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 rose since April 19th
On May 10th, the EV/EBITDA[1. Enterprise Value/Earnings Before Interest, Tax, Depreciation and Amortization Expense] valuation multiple for steel producers in developed Asia[2. Korea, Japan, Singapore, Taiwan and Hong Kong] rose to 9.52 from 8.93 times in April 19th 2013, rising 6.6% based on 2014 EBITDA estimates made by analysts in Asia. The multiple rose over the past few weeks as several central banks initiated interest rate cuts that will generally help support a weak global economy. Talks of the end to austerity in Europe has also fueled the broad market higher. The price index, which represents all steel companies in developed Asia, also rose higher, from 80.97 to 87.13.
High valuation multiples often point to higher earnings in the future. Additionally, analysts as a whole are often extremists with earnings (either extremely bullish or extremely bearish) when fundamentals are starting to deteriorate. 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 lead to lower valuation multiples. This also happened in 2009 when EV/EBITDA started to rise ahead of an industry turnaround. As long as EV/EBITDA does not begin to fall drastically and the divergence we have seen since mid 2012 holds, it suggests that the market is seeing better earnings than analysts’ estimates.
Shipping ETF follows steel ETF
This is supportive for shipping companies because steel is used in industrial manufacturing. If industrial manufacturing rises, so does the raw materials market, such as iron ore and coal, as they are used for making steel. The correlation between the Steel Index Fund (SLX) and Guggenheim Shipping ETF (SEA) has shown a strong positive figure of 0.94 since start of January 2011. It’s likely that demand will rise for companies, such as DryShips, Inc. (DRYS), Diana Shipping, Inc. (DSX), Navios Maritime Partners LP (NMM) and Safe Bulkers (SB). As some companies face revenue cuts in the near future as valuable contracts expire (see Why Diana will outperform Safe Bulker and Navios Maritime), and capacity growth remains high (see Current positive data shows supply to grow below 7% in 2013), 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.