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.
On July 5th, the EV/EBITDA1 valuation multiple for steel producers in developed Asia2 rose to a record 10.04x, based on 2014 EBITDA estimates made by analysts in Asia. The equal weighted price index rose slightly to 82.60 from 80.63 the prior week. Stock prices were under pressure in June as China’s financial woes hit the news and the market was spooked by the central bank’s plan to taper off the current asset purchase program. But a decline in interbank repo rates, although most likely temporarily, drove overall share prices higher.
Analysts versus the market
Although value investors often look for low valuations, high valuation multiples often point to higher future earnings for cyclical industries, like steel and shipping. Analysts as a whole are either extremely bullish or bearish when fundamentals are about to change. For example, from 2007 to 20 08 and in 2011, EV/EBITDA (next year estimated) kept falling while share prices rose higher, implying analysts were constantly revising their earnings higher. For a growing company that has limited competition, higher earnings often translates to higher share prices. But in a competitive industry with little product differentiation, fundamentals often revert to the mean. As long as EV/EBITDA holds at current levels, steel companies should perform well over the medium to long-term. Let the battle between the analysts and the market begin.
Medium-term: positive outlook; short-term risk remains
Positive outlook for steel companies generally translates to a similar outlook for dry bulk shipping companies, such as DryShips Inc. (DRYS), Knightsbridge Tankers Ltd. (VLCCF), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM) and Safe Bulkers Inc. (SB). This is because when steel companies are expected to generate more profits, they will use more iron ore and coking coal, which will drive shipping rates higher.
Continue to read why the market may be expected steel companies to generate higher profits and its significance on shipping: Why May industrial profits support dry bulk imports, positive for shipping
To see other key drivers that affect the marine shipping industry, visit our driver page, Marine Shipping.
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