The alternatives asset class is one that typically doesn’t garner much attention and can be easy to overlook. The individual holdings themselves typically aren’t flashy, and, on balance, alternatives make up a smaller portion of your portfolio than U.S. stocks, international stocks or bonds. Despite this, its significance to your overall portfolio shouldn’t be ignored as the value it provides is often realized when other asset classes are reeling. At OPCM, our alternatives typically take one of two forms: a hedge or a “niche” investment. The hedge portion is a bit more obvious, and is commonly used to mitigate some form of risk present in the portfolio (currency or interest rate risk, for example). The niche investment is more opaque, but, in general, describes attractive and unique investment opportunities where we believe there is significant price dislocation. Examples of this may be private equity, distressed companies or industries or even M&A (merger and acquisition) arbitrage. Of late, we have become increasingly interested in a potential niche investment that would fall under the distressed industry category: container shipping. More specifically, it is our belief that the companies which own container ships potentially offer significant value for long term investors. This is an industry that has seen a classic boom-bust cycle in recent years, but there are increasing signs that the clouds hovering over this industry may be parting, and attractive opportunities exist for patient investors willing to endure some choppy waters.
Container shipping is an old industry that has been a pillar of global trade for decades. It is a capital intensive and commoditized service that has historically done well in times of solid global GDP growth and poorly when growth falters. The business itself is straightforward: goods are loaded into a steel container box at various distribution facilities, loaded onto a truck or rail, transported to a container ship and sent to the destination port whereby it will be sent to the receiving party via truck or rail. This oversimplifies the process, but is more or less how things work. There’s a good chance that the shirt you are wearing, your car or your TV has spent some time on a container ship. Typically, the companies responsible for transporting goods (companies such as Maersk or COSCO) lease the ships from owners. The leases can be as short as a month and as long as 15+ years, with the length of the lease typically a function of supply/demand of ships and underlying economic strength. Compared to other forms of transportation like rail or truck, container shipping is by far and away the most economical to transport goods around the globe.
With global GDP expected to be at the highest level in years, this would seem to be an ideal environment for the containership business. Instead, this industry is just barely on stable footing and is less than two years removed from conditions that were far more dire than what was experienced during the global financial crises. Years of steady declines in shipping prices culminated in August of 2016 when Hanjin, the (then) world’s seventh largest shipping line, filed for bankruptcy resulting in over $10 billion worth of goods being stranded on ships that were stuck floating directly offshore of the world’s largest ports. What led the industry to this point? There were multiple contributing factors, but the biggest culprit was excess supply. Ship owners were aggressive in the aftermath of the financial crises in 2010, and ordered a large amount of new ships fueled by the expectation that the global economy was recovering and pricing would firm. While shipping rates did bounce back in 2010 and 2011, the combination of new ships being delivered and another wave of new orders in 2013-2014 proved too much for the industry to handle. Capacity was steadily outpacing demand which led to a multi-year period that saw excessive ships pursue insufficient volumes of goods resulting in a total collapse in pricing. In the second half of 2016, the price of a mid-sized vessel cost nearly 80% less than it did in 2011 and charter rates for vessels were over 70% below where they peaked in 2007. These were depths that no industry observers anticipated even a year or two earlier.
The Hanjin bankruptcy sent ripples through the entire industry and was the clearest signal possible that no party could afford to remain complacent. Almost immediately, companies put the brakes on new ship orders, started scrapping older vessels to sell the metal and clamped down on costs where they could. But, possibly the most notable development in the aftermath, was a rise in industry consolidation. From the beginning of 2016 until the end of 2017, the market share of the top five containership liners grew from 45% to nearly 57%. Weaker companies with lower market shares were the first to be snapped up, creating a more concentrated industry with healthier balance sheets, and, for the first time in a long time, a desire to restore more rational decision making to the industry after years of gluttony. Since then, we have seen many industry metrics begin to improve more meaningfully. The most important metric, containership charter pricing, is up 85% year to date and over 280% since December 2016. Despite this improvement, pricing is still 50% below where it was at the beginning of 2011. For the first time in a while, management teams are starting to express some optimism, noting that the worst of the recent industry woes are very likely behind them.
Dealing with distressed industries is not for the faint of heart, and often requires an uncanny amount of diligence and patience (as does reading an entire article on container shipping!). We certainly don’t expect fundamentals in the containership industry to get better overnight and understand that it could be an extended period of time before this industry is out of the woods. Despite this, distressed investments, along with our other alternatives exposure, can add significant value to a diversified portfolio due in part to their idiosyncratic returns. These securities often trade well below their intrinsic value for periods of time until the market realizes the disparity, often causing a significant upward rerating. We believe a lot of the containership industry is trading well below its true intrinsic value, but expect this to correct over time, driven in large part by more rational supply and improved pricing being sustained. In the meantime, our investment team will continue to look for the most compelling opportunities within this industry and others.
