Shipping Stocks: More Pain to Come?

The sector is facing a deteroiating outlook

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Sep 08, 2022
Summary
  • Shipping stocks still look cheap.
  • However, the industry is suffering from a poor outlook.
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Investing in sectors that rely on freely traded commodities is incredibly difficult. I’m not just talking about traditional commodities such as coal and iron ore here. I am also talking about freely traded goods and services in general, including things like spot shipping rates.

The ability to set prices

The reason why it is so difficult to invest in sectors that rely heavily on a third-party price benchmark is the fact that they have very little control over their own futures.

Take a company like Coca-Cola (KO, Financial) as a counter-example. This company can set its own prices. If it costs $1 to make a can of its eponymous soft drink, it can sell it for $1.30 to maintain a profit margin.

However, in commoditized industries where prices are entirely at the mercy of market demand, a company cannot set prices in the same way. This can result in incredible profits when demand is high, but when the supply-demand situation is unfavorable, it may be difficult to turn any profit at all.

If an oil producer wants to sell a barrel of oil that it produced for a price of $90, but it can only get $70 on the open market, it has no choice but to lose money on the sale. That’s just the way the market works.

Investing in these types of businesses is generally very difficult and not very sensible for long-term investors and those who do not have in-depth knowledge of the industry. Still, it can be highly profitable if the investment is timed at the right points of the cycle.

A case in point is the shipping industry. Investors who were savvy enough to invest in the dry bulk shipping industry in 2020, when the Baltic Dry Index, the benchmark for the price of moving major raw materials by sea, hit a multiyear low, benefited significantly when the price increased tenfold in 2021.

A booming industry

Shipping companies that relied on sport shipping rates to sell space on their vessels generated vast profits in 2021 and shipping stocks surged in value. They also began paying out generous dividends for shareholders as the money flowed into their pockets.

Star Bulk Carriers (SBLK, Financial) is one of the largest publicly traded dry bulk vessel operators traded on the American market. In 2020, shares in the company sank to a low of around $5 per share as its outlook became increasingly bleak on the slowdown in global trade. However, profits surged in 2021 as the demand for shipping space vastly outstripped supply, causing customers to bid up prices. Net profit increased from just under $10 million in 2020 to $681 million in the 2021 financial year. The company’s stock price also jumped, hitting a high of around $32 in the second quarter of 2022.

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Interestingly, shares in the company still look cheap. At the time of writing, the stock is trading at a price-book ratio of just 0.9. That looks cheap from a value investor's perspective. Wall Street also expects the business to distribute $6.51 per share in dividends in 2022, giving a dividend yield of 34% on the current share price.

However, when it comes to estimating this company‘s future earnings potential, things become murkier.

A weakening outlook

Star Bulk’s future earnings potential is tied to the strength of the global dry bulk vessel market, and this market is looking increasingly weak.

The Baltic Dry Index has plunged from around 5,500 to just above 1,000. It could fall further. Over the past 20 years, it has averaged about 800.

These types of companies are incredibly volatile and complex investments. If you know what you are doing, know the industry well and can keep in mind the historical trends of cyclical stocks, it can be relatively straightforward to make a profit. But this is not a business for the faint-hearted, and it can be all too easy to fall into the trap of buying high on optimism and selling low when things turn sour.

Any company that relies heavily on a freely traded price index is always at the mercy of the market, and any investors in the business need to know what they are involved in. Anyone who doesn’t understand the mechanics of the market, or tricks themselves into believing this time could be an exception where prices rise forever, could be in store for a very painful lesson.

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure