“Many shall be restored that now are fallen and many shall fall that now are in honor.” This quotation from the Roman poet Horace is spot on in describing the ebb and flow of markets. No wonder it appears as an introduction to Security Analysis, that investing classic by Ben Graham and David Dodd.
In short, the wheels of finance never stop turning and no asset stays on the top, or the bottom, of the heap forever. The latter is certainly a cheerful message for the beleaguered shipping industry.
Shipping has been a Waterloo for many an investor in recent years, but in the spirit of Horace, let’s see if the fallen shall soon find honor.
It would be hard to find a group of stocks more battered than the lot of dry bulk shippers, which mainly haul iron ore, coal and grain. The stock of DryShips (DRYS), an industry bellwether, is down 95% from its 2007 peak. This reflects the decimation in shipping rates.
The irony is that even though iron ore and coal are booming and food worries are front-page news, shipping rates are where they were during the pit of the financial crisis. The Baltic Dry Index is already down 40% this year!
The reason is simply that there are too many ships. In fact, new rates on so-called capesize vessels are below the costs to run the ships. Yet pathetically, new ships continue to hit the market. Last year was the biggest year of new ship deliveries in history. This year should see another slug of additions, expanding the world fleet by 15%!
Talk about a horrible industry… yet it won’t always be this bad. It can’t be. Unfortunately, as accurate as Horace’s sentiment is, he says nothing about timing.
Still, the forces of capitalism, like microbial organisms that break down dead carcasses, are beginning to work on the shipping business. Owners of vessels are starting to scrap their ships. In some cases, the ships are worth more as scrap steel than as ships.
For instance, a typical owner of a capesize vessel can pay $25,000 a day to keep his ship running…or he can scrap it and collect $10 million. What would you do? Exactly. And that’s what shipowners are doing in record numbers. In fact, they are scrapping ships at the highest rate in 28 years.
Some shippers are going out of business completely. South Korea’s second largest operator of dry bulk ships finally called it quits after losing money in six of the last seven quarters.
So it’s bad, which means ships are cheap.
A friend and reader works in a private equity firm. He told me he has begun to play in this space. “Typically, the value of ships falls $1 million for every $1,000 decline in the day rate, so boats are cyclically cheap right now,” he says. “The play is to buy ships today, charter them out for three-five years through the soft market and flip them when it turns.” The day rate, or spot rate, is what you can get for a ship today. Charter rates are negotiated longer-term contracts.
My friend’s is a contrarian position and he knows it. “We’re looking at buying some vessels with a group that did this successfully in the last cycle.” They all know there may be more weakness to come but believe now is a good time to accumulate ships. They will not always be so cheap.
“The challenge is managing the mix of charter and spot contracts to get you through the downturn safely but with enough flexibility to capture the upside when things turn,” our man on the spot continues. “The contracts can get you a decent yield, but the real return will come from flipping the ships when values recover.” He adds the consensus sees little upside, but “there could be big money in taking the opposite view.”
There often is.
The dry bulk trade isn’t going away.
All those big emerging markets need iron ore, coal and grain. The main sea lanes are to China, which makes up a third of the dry bulk trade. Japan is the largest importer of coal. And grain moves from the US and Brazil to the markets of the Middle East and Asia. None of these trends look like they will end anytime soon.
The industry just has to work through its huge backlog of ships, which scrapping ships, bankruptcy and no new ships should do. It will take time yet, but it will definitely happen, as Horace well knew.
By Chris Mayer