Buy This Shipper Before it Doubles

One of the most interesting indicators used in the financial markets is the Baltic Dry Index (BDI). The index, created and maintained by the London-based Baltic Exchange, measures the price of shipping raw materials such as iron ore, coal and grains around the world.

Like in any other vibrant market, the price of shipping is set by supply and demand. In this case, it is the supply and demand of shipping vessels — with an abundance of such vessels leading to falling prices and a dearth of vessels leading to rising prices.

While the BDI directly measures the supply and demand of shipping vessels, some believe that it also indirectly measures the demand for raw materials. And although the Baltic Dry Index sounds like a promising economic indicator in theory, the reality has been much different, with the index acting like a coincident indicator in the best of times, while offering false indications at other times. (This is an important lesson for investors: always do your own due diligence; never take something as a given when it comes to the markets.)

But even though the BDI is a poor leading economic indicator, it is still good at its primary purpose, which is to measure the price of shipping raw materials around the globe. In that respect, the index has presented a very volatile portrait of shipping prices, with a peak level of 11,800 in 2008, a trough level of 660 in 2009, and current levels near 2,700. As a matter of fact, shipping prices have displayed a pattern quite similar to the prices of raw materials themselves — which makes sense. After all, shipping itself is in many ways a commodity business.

That’s not necessarily a bad thing, as the picture for commodities remains bright. Aside from the one gigantic hiccup from the Great Recession experienced just a little over a year ago, the bigger picture remains one of rapid global economic growth spurred by the industrialization of China, India, Brazil and other emerging markets. As billions of people within these and other countries join the modern economy, the demand for raw materials will soar. In turn, those raw materials need to be shipped across the globe, and that’s where the shipping industry comes in.

The good news for investors is that shares of many companies in the dry bulk shipping industry are selling at extremely low levels. Take DryShips (NYSE: DRYS), for instance. Shares of the company were trading as high as $131 during the market peak of late 2007. Today, those same shares could be had at a -95% discount to those levels. And while there is nothing unusual about a stock being significantly down from its all-time highs — the S&P 500 is down -25% from its peak — the decline in shipping stocks has been especially brutal, in large part due to the enormous amount of debt that the industry took on during the boom.

As one can imagine, being overleveraged during one of the worst credit crises in history is a recipe for a disaster. DryShips was actually found to be in violation of several of its loan covenants — a situation that could have led to bankruptcy. That worst-case scenario was averted, however, when the company reached covenant waiver agreements with lenders.

Today DryShips finds itself still burdened with a massive debt load, but the risk of bankruptcy has diminished now that the worst of the credit crisis has passed. The company’s net debt stands at nearly $1.9 billion, or $7.28 per share — a substantial figure, considering the stock’s is fluctuating between $4 and $5.

But that isn’t the only thing interesting about DryShips’ stock price. The consensus expectation for earnings in 2011 is $1.02 per share, while the expectation for 2012 is $1.29. Using those figures, we arrive at a price-to-earnings ratio (P/E) of 4.5 and 3.6 for 2011 and 2012 respectively. By giving Dryships’ stock such a low valuation, the market is acknowledging the risks associated with the company’s massive debt load — but it is also giving investors a chance to scoop up the shares for cheap.

Another risk the market may be looking at is the company’s increasing reliance on its relatively new deepwater drilling segment, which following the oil spill in the Gulf of Mexico, has acted as drag on shares. But the Obama administration announced Tuesday that it will lift the moratorium on drilling in the Gulf of Mexico, and shares have spiked on the news. Tougher regulations are likely in the offing, but if one believes that offshore drilling still has a future, the current uncertainty presents an opportunity. Incidentally, DryShips has long been planning an IPO for its drilling segment, with the only obstacle being the poor market environment. An announcement by the company to go ahead with such a spinoff may end up being a significant catalyst for the shares. [Read more about Catalyst Investing Secrets]

Action to Take –> Risk-tolerant investors should consider buying DryShips to bolster their portfolio. It’s the proverbial high-risk, high-reward investment. While the upside is significant, there is also the potential for significant losses as well. A pronounced downturn in the economy, the shipping industry, or the offshore drilling industry could make it difficult for the company to service its debt, and thus continue as a going concern

In many ways, DryShips has become a leveraged play on the global economy. If the demand for raw materials continues to grow briskly, the shipping industry, and DryShips in particular, should benefit. In such a scenario, the company will be able to service its debt and generate significant free cash flow for shareholders. The market may then reward the stock with a higher multiple. Were shares to trade at just seven times 2012’s expected earnings, investors today would almost double their money.