A Beaten-Up Industry Poised for a Huge Comeback

I grew up in New York City, not far from the waterfront. As a special treat, my father would take me to the piers off Atlantic Avenue in downtown Brooklyn.

There we would stand and watch with amazement as forklifts unloaded heavy packages of cement and grains from gigantic ships that had just arrived from faraway places.

This was my first contact with the shipping industry, and little did I know how big an impact shipping would have on the world — and my income investing.

Today, marine shipping is responsible for transporting an estimated 90% of world trade. And while shipping is an ancient form of transportation, it’s being used more and more as world markets open up.

During the past 40 years, total shipping has grown four-fold — from just more than 8,000 billion metric-ton miles in 1968 to an estimated 32,000 billion metric ton-miles in 2008, according to Fearnleys Review.

And in the economic downturn of the past two years, demand for shipping — and the dividends paid by many shipping companies — fell sharply. But now the industry has started to turn around, providing an early entry point for select high-yield shipping stocks.

Specifically, freight rates, an indicator of the health of the shipping industry, have recovered from record lows for shippers of all stripes. Consider the following:

  • The Baltic Dirty Tanker Index (BDTI), which tracks freight rates for crude oil transport on 12 routes, has nearly doubled from its September 2009 lows.
  • The Baltic Dry Index (BDI), which measures freight rates for dry bulk cargo like coal and iron, has been volatile. But it’s still up almost +30% off the September lows.
  • The Drewry Global Freight Rate Index for container ships, which carry consumer goods, has climbed +24% between July and November 2009, a trend of rising prices for the first time since mid-2008.

So what do all these indices have to do with shipping stocks? The rates a shipper receives vary widely with the vessel size, routes, and contract terms, but higher freight rates generally translate to fatter profits.

Consider Bermuda-based Knightsbridge Tankers (Nasdaq: VLCCF). The shipper earned an average $36,900 per day for its oil supertankers and $44,300 per day for its dry bulk carriers in the fourth quarter of last year.

That’s up from $32,900 per day for the tankers and $39,200 per day for the dry bulk carriers in the prior quarter. Meanwhile, break-even for these vessels is $19,300 per day for the tankers and $16,900 per day for the dry bulk carriers, providing the shipper with a tidy profit that more often than not is distributed in the form of a high yield.

Volatile? Absolutely.

With a global rebound in the works and strong demand from China, the shipping industry’s outlook is optimistic — shipping consultant Drewry forecasts a +3.4% increase in global container traffic this year versus rates from 2009. That will push up average container freight rates about +15%, Drewry says. But no matter how optimistic the forecasts, investors need to tread carefully in this sector. Shipping rates and stocks are nothing if not volatile.

For example, Capesize dry bulk vessels commanded an all-time high of $233,988 per day in June 2008, only to fall to a decade-low of $2,316 per day six months later.

Changing rates can lead to wild swings in the shares and dividends of some shippers. The problem is that some companies seek to maximize earnings by leasing out fleets under short-term charters at spot market rates. If rates rise, earnings — and dividends — rise in tandem, but the reverse is also true.

Steady the Ship and Your Portfolio
For investors seeking a steadier income stream, shippers with longer-term leases — such as Navios Maritime (NYSE: NMM) — are the way to go. Their vessels are leased out under long-term, fixed-rate contracts that provide stable cash flow and dividends despite fluctuations in the short-term spot market.

One final note: It’s also important to check out the balance sheet of a shipper before you invest. Since many of them pay out most of their free cash flow as dividends, they often go to the capital markets to finance growth. New ship purchases and acquisitions can cost millions of dollars. As such, shippers tend to bear heavy debt loads, but some have more cash flow than others to cover their debt and dividends, while also financing growth.

This is one of the reasons many shippers saw their shares tumble in the financial crisis. Of course, with a rebound in both the global economy and shipping rates, now looks like an opportune time to pick up stable shippers at reasonable prices.

P.S. — Shippers are great for income investors, but you do have to be choosy about what you buy. That’s why I covered the industry in my March issue of  High-Yield International — bringing to light two of my favorite plays (yielding as high as 8.4%).  Follow this link to subscribe and read my latest issue…