Despite a bit of back and fill action the last few days, it appears the market is putting in at least a short-term low. While the long-term direction of our markets could take on any number of different outcomes, the climactic low placed last week in wake of the Bear Stearns debacle should mark a support point and give the markets several weeks of relief. During this time, shorter-term traders should be able to take advantage of a lift and many depressed stocks will show very attractive rebounds. Returns after such a fearful low can often stack up very quickly and account for the lions share of the full years profits.
In looking for names that are likely to benefit from this improving environment, I have been drawn to many of the shipping names. These companies include Diana Shipping (DSX), Dryships Inc. (DRYS), TBS International (TBSI), Eagle Bulk Shipping (EGLE) and more. While the names all rise and fall according to some of the same economic metrics, you should do your homework to determine the fundamentals of each before putting your capital to work. In this article I will cover a few of the issues facing the entire group and then make some specific statements about DSX. However the discussion can be applied to many other names within the group.
The dry bulk industry as it is called has a very close relationship with prices of commodities, supply and demand for those commodities, and the economic growth of emerging economies. As nations such as China and India demand more and more in the way of grains, metals, and many other materials, shipping rates have been increasing and the supply of available vessels has been stretched. Naturally when demand for transportation soars and supply of vessels is relatively inelastic, the price for use of those vessels will rise sharply. This is the phenomenon we have been dealing with for the last several years. Since it takes quite a bit of time for new ships to be manufactured, current owners of the vessels have enjoyed profits as day rates were pushed higher.
Within the past few months, however, the economic issues have caused concern about the sustainability of commodity prices. As inflation ramps in some emerging economies there have been questions as to the long term growth in demand for commodities. At the same time, some negotiations between the Chinese government and BHP Billiton (BHP) as well as Rio Tinto (RTP) over iron ore shipments from Australia to China have caused disruptions in the shipping schedules. While the long-term fundamentals still look very good for the shipping industry, lower spot day rates have caused significant drops in the share price of many of these shipping companies. These declines present investors with attractive opportunities to pick up stock at very reasonable multiples especially compared to the high prices that these companies were fetching just six months ago.
When looking more specifically at the companies individually, there are some key differences that typically hinge on 3 different metrics.
- The first issue is financing. When companies decide to purchase a new ship, they can finance that purchase with cash on hand, by issuing debt, or by issuing new equity. Since most companies do not have enough capital lying around for such a large purchase, most have turned to selling bonds or preferred stock to finance such transactions. Diana Shipping has a unique approach in that management has decided to purchase most of its new vessels using equity and so when it finds an attractive purchase, it issues a secondary stock offering to fund the purchase. This cuts down on risk as the capital is permanent and while it may at times be dillutive to current shareholders, most are usually constructive on the opportunity to purchase a new cash generating asset.
- The second issue revolves around the company’s dividend policy. While many managemet teams have decided to keep earnings in-house to build book value and possibly finance growth initiatives, Diana has decided to pay out the majority of its cash flow to investors thus keeping its dividend yield very high. So in looking carefully at the returns to investors including the past dividends, the stock has a very attractive historical return. One benefit of a healthy dividend policy is that it often helps to stabilize the stock somewhat as investors are unlikely to sell a holding that pays attractive cash flow on a regular basis.
- Finally, a firm must strategically decide whether to operate under the fluctuating daily spot rates or whether to engage in long-term charter rates. While the prices were steadily rising, it seemed to make the most sense to take advantage of the potential revenue increases by accepting the daily rates offered by the market. But in volatile times, it now seems wise to charter a large portion of available shipping days with long-term contracts to stabilize revenue and provide a more reliable earnings stream. Diana has historically made extensive use of long-term charters and while that may have caused management to forfeit some opportunity, the stable earnings and more recent new contracts at attractive rates have served the company well.
The last interesting dynamic to point out is that each ship has a definitive useful life before it must undergo extensive repair or be scrapped. New capacity is coming online in the form of new ships being built, but an aging industry fleet will likely have to retire ships taking a bite out of the new capacity. As scrap rates increase sharply this year, there is more incentive for owners of aging vessels to go ahead and take their ships offline which could throw current assumptions about the shipping supply into transition.
So as the industry adapts to the growing need for global shipping, and as the price and demand for commodities continue to rise, shippers are likely to enjoy growth as an industry. The recent market dynamics create an opportune time to look at many of these names as short-term trading vehicles, and a few qualify for long-term investments.
As always, please trade responsibly and with damage control in mind. But also have the discipline to step into the market when opportunities set up for high quality profits.
FD: Author has a long position in DSX and DRYS
Motley Fool on Bulk Shippers and TBSI in Particular
Barrons profiles the Dry Bulk Shippers in JanuaryDiana Shipping (DSX) – Prime Rebound Candidate