Valuing Fundamentals and Risk in the Drybulk Industry

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 |  Includes: DRYS, DSX, FREEF, OCNF, SBLK, TBSI
by: Erik Gholtoghian

Valuing securities: Where do I begin?

Over the years I have found that the market is the smartest acting set of knowledge out there. It incorporates the news you know and the news you don't know. But one factor, beta, seems to tell me more than anything else. Actually, beta is the co-variance a stock has with the market, which just means beta represents the total risk of the stock.

The higher the beta, the higher the risk of the company. My theory is that higher risk investments deserve higher return. In turn, I feel higher risk companies then need to have lower valuation ratios relative to their industries to compensate the market for such high overall risk, and low risk companies should have higher relative valuation ratios because they are safe.

In other words, high beta stocks should have lower PE ratios than low beta stocks, and vice-versa.

So now that you know my basic premise, I set out to analyze if there are truly undervalued and overvalued companies in the drybulk industry. My procedure was to first calculate each company's one-year weekly beta. For this type of study I don't like to rely on the 3-year monthly beta used by Yahoo Finance and most other providers, because I want a more timely measure that reflects more current events. Many changes took place three years ago that are no longer relevant today.

Then I decided which valuation metrics would be most appropriate for this industry. Because PE ratios are in many cases negative due to recent losses, and because earnings are so easily manipulated, I decided that the P/S and P/B ratios would be of most use.

Then I averaged the valuation ratios for each company and then took their reciprocal, which makes the fundamentals index in the table.

The main results of my study are presented below. In short, I divided the averaged valuation reciprocals by the beta (risk) to arrive at a ratio which captures fundamental value per unit of risk in the company. This statistic is very much like the Sharpe ratio or the co-efficient of risk CV, and I call it the alpha score.

As an example, you can see that DryShips Inc. (NASDAQ:DRYS) has higher than average risk, yet it also has higher than average valuations. My theory is that either DRYS needs to become a less risky stock (in terms of how it is traded) or it should be thought of as overvalued.

In contrast, TBS International (NASDAQ:TBSI) is the opposite case. The market has priced it with well below average risk over the last year, yet it has valuation metrics well below the industry.

So the results suggest to sell Diana Shipping (NYSE:DSX) and DRYS, and buy TBSI and FreeSeas (FREE). Star Bulk Carriers (NASDAQ:SBLK) and OceanFreight (NASDAQ:OCNF), on the other hand, are priced almost perfectly.

SELL

Company β α score Fundamentals index AVG P/S P/B
DSX 1.24 0.3 0.430 2.325 3.78 0.87
DRYS 1.94 0.4 0.823 1.215 1.9 0.53
Danaos (NYSE:DAC) 1.29 0.5 0.671 1.49 1.44 1.54
Genco (NYSE:GNK) 1.78 0.7 1.212 0.825 1.2 0.45
Navios (NYSE:NM) 1.92 0.7 1.418 0.705 0.87 0.54
Eagle Bulk (NASDAQ:EGLE) 1.55 0.7 1.156 0.865 1.28 0.45

Paragon Shipping (PRGN)

1.45 0.8 1.124 0.89 1.43 0.35
SBLK 1.34 0.9 1.149 0.87 1.38 0.36
OCNF 2.35 0.9 2.062 0.485 0.67 0.3

Euroseas (NASDAQ:ESEA)

0.68 1.2 0.794 1.26 2.01 0.51

Excel Maritime (NYSE:EXM)

1.44 1.6 2.273 0.44 0.62 0.26
FREE 1.27 2.8 3.571 0.28 0.39 0.17
TBSI 1.2 3.1 3.774 0.265 0.3 0.23
AVG 1.50 1.13 1.57 0.92 1.33 0.50
Click to enlarge

BUY

My theory is that traders know best. If the company is risky, it will be priced into the stock through its volatility and return. The only problem with the market being totally efficient is sometimes the beta (risk) and the valuation get out of sync, resulting in what I like to think of as valuation alpha.

It is never good to develop a model and follow it blindly. But after observing it and understanding what the model is doing -- and if you still agree that the results make sense -- a model can be very helpful in the valuation process.

My belief is that over the next several months, FREE and TBSI will outperform and DSX and DRYS will underperform. But don't stop with my opinion; develop your own even further.

Note: This valuation is in relative terms only. It is possible the entire industry is highly overvalued or undervalued.


Disclosure: I am long DRYS.

Additional disclosure: My study is so completely unbiased that I am actually holding a covered call in DRYS, which my model shows as a sell. I may cover the covered call at some point in the future if the model is correct.