Shipping 102

Heuristic for floating steel investors

Shipping is a complex and expensive hobby for investors and entrepreneurs. To be successful, or at least not a loser, we must play the game multi-dimensionally.

Shipowners and aspiring investors must be well-versed in the macro economy, geopolitics, corporate finance, and shipping operations. Risk management and mental resilience are also essential.

It's easier said than done. As in every intricate field of life, smarter people in the past established fundamental truths that are not absolute nor definite but relevant enough to guide our decisions.

Today's article is precisely that. It shares the collective wisdom of seasoned shipowners and investors. My contribution is limited to the fact that I was dumb enough to ignore those principles. Eventually, I realized my mistake, and the heuristics discussed below became a cornerstone of my research. Today, I am grateful to share some of them.

That said, let’s start with shipping 102 or simply how not to screw up.

Supply-side reign supreme

Like all capital-intensive businesses, shipping has inelastic supply and fluid demand. What defines the supply side, i.e., fleet growth? We have three prime variables: shipyard capacity, fleet age profile, and fleet order book.

The supply side also depends on secondary variables, like average speed, port congestion, and dock schedules. These usually act as amplifiers or dampeners in the system, enhancing or reducing the existing deficit or surplus.

However, in rare occurrences, they can even become a primary driver for vessel supply dynamics. In other words, vessel supply can temporarily be turned upside down from surplus to deficit and vice versa.

Demand-driven vs supply-driven

Vessel supply is only half the equation. To gain Alpha, we need a shortage of vessels. In other words, the tonne-mile demand growth rate must surpass the fleet growth rate.

However, there is a catch. LNG, LPG, and container markets are demand-driven. All three segments have massive order books and relatively young fleets. On the other hand, demand growth surpasses supply, resulting in a deficit of vessels.

Demand-driven markets have one drawback. A minor decline in demand would turn a deficit into a surplus, leading to cyclical contraction.

Bulk carriers and tankers are supply-driven markets due to low order books, aging fleets, and a lack of shipyard capacity. In addition, tonne-mile demand for crude oil tankers and bulkers remains intact.

Simply put, the best shipping segments to be positioned are those that are supply-driven and complemented by robust tonne-mile demand. A deficient supply acts as a cushion against adverse demand changes.

The Hare and the Tortoise

The interplay between supply and demand in shipping (and in any capital-intensive business) can be illustrated by the fable “ The Hare and the Tortoise.” The supply side in shipping is the tortoise, and the demand side is the hare. The supply is inelastic, unlike the demand. This dissonance leads to epic boom and bust cycles.

During a booming shipping market, shipowners go berserk ordering vessels…only to take delivery when the party is (almost ) over. Then, no one wants to hear about shipping. This leads to a shortage of ships to cover the characters' demands, resulting in a deficit. Drink, rinse, repeat.

The supply is always slow to respond to demand shifts, creating monumental bull runs and ruinous bear markets.

Shipping investors triad

How to estimate if shipping stock is attractive?

The impossible triad of shipping is here to help. As investors, we seek a high-spec fleet, low LTV, and a reasonable discount to NAV. However, it is impossible to get all three.

In most cases, the game is more nuanced. We get a so-so fleet, a moderately leveraged balance sheet, and a reasonable discount. In other words, nothing excessive.

At best, sacrifice one to get two. We can buy a top-quality fleet with a relatively low LTV at a steep price, as measured in PNAV. Or we can pick low LTV and a considerable discount to NAV, though we sacrifice the fleet quality.

Structural inflation

Structural inflation impacts the supply of new vessels and the shipping company’s valuations. The equation is simple:

The rising cost of financing + rising cost of labor + rising cost of steel > rising price of newbuilds > growing NAV > declining order book > tighter supply side

Rising financing costs, higher steel prices, and higher wages mean the price of new buildings is rising, increasing the shipping companies’ NAV.

Growth vs Income

I like companies with a focus. In shipping, this means operating only one type of ship—it is even better if it is one class. For example, only small LPG carriers, VLCCs, or Capesize vessels.

But why?

Not all LNG carriers/tankers/dry bulk carriers are the same. For example, VLCC tankers are the best place to be in the tanker segment, so I would pick DHT Holding. Handysize/small LPG carriers offer the best risk-reward, so my choice would be Stealth Gas.

The diversified fleets have one advantage: lower volatility because they are exposed to multiple markets. By picking conglomerates, we smooth the volatility inherent in each cycle.

Picking diversified shipping companies is neither wrong nor right. It depends on investors’ goals, skills, and risk tolerance. Shipowners with diverse fleets are excellent choices for dividend investors. The latter prioritizes income generation at the expense of growth. So, having exposure to multiple markets means lower volatility (in the context of shipping).

Conversely, concentrated fleets are for shipping growth investors who seek to maximize upside potential in exchange for significant volatility.

Volatility as admission fee

Shipping is an inherently volatile business. The MPT postulates that the risk is measured with standard deviation, i.e., the historic volatility of a stock. This is a misleading linear assumption in a world dominated by non-linearity.

That said, volatility brings not the risk but the potential reward. That’s why I like cyclical business. I chase double-digit Alpha, so I have to pay the price.

Besides the shipping triad, there is a basic investor triad. We can never get Alpha returns, low volatility, and high liquidity together. At best, we trade one to get two. My choice is double-digit Alpha, high volatility, and ample liquidity.

Final Thoughts

Investing is simple but not easy. The simplicity of the principles above is a reminder. They have one role: to reduce the chances of being wrong. In other words, to tilt the probabilities of being right in our favor.

Adhering to those maxims will not automatically transform you into the next Onassis. However, it will allow you to become successful in shipping investing without losing your mind and capital. Remember, to have a chance of winning, the first rule is to stay on the poker table under any circumstances. The same applies to investing.