This week I want to explore a really interesting study on dry bulk shipping done by Robin Greenwood and Samuel Hanson of Harvard. Don’t worry, this won’t be as dry an email as the title of that study makes it sound. The study was brought to my attention via a Verdad research report last month and I think it’s a really interesting commentary on the business cycle and how our behavior as investors drives booms and busts. A lot of what we are about to discuss is directly applicable to the broader world of investment, not just the dry bulk business.
Dry bulk shipping refers to moving large quantities of unpackaged commodities via ship. Think of things like iron ore, coal, gain, lumber, steel rods etc. The industry has been around for a long time, as you can imagine humans have been moving commodities by ship for probably as long as ships have existed. It’s extremely competitive and, thanks to the volatile nature of commodity prices, is an extremely cyclical industry. Great wealth is both created and lost in dry bulk shipping.
A few things make the dry bulk world hyper cyclical. For one, the cargo itself has a volatile price. When prices are high, there is more demand for shipping. When they are low, demand dries up. In the case of agricultural goods, that cycle can be driven by something as fickle as the weather in a certain month. Layer on top of that the fact that it takes 18-36 months to build a new ship, and you have a scenario where demand for shipping and the supply of ships can be way out of equilibrium for a long time, creating a huge boom or bust.
Now, the final amplifier in this chain is that the ship builders price ships based on current demand. This means when dry bulk shipping demand is high, the ship prices are expensive. When it’s low, they are cheap. This creates a miss match, where the input cost of the business is extremely responsive to supply and demand but the output, or pay off, is lagged by 18-36 months. Given we know how volatile the industry is historically, this miss match creates some strange behavior by dry bulk companies which, in this case, can be thought of as the investors.
Greenwood and Hanson found that shipping companies commissioned new ships when net earnings and new ship prices were highest. Consistently, this created a phenomenon where large numbers of ships are delivered 18-36 months after a boom in ship earnings, with that new supply increase having the obvious effect of lowering ship earnings that were dependent on excess demand. This “buy high, operate low” behavior means that the new and used ships bought at peak prices tend to exhibit negative future returns for the shipping company. The study found owners who bought ships at peaks could earn returns as low as -36%, while those who bought them at cycle bottoms could earn as high as 24%. That is a pretty large gap, and remember, it’s the same ship in both scenarios….the only difference being the price paid for it.
The shipping companies are making two mistakes, according to Greenwood and Hanson.
1) They are assuming the high levels of earnings and demand currently will persist into the future when they commission expensive ships.
2) They fail to realize that competitors are making the same decisions with the same data, and so the assumptions made in #1 are not just potentially overstating demand, but also understating supply.
The authors present an economic model that incorporates those two errors, and through it they explain most of the historical volatility in ship prices and earnings. Even with this data being “known”, ship owners continue to extrapolate good markets too far into the future and not account for other competitors reacting in the same way. This creates over investment, which inevitably leads to excess supply and therefor a low future return on investments made during that time.
There are obvious similarities to draw between a Greek ship captain and the average investor through a business cycle. High prices tend to create more buying, low prices tend to create less buying, and that behavior tends to reduce long term returns. Imagine a shipping company who banked their cash flow during a boom, and then commissioned ships with that cash when business was slow. I’m not sure if that company exists, and it certainly wouldn’t eliminate all the risks of dry bulk shipping, but you can imagine the profitability advantage that fictional company would have over its competitors.
In closing their piece, the Verdad author (unnamed in the research) says the following…
“IPOs and SPACs might be the equity market’s new ship orders, and valuation multiples for big tech companies are used ship prices. And, perhaps, equity investors suffer from the same extrapolation bias and competitor neglect as ship owners.”
That is one firm’s opinion and certainly it is not a perfect analogy, but imagine for a moment that stock purchases worked like ship purchases. You put up all the money at today’s price, but you don’t receive the stock in your portfolio for 18-36 months. If you like, you can imagine a bunch of investment bankers clambering around on scaffolding, welding your stock together until finally they break a bottle of Champaign over the top and slide it out of dry dock and into your portfolio. If that was the case, I bet it would narrow the universe of companies you would be willing to buy stock in. Some investors got a taste of that last week, when trading platforms like Robinhood limited stock trading in a few volatile names for just a few days.
So perhaps going forward we should remember these shipping companies as we captain our portfolios through the rough seas of the market. We shouldn’t get blinded by the next wave in front of us and forget to look out to the horizon, where we can focus on the assets that will get us the best future rate of return, which is of course abbreviated as…
“Arrrghhhh O Arrrrghhh”
Have a great weekend, me hearties,