The shipping business would seem to be directly linked to the health of the world economy. Why would you want to invest as the world slows down? Lynn Strongin Dodds finds that it is not that simple
Shipping has never been an easy asset class to navigate. Many believe that there is too much attention paid to the Baltic Dry index (BDI): some view it as a bellwether for economic growth; others are more circumspect about its reliability as a leading indicator. All agree though that investors should take careful consideration of the wider industry trends before testing the waters.
“The BDI is constantly being misused and misinterpreted,” says Tony Foster, chief executive officer of Marine Capital, a shipping investment management company. “It has a limited functionality within our own market, but people outside the industry draw the wrong conclusions. We conducted research last year that showed that from April 1989 to June 2010, there was little correlation - 0.179 - between the BDI and the OECD Industrial Production index.”
It is easy to see why the BDI, which measures the cost of shipping commodities, is often touted as a weather vane for the health of the global economy. The index constituents - dry bulk ships along with tankers and containers - account for over 80% of the tonnage of world trade, from iron ore, coal and grain products to fertilisers, steel, scrap iron, cement and petroleum coke. An increase in the index could be taken as a signal that the economy is on the move but Marine Capital’s research shows that while it may have forewarned of a downturn ahead of Q4 2008, it missed the cyclical peaks of 2002 and 2007.
This perhaps explains the mixed response to the index’s strong performance through August and September 2011 (see figure 2) - up around 50% - while the euro-zone crisis was wreaking havoc in financial markets. Despite the jump, the index, currently trading between 1,800 and 2000, is still a far cry from its peak of 11,440 in May 2008. In addition, Capesize container ships, the biggest vessels and the largest components in the BDI, benefited from the recovery of Australian iron ore exports in the wake of the January floods (Australian ports were so badly disrupted that mining giants such as BHP Billiton and Rio Tinto declared force majeure in the Australian state, a legal clause allowing them to stop contracted sales).
Aside from weather-related events, changes in trading patterns, inventory management, port delays and or/political disruptions can also take their toll. However, the biggest issue overshadowing the industry today is a supply/demand imbalance. As Tim Coffin, investment manager at Global Maritime Investments puts it: “The BDI does not just represent whether cargo is moving but also fleet supply versus demand and general macroeconomic factors. The industry is now being affected by an oversupply of ships that were ordered towards the end of the 2004 to 2008 boom. These ships are coming into service now, when there is a general reduction in cargo demand per tonne of shipping capacity, which is depressing rates.”
Doug Mavrinac, head of the maritime group at Jefferies adds: “Shipping has always been cyclical and fragmented with significant peaks and valleys. Investors have to be nimble and look for the entry and exit points. This is not a buy-and-hold sector. At the moment the biggest problem is that supply levels are at record levels and there is not the demand to absorb the extra capacity. We believe that supply will not reach more normal levels until 2012.”
Thanks to an aggressive use of leverage, the world’s shipping fleet swelled during the halcyon years. Figures from Hellenic Carrier show that the global dry bulk fleet is expected to grow by 12-13% this year. The overhang of new vessels is not expected to correct until into 2013. Some market participants had hoped that China and India’s respective economic engines would offset the oversupply - China imported 63% of all seaborne iron ore trade so far this year - but neither economy is immune from the global economic tailwinds.
The other related problem, according to Marine Capital, is that the supply and demand for ships is price-inelastic: small changes on either side will cause huge price movements. This why the BDI can be extremely temperamental - swings of 50% on the upside and almost 100% on the downside are not uncommon. On the demand front, this could be because if there are large shipments slated to go to Japan and China, there is little room to delay the shipment or change routes or mode of transport. On the supply side, ships can’t be quickly turned around to different routes or brought into service in response to price changes.
Although this might not be an ideal time to take the plunge, market participants do believe investors can find some interesting prospects. Ryan Bisch, principal, director of exotic alternatives at Mercer Investment Consulting, notes that shipping can be an attractive opportunistic investment option for investors with an appetite for private equity-like risk and illiquid assets. “However, it is important to note that it should form part of a diversified alternatives investment portfolio and that the success relies on the ongoing recovery of the global economy,” he adds. “As with the majority of investments, there are risks attached. Shipping in particular is not a homogenous market. It has different market segment, such as dry cargo and tankers, and they each might be operating at different stages in the cycle.”
Bisch thinks that the opportunity exists for investors to acquire vessels at valuations significantly lower than the pre-financial crisis peak. “This provides investors with the opportunity to generate a modest cash yield while they wait for the world to return to growth conditions and benefit from higher asset prices for the vessels.” According to Mercer’s research, a net internal rate of return of 18-25% or more can be achieved, although these high returns are dependent on partial recovery in underlying vessel asset prices.
As for gaining exposure investors can pursue different avenues including investing directly or via the futures markets as well as taking charge of the management of the ships and their freights. Listed shipping companies are also an option, but they will be subject to stock market vagaries.
“Assuming that an investment in shipping is a proxy investment for world trade growth, many investors buy shipping equities,” says Coffin of GMI. “However, equity investments are not direct investments into trade growth. They are buying into a company’s management style and strategy. The trick is to have strong risk management. Although, we do not see the BDI as a proxy for global growth we do believe that the shipping trade is a good indicator of where the action is in the economy.”
In terms of funds, Global Maritime Investments trades in physical and derivative bulk shipping markets. It captures the spread between the physical dry bulk and forward freight agreement (FFA) markets. The firm also recently launched the Global Maritime Assets fund, which aims to buy ships and operate them on a low-risk strategy of long-term leases or time charters.
Marine Capital on the other hand has Eclipse Shipping, a closed-ended fund which invests in cargo ships. Foster also believes investing in the sector can be a proxy for direct investment in the emerging market growth story without the same risk. “For example, China is in the middle of a significant urbanisation programme with the building of roads, bridges and power plants,” he explains. “Investing in the infrastructure projects directly can expose investors to sovereign and local issues as well as politics and possible corruption. However, investing in ships that carry the materials is another way to benefit from China’s industrialisation.”
Whatever investment route is taken, Mavrinac believes “investors will need a long term view, a strong stomach and patience. He suggests buying now at the cyclical trough and waiting for mid-2012 until the supply/demand imbalances improve. “Unlike other asset classes, shipping is about buying in anticipation of an event and then having to wait for it to happen,” he says.