On Value Traps

Over the past few months, we have seen a number of prominent distressed managers dip their toes into shipping:

• WL Ross Looks to Exploit Shipping Market (Ross)

• Ships Come in as Deals Heat Up (more Ross, Carlyle, Tiger Group, Fairfax Financial, Morgan Creek)

• General Maritime Announces Completion of $200M Oaktree Investment (Oaktree Capital)

I've been to a number of shipping event the last few months. I would guess that approximately 50% of the attendees are analyst and portfolio managers from distressed debt funds. Many people think there is real value in that space (pick your flavor - for this post I'll be using the 'tanker' market as the prime example), but very little capital is flowing into the space. How does one reconcile that?

The common reaction I receive when I ask a peer if he / she is looking at the shipping sector: "The fundamentals are only going to get worse from here, so we are going to wait until the supply/demand imbalance gets sorted out." If everyone believes that though, does that not inherently mean the opinion is priced into the various securities of tanker companies? Howard Marks shares a similar sentiment in "The Most Important Thing" regarding the debt market:

"Whenever the debt market collapses, for example, most people say, 'We're not going to try to catch a falling knife; it's too dangerous.' They usually add, 'We're going to wait until the dust settles and the uncertainty is resolved'

The one thing I'm sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there'll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it's a great bargain. Thus, a hugely profitable investment that doesn't begin with discomfort is usually an oxymoron." (my emphasis added).

To me, the reason that you are not seeing capital flow into the space are two fold:

1. 90% of money managers very much care about short term results. The number could in fact be higher. The most precious capital is sticky capital (hence the reason why many asset managers have gone public, why Sardar Biglari took over Steak N' Shake, why Phil Falcone set up Harbinger Group, why closed end funds fight off people like Phillip Goldstein, etc etc). Because in most cases, capital is not sticky, short term results are monitored religiously at the expense of long term value creation. I.E. I can't buy this stock today because it may go lower in the interim.
2. There are very few investments in the shipping industry (via the public markets) that offer a meaningful margin of safety.

Point 2 is what the rest of this post will focus on.

Warren Buffett has famously said, "The first rule of investing is don't lose money; the second rule is don't forget rule number one." And Ben Graham wrote in Security Analysis: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

I can, with VERY high confidence, say that at some point in the future, spot rates for VLCC (Very Large Crude Carriers or 200,000 DWT or more) will be higher. It might not be next year, or the year after, or the year after that. But at some point, VLCC rates will be substantially higher than they are today (negative TCE rates in some instances). Here is a chart (For reference -This is the rates for VLCC going from the Middle East to the Far East) :

You will notice that forecasting price in this segment is remarkable difficult. You will also notice that at multiple points in the past 10 years, VLCC day rates have been over 200x today's rates.

Buying on that opinion alone (that rates will be higher one day) would be speculating. Because most shipping companies are massively levered, with both recourse and non-recourse, ship level debt, buying the bottom part of the capital is akin to betting the sector turns before 1) the debt comes due or 2) covenants are breached. And, if you are wrong, you get zero.

Let's take an opposite extreme example: You start a shipping company with 100% equity. No debt whatsoever. In this scenario, outside of some working capital draws that may occur if day rates stay negative for a long time, you are essentially buying an at the money call option without an expiration date. There is then no theta decay. On an asset with massive volatility. How much is that call option worth? A significant amount of money.

Wilbur Ross is one of my favorite investors. Here is the formula:

1. Determine an industry that has staying power (i.e. will be around in 20 years) that is under severe stress
2. Purchase the senior bonds of a company in that industry at distressed levels
3. File the company, and convert your senior ownership to a majority equity share
4. Clean up operations
5. Wait

Whether it be coal, steel, banking, servicing, or auto parts, these are industries that will be around for a long time and benefit from a growing domestic and global population and middle class (Full disclosure: I do not know enough about his International Textile Group to comment). And because they will be around for a long time, there will be times when investors or acquirers value these industries dearly and will pay a much larger multiple on much higher run rate cash flows than you did. That's where the waiting part comes in.

(Editor Note: That is not to say you cannot make money in industries that will not be around in 20 years. If you had invested in USMO, a PAGING company, at the beginning of the year in 2009, you would have made 84% [assuming reinvesting the fat dividend there] vs 36% for the S&P [again assuming reinvested dividends]. But that is buying an un-levered company at the depth of market pain. )

I very much worry about buying into industries, even at relatively fair prices, that I do think need to exist in 10 years. That's the ultimate value trap. Some flavors of hard line retail (electronics) fit this bill. Is RadioShack (RSH) a bargain at 3.25x forward EBITDA? Maybe, but I'd rather pay up a few multiples for a company in an industry I am certain will be around in 10 years.

Like tankers - now I just need to find a way to do it in an unlevered entity or at the top part of the capital structure. Any ideas?