Great Bargains In Shipping…Adventures in Capitalism
I’m a value investor at heart, so I naturally gravitate towards cheap stocks. That said; companies are often cheap because of well understood problems. The money is made by having a divergent opinion for why things will get better, along with a catalyst—otherwise a cheap stock will stay cheap or even get cheaper.
In terms of valuation, there is no question that most US listed shipping stocks are insanely cheap. Most trade at less than half of NAV and some trade at less than a third of NAV; based upon values in the rather active secondhand sale and purchase market. This means you can sell off the ships, pay off the debt, and triple your money. These are the sorts of valuations that you’d only expect if a sector was projected to continually destroy phenomenal quantities of capital—much like the shipping has done for the better part of a decade.
Why am I bullish on shipping now? Besides silly cheap valuations, you have an imminent catalyst in IMO 2020, along with several longer-term secular trends. Let’s start with a few of these longer-term trends first.
- After a decade-long bear market where tens of billions in capital was destroyed, future capital will be restricted in the shipping sector. This means less equity and debt availability at a time when vessel owners are over-leveraged. This should restrict future vessel supply.
- There is an ongoing shift in trade patterns. Going forward, net US exports of oil, refined products, LNG, LPG and agricultural products will increase, even if global demand stays constant (which it never does). This is a result of the US being the low-cost producer for many of these products, hence the US will gain market share. You don’t have to be Magellan to look at a map and realize that products originating from the US must travel substantially more ton-miles to their growing end markets (mostly in Asia and India) than previous trade routes. Even if global demand stays constant, this shift in supply from the US, should result in an increase in ton-miles. As an optimist, I also tend to think that over time, global trade and GDP grow in line with historic growth rates, further increasing overall ton-miles. An increase in ton-miles is naturally bullish for shipping rates.
- I have noted this in the past but QE and NIRP have had the perverse effect of adding incremental supply to almost all capital-intensive industries. In shipping, this lead to a crushing glut of new vessel orders and subsequent historic lows in charter rates. With these forces going in reverse, there should be less incremental supply at a time when increased financing costs are forcing an increase in scrapping of older ships.
- Increased government regulations such as ballast water treatment systems are obsoleting older vessels where compliance does not make economic sense. I expect there to be increased regulations going forward—leading to a further increase in scrapping.
- Changes in bank regulations have restricted banks from lending as aggressively as in the past. This has served to remove a lot of cheap financing from the sector. Just look at how many companies have recently been forced to fund growth through 9% preferred issuances. That tells you that the cost of capital is going up—which should dramatically restrict new vessel supply.
- There is this odd misnomer amongst generalists that a trade war is bad for shipping. Maybe it is bad for containerships (though rates have not seen much impact yet), but generally speaking, trade wars are good for shipping. How do US soybeans get to China? They get transported to Brazil, offloaded, reloaded and then transported to China as Brazilian beans. All of this means more ton-miles and more time tied up in port. Almost by definition, a trade war is going to be bullish. It disrupts existing trade routes that operate at maximum economic efficiency and instead inserts government mandated inefficiency. In the end, products will be shipped to where they’re needed—it will just involve more ton-miles and more idling in ports. As we enter the era of strongmen (as my friends at Capitalist Exploits have noted many times), I suspect that there will be more political grandstanding and less financial logic in terms of arbitrary trade restrictions and subsidies. This will almost always increase total ton-miles. An increase in ton-miles is bullish for shipping rates. Absolute quantities of GDP and global trade aren’t the metrics that are relevant.
This is all interesting, but these are longer term trends. In the hedge fund world, you’re only as good as your last quarter. What’s the imminent catalyst? I spoke about IMO 2020 when detailing my long in Scorpio Tankers (STNG – USA) and I believe most investors are underestimating its impact. (As a side note, I’ve used the recent 20% decline in STNG to substantially increase my position and it is now by far my largest position).
IMO 2020 states that starting on January 1, 2020 all vessels must either use fuel with less than 0.5% sulfur or install a scrubber to remove sulfur from exhaust. Following this change, it is expected that low sulfur fuel oil (LSFO) will be a good deal more expensive than high sulfur fuel oil (HSFO), though no one knows how wide this spread will be. Shipping companies will find various ways to deal with this new restriction—all of them are bullish for charter rates.
- The obvious solution is to install scrubbers. This will involve substantial downtime during installation and likely lead to a 2-4% reduction in the global fleet in the next 36 months as operators opting for scrubbers undertake a phased installation process.
- Those who don’t install scrubbers will have to pay more for LSFO. Should the spread between LSFO and HSFO widen materially, less fuel efficient vessels without scrubbers will have a material operating cost disadvantage as fuel is such a substantial percentage of a vessel‘s operating cost. I suspect that this leads to increased scrapping of older vessels and a further reduction in global fleet supply
- Newer vessels are more fuel efficient, but since LSFO will cost more than HSFO, it may lead to “slow-steaming” or the process where charterers contract to operate LSFO fueled vessels at slower speeds in order to use less overall fuel per ton-mile. This could subtract 5-20% of the global fleet as it takes more days to travel a set distance, hence the need for more overall vessels.
- With shipyards focused on scrubber installations, there will be a shortage of new-build capacity in the next few years—especially as many shipyards have folded during the past few years. This should ensure that new vessel supply comes online at a slower rate.
All of the above kicks in on January 1, 2020. In past generations, the stock market was forward looking and would price in perceived increases in charter rates a few quarters in advance. Given the quant world we live in, it is likely that the machines do not yet have this programmed in their models—there is no other explanation for current valuations.
Remember, shipping companies have tremendous operating leverage on top of substantial financial leverage. History has shown that small changes in supply and demand fundamentals can lead to large changes in overall charter rates. Even small changes in charter rates can lead to huge changes in cash flows and valuations. For instance, at STNG, every $1,000 change in charter rates will lead to a $45 million increase in cash flow. With roughly 50 million shares outstanding, this is 90 cents a share of operating leverage per $1,000 in charter rates. LR rates are up roughly $10,000 over last year’s levels, even as we enter the seasonally weak refinery maintenance season. I suspect rates ramp dramatically from here as we get closer to IMO 2020 implementation. Could STNG earn its entire market cap each year for the next few years? Sure, why not. Can it earn a few times its market cap? Possibly. Will it? I don’t know. However, I know that at less than half of NAV and with a fully termed out balance sheet, I’m not taking much risk to find out. The same could be said for many other sub-sectors of the global shipping market.
I know why these shipping companies are currently so despised—everyone who has touched them in the past decade has been burned. However, I think that investors should look more closely at the sector. I don’t know of another sector that is more undervalued with so many imminent and secular trends in its favor. It is rare that you can buy a dollar for 30 to 50 cents and expect that dollar to earn a high return on capital while appreciating as well. As IMO 2020 takes effect, there could be a lot of positive surprises in shipping, while current valuations protect a lot of the downside if nothing good happens.
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Disclosure: Funds that I manage are long shares of STNG, long calls and short STNG puts (various strike and durations)
Article by Adventures In Capitalism