Larger World = Buy Shipping?

I don't currently own any shipping companies to speak of, but I have invested in them in the past ... and some general trends have started to get me interested again.

Nearly every shipping company -- whether it be a Jones Act shipper like Alexander and Baldwin, a big tanker company like Frontline or Teekay, a bulker or a container line, has gone up dramatically in the last couple of years. Some of them, notably the tanker companies, have been extremely volatile, but the general trend has certainly been positive.

So why consider investing in them again here? Well, there are a few fundamentals that underly the shipping industry, no matter the segment -- the global economy in general is certainly one, and the supply of ships is another. In recent years, China has been the real heart of the shipping story -- it has been China's demand for oil and commodities that have driven tanker and bulker rates higher on the margin, and China's increased exports that have driven container rates.

Which makes me step back and think more about this: Isn't the story of shipping really a story about the world growing larger? (cue, "It's a small world, after all")

It's true, the world has shrunk in some ways due to air travel and globalization -- no market is truly so foreign that it can't impact the global economy, or so remote that you can't invest in it in some way. And few societies remain isolated from the world at large.

You can get a piece of fresh tuna sashimi on your plate in Tokyo less than day after it's caught off the coast of Maine ... as long as you're willing to pay ... so in some ways, the world is shrinking and we're all becoming more connected.

But when it comes to big things, like tankers full of oil or container ships laden with flat screen TVs, the world is growing.

You see, a decade or two ago we didn't used to buy all that much from China and they didn't use that much imported oil. We used to get most of the oil for US consumption from our own wells, and make up the shortfall from nearby Mexico, Canada and Venezuela.

But now these markets are truly global. Which means that conceptually the world is shrinking, but in terms of the knots that shipped materials have to travel it has grown massive.

What are some recent catalysts that have gotten me thinking about this? European imports, Venezuelan and Nigerian oil problems, and free trade between the U.S. and South Korea. I think all of these have the potential to help spur an increase in the demand for heavy shipping, which might make an investment in a shipping company sensible ... even after their excellent recent performance.

The first issue is oil -- which travels by massive tanker ship, and generally is consumed as close to locally as possible because of the cost of transport (which is part of the reason why we get so much from Mexico and Canada -- in abstract terms we can pay them less for it than China can, because of the shipping cost). The U.S. has generally come quite close to satisfying our oil import needs with countries that are only one ocean away -- whether that's Nigeria or Venezuela or Norway.

True, there has always been some marginal importation from the Middle East, but it isn't anywhere near the top of the list -- and in a truly efficient market without political concerns, we could probably get by without any Mideast oil (it would all go to China and Europe, and we'd get almost all the rest). Everyone likes diversified supply, though, which makes things a bit less efficient than they might otherwise be.

So what happens if Chavez really does make a deal with the Chinese to cut off the US from Venezuelan oil? Or if the majors pull out of Nigeria because the unrest is too much to handle (or just cut production because they can't keep the pipelines open)? Or if the North Sea dries up even faster than we expect (it seems to be tailing off these days, according to what I read)?

None of those would cause a real shortage of oil, there is probably enough marginal production and discovery elsewhere to make up for any Nigerian or North Sea shortfall, and Venezuela's production would still be entering the market.

But it would mean that the U.S., still by far the world's leading oil importer, would need to pull in supplies from farther afield, since those are the biggest exporters that are relatively near our ports.

And since boat owners are generally paid lease rates by the day (or by longer terms, in some contracts), and not by the load, every additional knot that a barrel of oil has to travel brings some extra demand for shipping tonnage, and extra money into the pockets of shipowners. If it takes just a few days for oil to make it to Louisiana ports from Venezuela, it can take a month for a tanker to go from Kuwait, through the Suez canal, and get around to the US Gulf offloading facilities. As you can imagine, even if consumption everywhere in the world remained the same, the mere fact that the marginal oil production comes from Kuwait instead of from Venezuela would make a marked difference in the number of tankers that are needed, and in the prices those tanker owners could be expected to get.

That has long been an understood part of the market, of course -- this, along with the scrapping of single-hull ships, has been the big driver of the tanker market for many years, and it brings spikes when Nigerian oil or big Norwegian platforms go unexpectedly offline for a period of time.

The fear has been that so many ships are being built and hitting the water right now and over the next year or two that the supply/demand imbalance will swing back the other way. Now I'm starting to wonder if that's too pessimistic, given the fact that China, India and the US are likely to be competing for oil from around the world.

And a similar phenomenon has been coloring the container ship market, which I haven't ever looked at before. While China has been supplying the US with cheap consumer goods, which almost all travel by TEU (20-foot equivalent units, or something like that) containers on container ships (the ones that look like they're carrying giant legos), they haven't supplied Europe to quite the same degree. Now that's changing, and Chinese exports to Europe are climbing. Why is that important? Well, for one of these big container ships it takes 8-10 days to get from the coast of China to US West Coast ports ... but it would take the same ship more than half again as long to get through the Suez canal and make it to the big container ports of Europe. Chinese TVs are still cheaper than French ones, even with the extra shipping cost, but it means more demand for boats and more money for shipowners.

The world may be shrinking for people and air cargo, but for ships the routes are getting longer and more lucrative as the spread of capitalism, export-led economies, and free trade means that anything can come from anywhere ... and be in demand anywhere. And I haven't even mentioned the possibility of expanded two-way trade with South Korea ... or the number of deals the Chinese are making for South American commodities and steel.

So what am I doing with this thought? Not much, yet. The safest bet on these markets is probably the ship owners that lease out their boats for years (and sometimes decades) at a time, thereby making them a bit less susceptible to fluctuating day rates -- that would be Ship Finance Limited (SFL), which buys and provides long term leases primarily on tankers to the shipping companies, or Seaspan (SSW), which does the same with container ships. Both of these tend to trade in part on their very nice dividends.

The racier investments would be the operators of the ships themselves -- the ones who pay those long term leases, or own the boats themselves, and hold some or all of their ships for the spot market (meaning, booking journeys one at a time at prevailing rates instead of signing longer term time charters). Frontline (FRO), which runs most of SFL's ships, does this in the tanker biz, I'm not sure if there's a pure play on this for containers or bulkers but I expect there probably is.

It's an interesting business, but one that has in the past been extremely volatile -- with cyclical downturns bringing the companies down to well below the book value of their hulls. Whether that's going to change in this new, bigger world, I don't know.

disclosure: I don't own any of these companies at the time of writing, but may invest in them in the near future.

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Indirect Investing

One of the themes that has come up with several companies I'm thinking about or have recently bought is the notion of the "indirect investment", by which I mean the purchase of a company in order to get access to the earnings (or growth,or whatever) of a subsidiary or related company -- either at a discount, or because the subsidiary isn't separately traded, or just for diversification in getting two significant businesses in one package.

Cypress Semiconductor (CY) fits this idea nicely, and I own a few LEAP options in the shares and remain tempted to buy the common stock -- it's a downtrodden semiconductor company which the market doesn't like at all. They haven't had particularly nice margins of late, or anything else to make the Street stand up and cheer, and short sellers are holding about 10% of the float.

Most importantly in my opinion, though, many years ago they bought a tiny company that had technology and designs for manufacturing solar cells, and built manufacturing capacity for that company. They've since IPO'd part of that solar company, called SunPower Corporation, but they still own about 70%. And today, though Cypress is the parent, Both companies trade at similar market caps, with SunPower's enterprise value of about $2.5 billion and Cypress at about $2.6 billion.

So that means, if you buy Cypress you're getting $1.75 billion of SunPower, which means you get the semiconductor business for substantially less than a billion dollars. Now, whether or not the semiconductor business is worth more than that is another question -- but even though it's not growing as fast as solar, there is certainly a market. The Semiconductor Industry Association (they're unbiased, right?) reported 9.2% growth year over year in January, so if Cypress was a proxy for semis as a whole you might be tempted. They do work in many different segments of the semiconductor marketplace, so perhaps there's an argument to be made there.

This may be too widely understood an "indirect investment" to make any money from, especially since Cypress has resisted "unlocking the value" of their SunPower subsidiary by selling it or spinning it off ... Cypress is probably already trading primarily on the value of their SunPower holdings.

In solar power, there's another way that I've held on to a somewhat indirect investment, too -- my shares of MEMC Electronic Materials (WFR) were initially bought because they were cheap, the share price didn't reflect the great position they held in the semiconductor wafer business because of their integrated supply chain and good supply of polysilicon in a tight market. But one of the reasons I've held the shares after a huge advance,and in the face of an uncertain balance between burgeoning silicon supply and hopefully booming demand, is their growing exposure to solar power -- including warrants to purchase five percent of Suntech Power (STP) that they received in exchange for a long-term silicon supply agreement. That doesn't yet move the needle at WFR, but it could very well do so in the future -- or at least cushion any blow from a slowdown in semiconductor demand, should it come.

Moving away from silicon, Naspers (NPSN) is another investment along these lines -- I bought shares recently, and while I like the cash generation of their core media (South African newspaper and pay tv) assets, what I really like is the growth potential of their partially owned division, Chinese IM leader (with the QQ product) and portal company Tencent, and their acquisition spree in emerging markets media and internet companies.

The impact on the market cap is big here, too, since Tencent is roughly a $6 billion company and Naspers owns about 36% ... and NPSN itself has a market cap of about $7 billion, so roughly a third of Naspers' market cap is attributable to their not very profitable (in earnings terms) Tencent holdings, which significantly depresses the company's PE ratio and makes them seem a bit more expensive than they really are.

Tight relationships among corporations can give us opportunities to do this kind of investing in nearly any industry -- Ship Finance Limited, a company I've owned in the past, gets an indirect ride on the profits of former parent Frontline. They own Frontline's ships and get a steady lease rate for them, which they churn out as a high, steady dividend yield ... but if the tanker business takes another turn up they'll get a bonus from a profit sharing agreement whereby they get a portion of all profits over a set level on their tankers. Which is probably why the shares are just about at all time highs while the more leveraged Frontline languishes on the currently tepid prognosis for tanker rates.

This kind of investing is not unusual, of course -- a lot of what professional investors do is try to find hidden values in the companies they're interested in, and many arbitrageurs spend their days figuring out which companies are likely to move to unlock those values in a particular time frame.

Other examples abound -- buying Roche a few years back to get a cheaper bid on the future of Genentech comes to my mind as one example ... and in a related way, biotech and other IP-heavy industries also give us the opportunity to invest in companies because of royalties they receive from successful or promising products.

Using the Genentech example again, this might mean buying PDL Biopharma (PDLI) because of the humanized antibody royalties they get from several of Genentech's big products, including Avastin and Lucentis (though PDLI also has its own issues, including a looming fight with a big investor about their spending habits).

Whatever your focus, it sometimes pays to look a little deeper into the companies that interest you -- maybe the companies that don't appear to be publicly traded are really available for investment as subsidiaries of others, or maybe the shares that look a little too pricey are hiding an unusual gem.

full disclosure: I own shares in Naspers, MEMC Electronic Materials, and PDL Biopharma, and call options on Cypress Semiconductor. I have no position in the other companies mentioned.

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Question about Tankers (OSG)

I got a question from a reader about Overseas Shipholding Group (OSG -- click to register for free RT streaming quote) a couple days ago:

"What do you think about OSG at this moment? Price is almost equal to book value. PE is a low 3. Earnings are almost 30% of stock price. Is it a good buy? What's your projection on this one? You held this stock couple years ago and not sure, if you still have any interest in this stock?"

I do still track several of the tanker stocks. OSG is a big tanker owning company, not quite the biggest but certainly near the top of the heap. I took a wild ride on some tanker stocks in 2003 and 2004 as they recovered from a dramatic bottom to reach ridiculous heights, but I sold all the shares I owned of Frontline (FRO), OMI (OMM), Torm (TRMD) and OSG in December of 2004, before I began writing this blog.

That turns out to have been a reasonable point to get out -- it was the end of the uninterrupted shot to the moon, though you could certainly have made plenty of money in these stocks over the past year or so as well.

Since my portfolio was overwhelmingly oil stocks and tanker stocks in 2004, that's my frame of reference on prices -- and investor psychology being what it is, I can't face buying oil stocks at today's prices after having sold them about 50% ago. That doesn't make sense on any rational level, but it's still a human being placing the buy orders here and that's one of my handicaps.

But tanker stocks haven't climbed so much since I sold all of mine -- so what do I think of the sector?

Back when I made my purchases, it was an undiscovered sector in many ways and the argument in favor of the shares was almost irrefutable. FRO, the largest operator, was crossing $14 after having hit a bottom the previous year of $3 (it's at about $40 today), so volatility was expected, but the business climate was brewing a perfect storm for any company that owned VLCC or Suezmax tankers, anything that could transport crude oil from the Middle East to the US, China and India. Single hulled ships were being phased out gradually, Venezuela and Africa, which are shorter trips for US bound tankers, were having production or political problems and more oil had to be freighted longer distances, no one had invested in any new large crude carriers for years because of the cheap oil climate and lack of demand for tonnage, and as soon as it became clear that more tankers were needed the rush was on to build them -- but shipyards had full order books already and the backlog for new tonnage reached years ahead.

So any company that owned tankers could charge ridiculous dayrates for them as demand went through the roof. FRO was my biggest holding and a big beneficiary, because they had their entire fleet leveraged to spot voyages at high rates (instead of long term contracts at more moderated prices) and because they were committed to spitting off almost all of their free cash flow as dividends. FRO yielded upwards of 30% for a year or so, in addition to capital gains of more than 100%.

I think that easy money is over for all of the companies in this space, but I think they're also fairly valued and might make reasonable investments here. Here's my thumbnail assessment of each -- but remember, this is based on my memory and I haven't looked into these in any great detail lately:

FRO -- still highly leveraged and with very low book value in comparison to it's competitors. That's because they've spun off all their tonnage to Ship Finance Limited (SFL -- almost a FRO subsidiary, but separately owned and traded), and they lease it back to then charter on the spot market. I think they're still the largest VLCC operator, and due to the fact that they've already spun off their boats they don't have the same downside protection that some of the more stable operators do. This is the best bet for leveraging returns to higher spot rates, in my opinion.

If you want a little more stability but like the buccaneering bets of Frontline, buy SFL -- you get the yield from leasing the tankers to FRO, and this is fairly stable so it almost acts like a REIT, but you also get a profit-sharing kicker if FRO's rates top an agreed number.

OSG is a more stable tanker company, also focused on the large crude carriers in the main, and also with some complex lease and share agreements with other investors to help finance these incredibly expensive boats. OSG has a more diverse fleet, and never got quite the sexy attention given to FRO or some of the others. They time charter more of their boats, which makes things a bit more stable and means they're not as subject to vacillating spot rates -- either high or low. OSG would make me sleep better at night than FRO.

OMM is a smaller company that focuses on smaller ships -- Suezmax and Aframax tankers, I believe. I actually like this company more than either FRO or OSG at this point because the management never placed outsize bets during the wild bull market in 2004 ... and because they're in a little bit different business. OMM charters both product tankers (carrying refined products like heating oil or jet fuel or gasoline) and smaller crude oil tankers. It was their practice to have about half their fleet on multi-year time charter and half on the spot market to try to get the best of both worlds, which made a lot of sense. Whereas FRO always seemed to be aggressively trying to free up cash to dividend out to it's majority stockholder (and the rest of us, of course), OMM always seemed to me to be building a sustainable business with lower debt and a longer range vision than OSG or FRO, though all companies in this sector are pretty heavily leveraged.

And TRMD was my favorite for a while -- six months after selling it it sat on my wish list. This Danish company is very thinly traded here in the US and still very much uncovered, but it's not nearly as cheap as it used to be, either. Today I still like Torm's exposure to a very diverse set of shipping businesses, from a few bulkers to product tankers, including edible oils and other non-petroleum products.

I reconsider buying into this business every now and then, but the real time to buy is when everyone thinks things have bottomed out and the banks are going to start repossessing the ships. It might be that the tanker industry is more corporate and better financed now, and won't see those wild swings as marginally financed families tried to build their fleets -- if so, the downside will be a bit more limited than it used to be in this sector. I think I'd be more interested in product tankers in the near term, since I think the real worldwide shortages are going to be in refined products, not crude oil for the foreseeable future ... but that's just me. If I were to buy one of these today it would probably be OMI, but I'm not in the market at the moment.

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