Most investors know that the higher the leverage, the greater the risk and reward. While companies in the same industry will often share similar leverage (the portion of business funded by debt and shareholder’s capital), this is not always the case. It is a common misconception that greater leverage will generate higher returns: when an industry is in decline, companies with higher leverage will under-perform.
The dry bulk shipping industry is quite commoditized with price being the major factor of competition. When supply is outpacing demand growth, prices for shipping goods will fall, decreasing bottom line earnings for ship owners. Leverage will amplify the effect of price changes on ship owner’s return.1
The debt to asset ratio, measured by debt over assets at a specific point in time, is a common metric used to measure leverage. Since 2008, companies with higher debt to asset ratios have generally performed worse. These companies include DryShips Inc. (DRYS), Eagle Bulk Shipping Inc. (EGLE) and Excel Maritime Carriers Ltd. (EXM), with Safe Bulkers Inc. (SB) being an outlier.
Although global economic environment are showing signs of recovery and should benefit shipping companies, current supply and orders for dry bulk ships are still above the norm (see “Dry bulk orders still at elevated levels, negative for shipping“). If the dry bulk shipping industry does recover during the second half of 2013, as most analysts are expecting, companies with higher leverage ratios will generally outperform than those with lower leverage. However, in the short run, companies with lower leverage are safer.
To lower risk, investors may consider the Guggenheim Shipping ETF (SEA) that invests in the leading high dividend paying shipping companies, according to the issuer. Its portfolio of holdings also includes the tanker industry (oil shipping), which is backed by very favorable fundamentals (see “Tanker order may be bottoming, opportunities ahead“).
- Suppose company A purchases a $2,000 ship with $1,000 in firm cash and $1,000 in debt, whereas company B uses all cash. Suppose that $2,000 ship can generate $500 in earnings every year. That is great for company A because the company will generate 50% in return ($500 in earnings / $2,000 total cost of ship), while company B generates 25%. But if the ship begins to lose money, say -$250, the return for company A is -25%, while it is just -12.5% for company B. ↩