The traditional value investment process is fascinating in many ways. The idea that a well-trained financial wizard can dive into inches thick financial statements, find the unquestionable intrinsic value in a company and profit by buying the stock has been a motivator for many professional analysts over the years. But soon after the first tries it becomes evident that in order to be successful a value investor needs one of the two conditions: either a trigger that would "unlock" the value or unwavering patience and financial stamina to wait for one to appear in the future.
The shipping industry, with its extreme cyclicality and the current dire state is a case in point. The global container shipping industry is in flux (Supply Chain Quarterly), with overcapacity, slow growth in demand and the resulting low shipping rates plaguing the industry (a good SeekingAlpha article).
It is not surprising then that the doldrums in the industry produce very exciting valuations: P/Es as low as 2x should attract sufficient attention from the value investors.
Source: Google finance Click to enlarge
The problem is of course that there are reasons these companies are trading at such low multiples: many of the long-term vessel charters are up for renegotiation in 2017 and if the shipping rates do not change for better, the new charter rates will translate into significantly lower earnings.
(click to enlarge) Source: Shanghai Shipping Exchange
But if this is the case then our hunt for a trigger turns into a hunt for an appropriate valuation - it is clearly wrong to price these assets on the back of their current intrinsic worth. In other words, if the trigger is what "unlocks" value, is not trigger then the value itself?
Let's run a parallel: if a large office block is built next to a sandwich shop, providing a steady stream of new customers, was it the intrinsic value of the sandwich shop or the fact that an office block was built? Would you buy a sandwich shop and wait for someone to build an office block next to it, or would you rather try to guess or find out where they will build the next office block?
As it happens, focusing on the intrinsic value of the shipping industry would lead nowhere. But looking for a trigger and trying to price it may yield a contrarian trade: the Supply Chain Quarterly article highlights a number of interesting changes - almost like "office blocks" next to the sandwich shop. Although separately, these changes are not sufficient to move the needle, their combination may in fact result in a significant change in the industry.
New Vessel Sharing Agreements Result in Greater Control
Vessel Sharing Agreements are a form of co-operation between container shipping companies. Traditionally they have been a way to optimize the use of vessels, but lately the agreements go a bit further by trying to consolidate operations on ground as well as on sea. Although VSA(s) have not translated into any form of control over pricing or capacity, this may change in the future as the number of alliances shrinks (from 4 to 3) while the total market share increases.
Out of total market of 20.7 million TEU (Source: Alphaliner) the alliances control 15.9 million TEU, or 77%. To be clear, shipping companies are not targeting measures to improve revenues with VSAs at this stage - it is still a highly competitive spot market driven by available capacity. Available capacity, however, is less likely to be driven by market share concerns going forward, if the top players are not threatened.
Capital scarcity is finally putting pressure on orders
Once an order for a vessel is placed, cancellation or delay is extremely expensive, which partly explains why the capacity in the industry is still increasing. However, orders will have to be financed, and there is plenty of evidence that the wave of industry exits of the banks over the last few years has created scarcity of capital.
Among the banks that intend to cut their exposure are NordLB (down by EUR 5 to 7 billion from 19 billion, source: Reuters), Deutsche Bank (down by GBP 1 billion from 5.5 billion, source: Reuters), RBS has been continuously shrinking the business, while HSH, Commerzbank, DVB and KFW "have been forced to take writedowns and boost capital buffers (Source: Reuters).
Although the main reason for the banks to exit the business is changing capital requirements under Basel II/III, the current state of the business and particularly shorter end of life of the asset (as shippers scrap earlier) combined with a yield that is too low to compensate for the risk does not leave room for maneuver.
Part of the void left by the European banks is filled by the Chinese banks that have quickly taken the lead in the industry. However, financing is still available only to the largest and the most stable players.
Higher oil prices will cause capacity reduction
Low oil price environment is not particularly good for capacity management. With over 50% of on-sea operational costs being fuel, low cost of fuel makes operations of older fleet economically viable. As we slowly approach the end of oil glut in the market and (arguably - a subject for a different article) lack of capital expenditure in oil exploration and development becomes evident, higher oil prices will make the scrapping equation that much easier.
Newer vessels are not only technologically more advanced (double-digit savings in fuel are achieved by using various technologies - see EIA report), but they are also significantly larger, which makes them up to 50% more economical per TEU (Source: Fortune)
Benefiting from the trigger
The combination of much larger vessels, which limits the ability of smaller players to finance large-ticket projects, high oil price, limited and disciplined financing and larger alliances is likely to become the shot in the arm so badly needed by the industry. It appears that the early indication is positive: the order book is shrinking fast, with the book-to-fleet ratio down to 17.1% (source: IHS) - the lowest level since 1999.
As far as we are concerned, benefiting from this newly found trigger requires a look along the supply chains. Container leasing and vessel lessor companies mentioned earlier are the only reasonably direct way to gain exposure.
Here again, the question is whether we value the companies or the trigger - the combination of the factors that is likely to improve the market. Trailing 12-month earnings is the place to start, but these numbers are meaningless. As the business of container companies [(CAI International (CAI), Textainer Group Holdings (TGH)] is based on spot pricing, their earnings have already reflected the downside and a DCF pricing based on these earnings shows no value for them. Costamare (NYSE:CMRE), Danaos (NYSE:DAC) and Seaspan (NYSE:SSW), on the other hand have been cushioned by the long-term charter agreements and their earnings do not reflect the downside.
Valuing the companies on their own then would result in wrong conclusions. Of course, one could argue that simply using P/E's with forecast earnings per share would address the issue. But what is the chance that the forecast earnings includes the trigger that we carefully constructed? The thesis here is that due to the factors mentioned, freight rates are likely to recover soon, resulting in reversal of returns for these companies back to their cross cycle average (the industry being hyper cyclical, of course, the upside could be a lot bigger, but we are pricing the conservative scenario).
Whether we valued the trigger or the companies is probably not so important in the end. The key takeaway here is that valuation that serves the purpose of profitable investment is less focused on the intrinsic characteristics of the company and more on the insight into the business dynamics. It is the reasonable confidence in the triggers that compels me to suggest a cautious (speculative, small proportion of the portfolio) long position in these companies.
There is of course always the risk that recovery takes longer than expected; there are plenty of arguments to support that view. A more protracted recovery could be detrimental for most of these companies due to the high leverage. Inability to roll the debt is of course the recipe for bankruptcy. One way to manage this risk is to monitor the debt structure and cash flows per company.
The upshot is of course that due to the high leverage the cost of capital is relatively low and due to the cyclicality and capital intensity, the operating leverage is very high.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.