Global Shipping Stocks - A Distressed Industry In Transition

| About: Guggenheim Shipping (SEA)

The global shipping industry has gone through a severe boom and bust cycle over the last decade. Driven by above average growth of world trade volumes in the economic boom years up to the global financial crisis in 2008/09, overoptimistic shipping companies and generous lenders have invested heavily in new freight capacities. Then the global financial crisis suddenly caused demand to disappear. An uptick in global trade in 2010 brought short-term relief, but since then growth in trade has been again dismal.

The industry now faces a supply glut not seen since the last crisis in the 1980s. Shipbrokers estimate that there is a 20% oversupply in the global fleet, especially in the dry-bulk, container, and crude oil tanker segment. And the outlook is not rosy. Orders that have been made in the last decade are coming to the market now, adding even more supply. What is more, freight lines trying to cut costs are currently increasing orders for ships with more fuel efficient technologies. At the same time, plummeting metal prices have reduced the incentive to scrap old vessels.

This massive oversupply has caused freight rates, the determinant of revenues besides shipping volume, to collapse at a time of rising fuel prices, which account for 60-70% of costs. The decline in revenues and increase in costs has squeezed operators' margins heavily. Indeed, all but 7 out of the 30 biggest shippers lost money in 2012 and cumulative losses in the industry over the last 4 years amount to around USD 7 billion. Besides, additional cost pressure is common from tightening emission rules, most likely harming especially companies with old, 'dirty' fleets. This stands in stark contrast to ever growing record earnings seen during the boom years.

Unsurprisingly, shipping stocks have collapsed during the financial crisis and never managed to recover. For example, the DAXglobal Shipping index, an index that tracks the leading publicly traded companies in the industry, has lost more than 70% from its peak value in 2007. Since hitting a low in early 2009, it has returned a mere 30% whereas leading global equity indices have rallied.

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An unprecedented crisis like we can see it in the shipping industry is exactly what contrarian Investor look for. Dismal performance over numerous years, unprofitability, a clouded outlook for years ahead and a pessimistic media sentiment on the industry have historically usually led to low priced in expectations. Low expectations are easily beaten and guarantee outperformance going forward. Indeed, it's reported for years now in business media that the shipping sector is seeing a supply glut, thus it's hard to imagine that the negative fundamental trend isn't already priced in. Consequently, the shipping industry is highly likely to eventually follow historical patterns and surprise pessimistic investors as they adjust for the new industry environment and manage a turnaround.

My preferred investment vehicle for European investors to profit from the inevitable turnaround is the ETFX DAXglobal Shipping Fund (ISIN DE000A0Q8M45) which tracks the DAXglobal Shipping index. In the US, the Guggenheim Shipping ETF (SEA) is a convenient way to gain exposure to the industry and has a comparable composition as the DAXglobal index. The DAXglobal Shipping index comprises the 20 largest and most liquid publicly traded companies in the sector having a market cap of at least USD 500 million. The sector distribution within the industry is tilted heavily towards shipping lines, with the biggest 4 lines accounting for nearly 60% of the total index. The low share of engineering companies should be strongly positive for the performance of the index as the volume of orders for new ships will likely decline in the coming years.

As around 90% of the companies in the index are located in countries with highly developed capital markets, mainly in Japan and Singapore, they should have a substantial competitive advantage against smaller competitors based in emerging markets when it comes to funding. Indeed, European banks, which have historically financed around 90% of the sector, are strongly scaling back their support now, which will make access to capital markets crucial for survival and growth in the on-going consolidation within the industry.

Besides finance, strategic planning and managerial capacities are the other key determinant of success in the bleak environment the sector faces. The leading companies should clearly have a big advantage and more experience here. On the one hand they have better economies of scale, which are key success factor in the nasty cut-throat competition that is gaining momentum. Moreover, all 4 leading shipping lines are strongly diversified vertically and horizontally, offering integrated services that clearly distinguish them from smaller competitors.

Since operating revenues and costs in the industry are mainly incurred in USD, the profitability of shipping companies in their accounting currency is heavily influenced by the performance of the respective currency against the USD. This offers a big advantage for international investors. While exchange rate movements impact translational profits of shipping companies and in further consequence the stock price, these currency movements at the same time impact the home currency return of foreign investors, therefore offsetting the exchange rate impact. Consequently, mainly the performance of the investor's home currency against the USD matters.

As volatile profitability is highly likely in the years ahead, a strong financial position is crucial to survive short-term, intermediate setbacks in earnings. Due to unprofitability over the last years, the 4 largest companies in the DAXglobal index now face all a relatively tight liquidity situation. With current ratios of around 1, there is not much room for a decline in operating cash flows. Nevertheless, positive is that cash plus short-term investments exceed short-term debt at all companies, so they would be at least able to service the most dangerous form of liabilities in case of a slump in operating cash flows. What is more, the majority of costs are variable and thus a rapid debt build-up during a demand crisis could be avoided. To sum up, the biggest companies in the index show financial stability only in the short-term, an extended decline in operating cash flows for numerous years would eventually cause a default of the biggest companies in the index as longer-term debt matures and a roll-over during an industry wide crisis might be impossible.

Besides the short term financial stability of the index companies, a close look at the underlying macroeconomic risk factors is essential to identify possible threats. As the supply trend of shipping capacities is highly static over the mid-term, global trade volumes are the sole determinant of shipping lines' revenues. Trade in turn is strongly positively correlated to global growth as history shows. Besides revenues, global growth also indirectly impacts costs through fuel prices. So the positive correlation of profitability to global, growth both on the revenue and cost side, cancels itself out to a limited extent. Strong growth increases revenues but also drives fuel prices up, limiting the growth in profitability while slow growth in turn should depress both revenues and fuel costs, limiting the downside. Admittedly, fuel prices are less elastic on the downside than on the upside, so the correlation to global growth is expected to be asymmetric rather than linear, nevertheless, should be clearly visible through extreme scenarios, i.e. an economic shock event.

The channels through which global growth impacts demand for shipping services are numerous. First, the availability of trade finance is typically highly cyclically for banks are more willing to lend during boom times than in recessions. Moreover, during tough economic times, societal pressure often forces politicians to turn towards protectionism since it's believed to help local economies. In fact, reports by the U.S. Trade Representative and by the European Commission confirm increasing distortion of global trade through new trade barriers, directed towards both nations, since the financial crisis. The further trend in global growth will clearly decide whether the trend towards protectionism will pick up momentum.

Beside these political trends, a reversion of the globalization of manufacturing supply chains may become visible. Numerous economists believe the trend towards offshoring in manufacturing will be reversed as the US is seeing a substantial decline in energy costs, increasing competitiveness of labour costs and the emergence of 3D-printers. Should these predictions actually realize, trade flows from emerging markets to the US will be significantly depressed while it's unlikely that growing flows in the other direction can avoid a decline in total trade volumes.

Another substantial tail risk is the slowing trend towards physical investment in China. The Chinese investment boom of the previous years and the corresponding appetite for raw material imports has strongly fuelled international trade. As the Chinese state is now planning to reduce the state's role in the economy and is shifting to a more consumption driven economic model, imports may be under severe pressure.

Although there are numerous threats ahead for the sector, there clearly are substantial opportunities out that can help the industry to recover. While trade between the largest developed economies and emerging economies may indeed slow down as outlined, intra-regional trade within emerging economies, especially in Asia, is expected to grow strongly in the coming years. Furthermore, the natural gas boom in the US is expected to boost global LNG trade as soon as export facilities are built. The leading companies in the DAXglobal Shipping index are already active in the field of LNG shipping and thus will profit from the trend. Besides, the emergence of a new, shorter trade route from Asia to Europe through the Artic Sea north of Russia may boost trade due to faster shipping times and lower costs for customers. In the Americas, the USD 5 Billion expansion of the Panama Canal will open new options for inter-regional trade as well as a direct connection of the US East Coast with Asia that will grab market share from road and rail transport within North America.

To sum up, numerous tail risks undoubtedly exist. Global growth will be the key determinant of the shipping industry's fortunes, but the emergence of new trends actually highlights the longer-term opportunities in the industry. Nevertheless, as shipping stocks have appreciated at the same time as popular business media is increasingly reporting about the tail risks described above, it's difficult to assess whether the market has discounted them appropriately already. Even if the strong relative performance of more than 30% over the last year and a significantly positive deviation from the index's 12 month SMAvg usually are a positive sign for a continued outperformance, an immediate investment seems too risky. I would rather wait for a decline of 10-20% from current levels as it increases the likelihood that tail risks are being priced in. After such a significant correction, the downside risks of a bet on the long-term turnaround of the shipping sector would be minimized.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.