On Value Traps

Over the past few months, we have seen a number of prominent distressed managers dip their toes into shipping:
I've been to a number of shipping event the last few months. I would guess that approximately 50% of the attendees are analyst and portfolio managers from distressed debt funds. Many people think there is real value in that space (pick your flavor - for this post I'll be using the 'tanker' market as the prime example), but very little capital is flowing into the space. How does one reconcile that?

The common reaction I receive when I ask a peer if he / she is looking at the shipping sector: "The fundamentals are only going to get worse from here, so we are going to wait until the supply/demand imbalance gets sorted out." If everyone believes that though, does that not inherently mean the opinion is priced into the various securities of tanker companies? Howard Marks shares a similar sentiment in "The Most Important Thing" regarding the debt market:
"Whenever the debt market collapses, for example, most people say, 'We're not going to try to catch a falling knife; it's too dangerous.' They usually add, 'We're going to wait until the dust settles and the uncertainty is resolved'

The one thing I'm sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there'll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it's a great bargain. Thus, a hugely profitable investment that doesn't begin with discomfort is usually an oxymoron." (my emphasis added).
To me, the reason that you are not seeing capital flow into the space are two fold:
  1. 90% of money managers very much care about short term results. The number could in fact be higher. The most precious capital is sticky capital (hence the reason why many asset managers have gone public, why Sardar Biglari took over Steak N' Shake, why Phil Falcone set up Harbinger Group, why closed end funds fight off people like Phillip Goldstein, etc etc). Because in most cases, capital is not sticky, short term results are monitored religiously at the expense of long term value creation. I.E. I can't buy this stock today because it may go lower in the interim.
  2. There are very few investments in the shipping industry (via the public markets) that offer a meaningful margin of safety.
Point 2 is what the rest of this post will focus on.

Warren Buffett has famously said, "The first rule of investing is don't lose money; the second rule is don't forget rule number one." And Ben Graham wrote in Security Analysis: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

I can, with VERY high confidence, say that at some point in the future, spot rates for VLCC (Very Large Crude Carriers or 200,000 DWT or more) will be higher. It might not be next year, or the year after, or the year after that. But at some point, VLCC rates will be substantially higher than they are today (negative TCE rates in some instances). Here is a chart (For reference -This is the rates for VLCC going from the Middle East to the Far East) :

You will notice that forecasting price in this segment is remarkable difficult. You will also notice that at multiple points in the past 10 years, VLCC day rates have been over 200x today's rates.

Buying on that opinion alone (that rates will be higher one day) would be speculating. Because most shipping companies are massively levered, with both recourse and non-recourse, ship level debt, buying the bottom part of the capital is akin to betting the sector turns before 1) the debt comes due or 2) covenants are breached. And, if you are wrong, you get zero.

Let's take an opposite extreme example: You start a shipping company with 100% equity. No debt whatsoever. In this scenario, outside of some working capital draws that may occur if day rates stay negative for a long time, you are essentially buying an at the money call option without an expiration date. There is then no theta decay. On an asset with massive volatility. How much is that call option worth? A significant amount of money.

Wilbur Ross is one of my favorite investors. Here is the formula:
  1. Determine an industry that has staying power (i.e. will be around in 20 years) that is under severe stress
  2. Purchase the senior bonds of a company in that industry at distressed levels
  3. File the company, and convert your senior ownership to a majority equity share
  4. Clean up operations
  5. Wait
Whether it be coal, steel, banking, servicing, or auto parts, these are industries that will be around for a long time and benefit from a growing domestic and global population and middle class (Full disclosure: I do not know enough about his International Textile Group to comment). And because they will be around for a long time, there will be times when investors or acquirers value these industries dearly and will pay a much larger multiple on much higher run rate cash flows than you did. That's where the waiting part comes in.

(Editor Note: That is not to say you cannot make money in industries that will not be around in 20 years. If you had invested in USMO, a PAGING company, at the beginning of the year in 2009, you would have made 84% [assuming reinvesting the fat dividend there] vs 36% for the S&P [again assuming reinvested dividends]. But that is buying an un-levered company at the depth of market pain. )

I very much worry about buying into industries, even at relatively fair prices, that I do think need to exist in 10 years. That's the ultimate value trap. Some flavors of hard line retail (electronics) fit this bill. Is RadioShack (RSH) a bargain at 3.25x forward EBITDA? Maybe, but I'd rather pay up a few multiples for a company in an industry I am certain will be around in 10 years.

Like tankers - now I just need to find a way to do it in an unlevered entity or at the top part of the capital structure. Any ideas?


  1. Great post : really liked this post

    IF you want me to do some digging around .. i.e. read 10Ks , 10q s etc I'd be *very happy* to lend a hand ...

    But I need some direction, example some one ..probably you ... telling me where to start and what the target group is etc etc

    my twitter a/c is https://twitter.com/#!/ToSubu

    my facebook profile is



  2. Perhaps check out Diana Shipping (DSX). LT Debt/Equity of about 30%. Obviously on an earnings basis it does not trade as cheap as the others because it is not has risky (loss of permanent capital), but it does trade currently at 0.17 price to stated book.


  3. Anonymous9/13/2011

    DHT. They're leveraged, but no real maturities for a year or two and most of their ships are on long-term charters with 1-2 years remaining. Should help them weather the storm better than some others.

  4. Anonymous9/13/2011

    Ships are not an asset without theta decay. The ships are made of steel -- they rust and become less efficient over time. New ship designs emerge (e.g. greater fuel efficiency) that puts your ship further up the cost curve.

    It's not as slam dunk as you might think.

  5. Anonymous9/13/2011

    Excellent post, and excellent blog.

    I think there's a typo near the end, though. Surely "I do think need to exist in 10 years" should read "I do NOT think ..."

  6. Anonymous9/13/2011

    one may also consider who is running the operation...

    I like FRO simply because Fro is has Fredriksen at the helm.

    considering that Fredriksen basically owns FRO's debt one can assume FRO will weather the storm.

  7. Anonymous9/13/2011

    It's also worthwhile to mention the scrap value of these ships, which may provide a value back-stop in a liquidation scenario.

    Great post.

  8. Anonymous9/14/2011

    Take a look at Navios Maritime (NM). Best in class CEO. Have been selling ships and de-levering. No major maturities. Youngest fleet of ships out there (avg age 4.6years vs indust 15+). Minimal cap-ex with newer ships. 60%+ of ships are on long-tern insured charters at above market rates. Very strong earnings visibility.. This is really a sum of the parts play. They own 64% of a south american logistics business which is going to be spun out. They are the GP of a MLP (NMM) own 29% ownership. The divdend they recieve from the MLP covers 100% of NM divdend + IDR's. Plus they own 53% of a tanker business ticker NNA.

    Sum of parts for the company is $9-$12. Currently in the mid 3's yielding 6%+ to wait.

  9. A few months ago I spent some time trying to understand the dry bulk shipping industry. I suppose the tanker industry will be similar.

    The first conclusion I've drawn is: all conventional valuation metrics like ROA, P/B, profit margins are not useful. It's because ship prices are directly influenced by charter rates which fluctuates widely by pure supply/demand. The denominator in ROA and P/B are, thus, very sensitive to the timing of the ship purchases. At the same time, since shipowners can decide between locking in the revenue using time chartering or gambling on the spot market, the numerators in the ROA and profit margins are sensitive to the timing of these decisions.

    I've tried to come up with a way to calculate their liquidation value = Ships (including undelivered) valued at GFC prices + NPV of time charter above spot + Net current asset - Debt - Contractual Obligations

    Out of all the bulk shippers, PRGN, NM and DSX had market caps around my calculated liquidation values at the time.

    I think the proper investment thesis will be: (1) find a shipper with enough staying power to weather the downturn; (2) the shipper has significant exposure in spot charter so when the industry recovers, it will get multi bagger increase in profit in very short time.

    I have yet to conclude if such opportunity exists... I've already diverted my energy to other areas.

    Btw, I like the way you looked at it from the option perspective.

  10. Anonymous9/16/2011

    "The number could in fact be hire. "

    Did you mean higher?

  11. Might want to consider genco. 1) Very new fleet (low cost shipper). Genco's daily operating cost for a ship is about $5k; with time charter rates for capsize ship at 25k per day and for Panamax and handyman ships at 15k per day it is quite profitable and cash flow positive even if rates drop significantly lower. 2) genco does have many long term fixed rate contracts so it is more exposed to rate risk which has it's pros and cons but with 300m in cash, strong cash flows it can withstand a poor rate environment for a number years.

  12. Well said Mako. The tough part about calculating liquidation or replacement value on the ships is that they are also highly linked to spot rates. You can do a discounted cash flow as most operating cost are easily obtained or you can look at recent ship ans purchases. This is a good site that summarizes recent ship transactions: www.brs-paris.com.

    That said, Mako hit the nail on the head. If you want to benefit from a long term investment in the shipping industry you want to look for a beaten-up company with 1) staying power (modern fleet, low operating costs, strong cash position and manageable debt) and 2) exposure to the upside when rates eventually turn.

  13. I should make a correction to my post above.

    Genco does NOT* have many long term fixed contracts..

  14. What do you guy think about Frontline ?
    It is heavy levered but the wildcard in John Frederiksen. He own about 1/3 of the equity and some part of debt belong to him also. I don't think he will let FRO wiped out. It is his legacy .

  15. the alex10/02/2011

    Check out Crude Carriers ticker: CRU. Unlevered shipping. the guys that run it semm pretty bright.

    I do not like FRO. They basically only own charters, not real assets. Recovery on the CBs is possibly zerol You are buying Fredriksen's good name. that's about it.

    If you really want to play, you should sniff around at Platou or Pareto and look for some of these really smal debt or private equity issues backed by one or two ships. They will be at distressed levels and Norwegian trustees are easy to deal with.

  16. Good post Hunter!I was starting to feel alone in my thinking that there might be some value in the Shipping Industry (particularly Tankers). Although medium term economics for the industry are weak, the shipping industry is well know for its pronounced cyclicality. Below is my stock recommendation.

    I think at this point we need to look at asset values behind the companies. From that perspective, I think Overseas Shipholding Group (OSG) is a great buy at current prices ($14) with a long term (2-3) years time horizon. The reasons for this are:

    1. A large company with a solid liquidity position and size (110 vessels). A couple of months ago secured a $900m revolving credit facility.

    2. Underlying book value of tangible assets is $53/share. Not very highly levered with a Assets/Equity ratio of 2.35.

    3. A number of insiders have made significant sized purchases recently (over the past couple of months)

    4. Although its halved its dividend to 88 cents it is still yielding 6% on the current price.

    However, at this time I must express a caveat in that short term volatility in this stock is immense and therefore it would be inadvisable to trade in this stock on Margin.