Valuations can often tell investors the outlook of equities in the near future. Although value investors often look for valuations that are low, high valuations can often signal better times ahead. This is especially true for cyclical companies, such as steel producers and shipping companies, as has been mentioned by Peter Lynch in his famous book Beating the Streets.
Steel producers’ valuation multiple fell just slightly in March
On March 29th, the EV/EBITDA1 valuation multiple for steel producers in developed Asia2 stood at 8.72 times, based on 2014 earnings estimates made by analysts in Asia. While the price index has fallen from last month’s 90.89 to 84.75, a move of -6.76%, the valuation multiple has only fallen by -0.88% since the end of February. This suggests that the cut in earnings estimate was larger than the cut in what the market was willing to pay a dollar of estimated earnings for.
Investors should know that the market often moves before developments in earnings. Additionally, analysts as a whole are often very bullish or bearish with earnings when fundamentals are starting to deteriorate or turning up. For example, EV/EBITDA kept falling from 2007 to 2008, signaling either extreme optimism among equity analysts, which inflates EBITDA, or an increase in the required rate of return demanded by the market, which reduces the amount investors are willing to pay for one dollar of EBITDA — both of which leads to lower valuation multiples. This also happened in 2009 when EV/EBITDA started to rise ahead of industry turnaround.
High valuation suggests the market sees better times ahead for shipping
As long as EV/EBITDA does not begin to fall drastically it is a sign that the market is seeing better earnings than analysts’ estimates and that it is willing to pay more for one dollar of current analysts’ estimated earnings for 2014. This is supportive for shipping companies because steel is used widely in industrial manufacturing. If industrial manufacturing rises, so does trades of raw materials, such as iron ore and coal, that go into making steel. Demand will then rise for companies such as DryShips, Inc. (DRYS), Diana Shipping, Inc. (DSX), Eagle Bulk Shipping, Inc. (EGLE) and Safe Bulkers (SB). As some companies may be in distress, investors may want to consider the Guggenheim Shipping ETF (SEA), which invests in leading shipping companies worldwide and corresponds generally to the Dow Jones Global Shipping Index to reduce risk.
© 2013 Market Realist, Inc.