating profits before financing costs. Conversely, the year-end value of a five-year old capesize fell from $148m in 2007 to $45.5m in 2008. Such loss was, however, reduced by robust 2008 earnings, as charter rates remained close to 2007 levels.
JP Morgan has calculated historical, pro-forma, unlevered IRRs from 1989 through 2009 for bulk carriers, tankers, and container vessels. It assumed that one five-year old vessel of each standard size per sector was purchased for cash, operated for five years and resold as a 10-year-old ship. As would be expected from a cyclical industry, dispersion of five-year holding period IRRs was high: for the dry cargo sector, returns ranged from a near 3% loss to an almost 90% profit, while tankers returned between zero and almost 60%. The average holding period IRR exceeded 19% for both sectors. No loss-making five-year periods were found for tankers, and the dry cargo sector generated only small losses in three out of 16 periods.
Average pro-forma historical returns are not reliable predictors of future returns. But they seem to suggest a low risk of loss from unlevered, five-year investments: ‘unlevered' being a key qualifier. Past shipping bankruptcies have primarily occurred due to lack of staying power resulting from over-leveraging and insufficient back-stop liquidity. These real-life constraints were not contemplated in the pro-forma calculations. However, an irrefutable conclusion of the study is that investment timing relative to shipping cycles is key.
But medium-term prospects for the industry look encouraging because of a slow-down in shipbuilding orders, cancellation of building contracts and postponement of delivery dates. While ships on order at June 2010 represented 60% of the actual fleet of bulkers and 28.7% of tankers, the ratios have almost halved to 29.5% and 15.7%, respectively.
Ship demolition is also helping: 25.6m DWT of carrying capacity was scrapped in 2010, 39.7m DWT in 2011 and 14.3m DWT in Q1 2012 - demolition is nowhere close to matching deliveries, but supply growth should subside while demand growth rises.
Sentiment is improving, according to Moore Stephens, an accounting and consulting firm. Its Shipping Confidence index has been recovering from its three-and-a-half year low of August 2011. Interestingly, the increase in respondents expecting charter hires to improve contrasts with a reduction in those planning to make investments this year. Investment capital held by traditional players is limited and dwindling. This would favour savvy, liquid investors looking for market opportunities.
There are essentially three ways to get exposure: public equities, shipping-oriented hedge funds and private equity. The universe of listed shipping companies is small and their liquidity is generally insufficient for institutional portfolios. According to Bloomberg, the largest 80 listed shipping companies had a combined value of $127bn on 16 March 2012 - which is less than one-quarter of Apple's market cap.
A number of maritime hedge funds generate exposure through long or short positions in listed equities, freight-forward contracts and/or actual chartering of ships. The non-directional hedge fund approach and the (general) lack of investment in hard assets may not be the best way to gain from rising ship values.
Arguably, for medium-term investors able to bear the illiquidity, the most promising exposure is ownership of ships through a private equity fund. Ships purchased near the bottom of the market should generate significant operating profits and capital gains as the market improves. Whereas public companies are likely to reinvest cash flow at ever-higher market levels, private equity ought to return a significant dividend long before exit. On top of the pure shipping aspect, a real-asset investment should also act as an inflation hedge, as steel prices influence ship values.
While the industry itself is highly transparent on a macro level, operating intricacies leave many opportunities for leakages at the commercial level. Crucial points for investors are: track record and reputation of the ship operator; alignment of interest between the investor, investment manager and ship operator; and tight control of all financial and operational aspects.
There are still clouds on the horizon. But as prices and charter rates tend to anticipate improving fundamentals, we may be fast approaching an exceptional opportunity to invest. If the recent experience is any guide, substantial returns will be generated from ships over the medium term. Provided the investment is not over-leveraged and adequate back-up liquidity is available to bridge an unexpected delay of the recovery, downside risk should be limited.
Marcel C. Saucy is senior partner with Zurich-based Fincor Finance