Shipping Outlook 2017 – Returns set for a comeback
“Capital Returns” benchmarked to shipping
In our DFRS Shipping Outlook 2017, we benchmark our shipping investments thesis to Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 by Edward Chancellor.
In a fascinating account, Edward Chancellor (editor and introduction), covers “Capital Cycle”, predicated on investment strategies employed at Marathon Asset Management.
Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns.
Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpeter’s process of “creative destruction” – as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing.
The key to the “capital cycle” approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side”
We believe the outlook for the global shipping industry and expected future returns directionally can be meaningfully explained using the “Capital Cycle” framework. We have identified key tenets under the “Capital Cycle” investing approach and looked at key sectors with this framework over the past few years, and base our future recommendations in accordance.
Key tenets under capital cycle investing approach
• Most investors base their decisions focussing on demand forecasting rather than supply. This happens despite knowing that demand is essentially a black box and does not pay enough attention to supply side. Market and investors remain entirely focused on swings in the Chinese commodity demand; there is a similar risk as the extrapolation of Indian coal demand in 2011-14.
• It is the changes in the supply side dynamics that drive industry profitability. This key principle is often overlooked and stock prices fail to anticipate shifts in the supply side. Dry bulk shipping and container shipping is undergoing a massive supply side normalisation after years of supply growth, return expectations to rise owing to the shifts.
• Irrespective of growth, only sectors/companies with a supportive supply side can justify good valuations. For eight years, the market did nothing. Shipping investors have been at the receiving end and we believe it is time to increase the exposure. Dry bulk companies still trade at fractions of their restructured books. The leaders in container shipping will increase the market share, and when this will be coupled with dwindling supply growth, it will make for a potent mix for returns.
• Management and the company’s capital allocation skills are paramount. Investment banks drive the capital cycle, largely to the detriment of investors. Many new entrants, backed by fresh equity capital, saw their investors go through a painful value destruction. Many managements overextended their balance sheets and leveraged to the hilt. The restructuring has been painful, but survivors will make a comeback.
• When policymakers/governments/sovereigns interfere with the capital cycle, the market clearing process might come under stress. (In economics, market clearing is the process by which, in an economic market, the supply of the traded goods is equated to the demand, so there is no leftover supply or demand. The new classical economics assumes that, in any given market, prices always adjust up or down to ensure market clearing.) Container shipping industry is the perfect example of the diluted market clearing process, but we believe it has run its course.
• Investors are better positioned when employing the capital cycle approach. In our view, any company is available at a cheap rate when earnings are under stress. The key is to figure out whether that stress is permanent or temporary. We believe the stress levels for the shipping sector to ease significantly in 2017, primarily driven by supply normalisation, with real profitability and returns emerging over the next 18-24 months.
It is the changes in supply side dynamics that drive industry profitability
Basing our sector views on the “Capital Cycle” approach, our top sectoral picks for 2017 are container shipping and dry bulk shipping. We remain negative on tanker shipping and neutral on gas shipping.
DFRS top shipping stock picks for 2017
“Attractive” stocks for 2017
• A.P. Moller Maersk A/S (MAERSKB DC) – Positive outlook on contract rates is a key tailwind for share prices, in our view. The continued recovery in Asia to Europe spot market rates has improved carriers’ chances of securing higher 2017 contract rates and is a good sign for Maersk Line heading into the contract season. We believe Maersk Line will be a key beneficiary from a positive turnaround in freight rates, and recommend APMM shares on the back of continued positive industry developments in coming quarters.
• Orient Overseas International Ltd (316 HK) – We believe higher and more sustainable freight rates are more likely outcome in 2017. As OOIL normally undertakes 60-70% of Transpacific trade and 35-50% of Asia-Europe trade volumes on a contract basis, this could prove a key positive for the company. Recovery in OOIL’s biggest market, Intra Asia will support profitability. OOIL’s financial soundness negates balance sheet concerns in what has been a volatile period for sector profitability. The added speculations around M&A activity will also support the stock price.
• Pacific Basin Shipping Limited (2343 HK) – Pac basin has been one of our top picks in the dry bulk sector and we continue to maintain our positive stance on the company acknowledging its ability to deploy its fleet at higher than market rates. In addition to reasonable valuations, the company has no concerns on the balance sheet. PB has a rich pedigree and maintains its leadership position in the Handysize and Supramax segments.
• Scorpio Bulkers Inc. (SALT US) – SALT has addressed debt and liquidity concerns in 2016 and continues to negotiate with shipyards and lenders to supplement liquidity. It has also taken advantage of the rise in freight rates and has contracted 17 vessels on short-term charters, with most of the contracts expiring by second quarter. With majority of its fleet deployed on the spot markets, the freight rate recovery post the seasonal weakness in 1Q17 will be a key catalyst.
• Star Bulk Carriers Corp (SBLK US) – Multi-pronged actions in 2016 have considerably eased liquidity risks and the company has managed to restructure its balance sheet on multiple counts. On earnings, we believe cost management to support operating earnings in FY17. SBLK has one of the lowest average operating expenses for its vessels and a favourable freight rate environment will positively impact EBITDA.
“Unattractive” stocks for 2017
• Our key negative call for 2017 is “Unattractive” rating on all tanker stocks under our coverage, Euronav NV (EURN US), DHT Holdings Inc. (DHT US), Nordic American Tankers Ltd. (DHT US), Tsakos Energy Navigation Ltd. ( TNP US) and Teekay Tankers Ltd. (TNK US).
• We forecast declining earnings and diminishing dividends to keep tanker shipping stocks under pressure in 2017. Marginal recovery in freight rates is unlikely to be supportive of stock prices.
• Dividend expectation is the key driver of the tanker shipping stock performance and we do not expect dividend increases from any of the companies under our coverage.
Source: Drewry Financial Research Services