Back in November, during our brain storming session we came across an interesting investment opportunity in a very challenged sector; shipping. The sector is favourite amongst the distressed value players due to its extremes in magnitude and duration of cyclicality, capital intensity and fragmentation. True to its nature the shipping sector does entice investors every now and then, but by the time analysts complete their due diligence and are done with writing their report, the bubble pops. Unlike other sectors, shipping has very many wild cards working for or against the cycles.
“I like businesses that has few fundamental factors deciding the outcome” – Warren Buffet
Just like any other mature sector, shipping is highly commoditised with some pockets of niches and container shipping being one of that segments. Since 1965, when the first container ship was launched, the segment has grown every year, except for 2007, at some multiple of global GDP growth rate. If you discuss the container shipping with an industry expert, the first thing that they would point that it was container shipping that enabled globalisation and not other way round. Fair enough, for we are not a historian.
From our previous work on the segment, we were aware that with average operator barely breaking even, the container shipping has not been profitable at least since 2010. The industry is going through some serious consolidation with the share of the top 10 operators having risen from around 45% in 1996 to around 65% in in 2016 and to around 85% currently. Due to high operating leverage in the business the freight rates followed by volumes have the highest sensitivities to the operating profit line. Given the high consolidation in the industry, the argument about the volume growth coming back was not a concern.
Estimating future freight rates and it’s sustainability was bit tricky due to high historical volatility observed. But then we found something very interesting, the Newbuild order book (the ratio of the capacity under construction to existing capacities) was standing at just 7%, lowest it has been in last forty years. Moreover, the order book was almost non-existent in the mid-range segment and the scrap rates of ships were all time high. We being the firm believer in the normalization of Global economy and given the current order status of the newbuilds and scrap rates, we anticipated spike in the freight rates in near future. Our last task was to estimate the duration over which the high freight rates would hold at that level. Obvious scenario to consider was, what if seeing the high freight rates the irrational players flock to the shipyards and start ordering ships. If that were to happen, it would take at least two to three years for the capacity to hit the market and start affecting supply-demand balance. Another defining factor to consider was IMO 2020 regulation related to air pollution which mandates ships to limit the Sox and Nox emission. With this regulation, the ship operator had a choice to make 1) Go for expensive Capex heavy scrubber installation, 2) Use low Sulphur fuel, which depending on the prevailing spread costs much more than regular fuel oil or 3) Order new ships with LNG propulsion. A typical ship has lifespan of 25-30 years, and container ships are between 50-100% more expensive than usual oil tankers or a Bulk carrier, ordering a new ship at this regulatory transition phase would be a big gamble for an average ship operator. Considering all these factors gave us the confidence that the high rates are going stay here.
During the course of our due diligence, we came across an interview of the management of a container shipping company which detailed that during Covid-19 crisis, the marginal ship operators had cut down their costs (i.e., capacity) to an unprecedented level in order to preserve liquidity.
As the world slowly came out from the height of the crisis, freight rates spiked and these marginal players with 10 ships in pre-Covid world were more profitable and now they are with operating just four. Hence, it would be fair to conclude that Covid-crisis has bought rationality in the container shipping industry by accident, and hence goes the title of this article “Serendipity”.
With somewhat clear visibility on the industry evolution, we had to make a choice between Hapag-Llyod and Maersk. We decided to go for Hapag Lloyd because; (1) It’s a pure-play on container shipping, we didn’t want any exposure to horizontal integration at this stage (2) Capable management that have almost doubled the operating margins and successfully integrated handful of major M&A along the way, (3) Strong shareholder base and lastly, (4) our Quality-Value framework painted much better picture for Hapag than for Maersk.
“Successful investing has to be more about superior judgments concerning (a) qualitative, non-computable factors and (b) how things are likely to unfold in the future” – Howard Marks