When we upgraded the Dry bulk shipping sector in June 2016, we had argued that “the long-awaited normalisation process has already begun in the dry bulk shipping; even as we highlight that recovery will be slow, but the time to be permanently bearish on the sector has passed. In our view the normalisation provides opportunity over the next two years.” Our core argument was, “the sector is becoming a supply-side story rather than demand, which has been the case for much of the last decade.”

Our normalisation thesis was based on multiple variables aligning in favour of the sector, “ supply-side rationalisation the key theme of 2016-18, capital is scarce, easing bankruptcy risk, pessimism is at its peak, sector is out of favour and nowhere on investors radar, speculative money is throwing in the towel and serious and patient capital is deploying.”

On stocks, we had stated, “assets as well as dry bulk equities overshot on the downside; the normalisation process will lead to great opportunities even with incremental gains in the underlying markets as discount to NAV narrows”.

Since then, the dry bulk stocks have been the best performer with outsized gains and our top sector picks Star Bulk Carriers Corp (SBLK US), Scorpio Bulkers Inc. (SALT US) have been on a tear and other stocks have followed up with decent gains. Our DFRS Maritime Model portfolio which remains heavily weighted to dry bulk (42% of overall weightage) is up 18.4% since the start of the year.

The run up in stocks has been ferocious but that can be explained by a return of strong investor interest, massive short covering in key US listed names and a reset of valuations. Valuations in historical context do seem cheap but the “value play” is mostly done in our view, “optionality” though still remains very high.

For 1H17, we believe most of the factors having played out well over the past 6-9 months, the sector is ripe for a near term consolidation as returns have already been front loaded. We do expect another rally to follow in 2H17 as freight markets catch up and expectations for a better 2018 starts getting discounted in the price.

Longer term, we see the cost structures which have been “cut to the bone” over the last few years will start rising again. For many companies, lower interest costs have been achieved by way of debt restructuring and interest payment moratoriums. As losses narrow and profitability returns the covenants will also kick in in the near future.

We remain positive but believe stocks could be at the risk of “too soon too fast”, much desired would be a near term consolidation as underlying freight market improvements pan out.

The key risk to the dry bulk recovery is return of new orders led by subsidy-backed ordering activity by Chinese companies at local shipyards. For instance, ordering in 2016 was mainly attributable to the 30 VLOCs ordered at the Chinese shipyards, most of them by Chinese shipowners. Government intervention in a bid to support the struggling enterprises could delay the recovery in the sector.

The dry bulk stocks are likely to enter a short term consolidation after a sharp rally that we have witnessed since the start of 2017. Even after the sharp rally, the current stock prices have factored in only 5% of the premium on the asset prices and are still below our target prices based on a premium of 10% on the current asset prices.

In a very bullish scenario, which is not our base case, there could be significant upside if the asset prices rise faster than our expectations. We note that changes in asset values have an amplified effect on stock prices due to high optionality of the dry bulk companies.

Source: Drewry Financial Research Services