Rule Number One: Invest in Flexible Businesses
Yet it is hardly talked about in terms of investing, perhaps because it not easily quantifiable. Even so, being able to recognize a stagnant or inflexible firm can be an immense tool for any investor. To illustrate how failure to respond to changes can affect a firm (and thus your investment), we will turn back the clocks to the year 2006 where the shipping industry mania was already in full effect.
With exploding global demand, strengthening trade relations between developed and emerging markets and the flow of easy credit, it seemed as if everyone was opening up shop as a shipping company. Between 2004 and 2007 alone, over fifty companies filed for an IPO in the worlds stock markets.
With extremely low barriers to entry, the industry soon became extremely fragmented, consisting of dozens upon dozens of small shippers operating across the globe. Some of the largest shipping companies at the time barely reached the $1 billion dollar mark in size.
Things appeared to be going quite well. Rapidly rising contract rates (as determined by the Baltic Dry Index) and growing global demand (specifically from the likes of China and Brazil) prompted many shipping firms to, in some cases, “double or triple [their] current fleet” over the next 12 to 24 months. No one at the time could possibly foresee the future ahead.
Around mid-2008, almost every shipper was experiencing new stock-price highs, with most paying dividends in the range of 5-10% annually. Below are the stock-price charts of three large and well-established shipping companies (DSX, DRYS, FRO) along with an ostensibly ‘niche’ shipper (TBSI):
The key to the unraveling of the shipping bubble after all turned out to be their core method of doing business. Of course the crash of the global economy hit the industry hard, but it was their inability to cope with changing conditions that provided its final downfall.
During a recession, most retailers only need a few quarters to correct inventory levels with falling demand. Oil companies can curb drilling and bio-tech companies can revise R&D spending fairly quickly. The industry-standard method of financing ships along with the innate time constraints offered most shippers a minimum of two or three years before they can alter supply to cope with changing demand.
When a firm wants to grow their fleet, they usually enter into a financing agreement that lasts over the life of the boat (figure around twenty years). From there, the company enters into a purchase agreement with a shipyard and agrees to accept delivery of the boat in around three years (once the boat is built). Failure to accept delivery on the due date may result in fee’s of over 20% the original purchase price as the shipyard is forced to dry-dock the ship for you.
When the financial crisis hit, spot rates for ships plummeted along with global demand. Because firms had agreements that extended three, four, or five years into the future, they were already locked into accepting new ships while they couldn’t find charters for their existing fleet. While charter rates were falling, shippers were ready to flood new supply onto the market for another five years.
Faced with high interest payments, rock bottom revenues, and up to 50% of their fleet dry-docked, dozens of shippers filed for bankruptcy. The following chart paints the picture well:
Years later, rates have slowly climbed back up, but a guaranteed supply glut for another few years continues to pressure even the best run shipping firms. In fact, many companies haven’t reinstated their cut dividend from 2008.
The moral of the story: Never invest in companies/industries that can’t deal with change. Regardless if you believe conditions will improve for years to come, always remember, a recession can always be right around the corner.