Misunderstanding that low valuation will lead to good performance
Investors often assume that investing in low valuation companies will always lead to outperformance. Price to book ratio is often used as a valuation metric for industries that have hard assets. Since the majority of tanker companies’ assets lies in ships, the equity book values on companies’ financial statements generally reflect the difference between the values of ships and the amount owed to creditors. This may lead investors to think that companies with lower price to book ratios are bargains.
Since the end of 2008, regardless of whether an investor placed his or her investment in low or high valuation companies, the one year returns have been guesses at best. Current research shows no relationship between price to book ratio and performance, with an r-squared value of just 0.04 – even below that of its sister industry, dry bulk shipping firms (see “Valuations for shipping stocks show no evidence of relationship to performance“).
Why is performance all over the place?
Tanker ships are generally serviced out on long term contracts. When contracts expire, companies will renegotiate shipping rates closer to the current market rate. For the past four years, companies had to renegotiate them at lower prices due to industry oversupply that depressed shipping rates and kept them low. As a ship’s value is partially dependent on expected future cash flows that it can generate in its lifetime, which is driven by shipping rates, lower shipping rates mean lower ship values. Because expiration dates for long term contracts vary on ships and companies, managers will charge impairment expenses (write-down their ship values in their financial books) at differing periods.
A low price to book ratio could mean that the market is expecting lower free cash flows but has not fully priced in the expiration effect. However, it could also mean the market has priced in lower expected revenues in the future. A high price to book ratio may reflect the company’s valuable long term contracts that have yet to mature. As long as that persists, those companies will continue to outperform. Yet, as the long term contracts draw closer to maturity, the market will start to reflect lower future revenue by dragging price to book ratio and share prices down in the near future.
Investors should look at company specific drivers or consider diversification
Investors should focus on company specific drivers when looking to invest in dry bulk shipping companies, such as Nordic American Tanker Ltd. (NAT), Frontline Ltd. (FRO), Knightsbridge Tankers Ltd. (VLCCF) and Teekay Tankers Ltd (TNK), instead of simply purchasing ones with lower valuation metrics. Alternatively, investors could diversify away from specific company risks through the Guggenheim Shipping ETF (SEA), which invests in large shipping companies worldwide.
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