In one of the best business books ever written, in our opinion, ‘Only the Paranoid Survive‘ by the former CEO and Chairman of Intel Andy Grove, the then young executive Grove is agonizing with Gordon Moore, co-founder of Intel and brilliant engineer (of the ‘Moore’s Law’ fame in the semiconductor industry), about the price war ensued by the Japanese in the DRAM memory chip business and Intel’s precarious position.
Grove recalls early in the book:
“I looked out the window at the Ferris wheel of the Great America amusement park revolving in the distance, then I turned back to Gordon and I asked, “If we got kicked out and the board brought in a new CEO, what do you think he would do?” Gordon answered without hesitation, “He would get us out of memories.” I stared at him, numb, then said, “Why shouldn’t you and I walk out the door, come back and do it ourselves?”
This may seem like a casual observation, but Intel effectively invented the DRAM chips and Moore’s suggestion to get out the market was almost sacrilegious. Intel did indeed move away from memory chips and into value-added ‘mother boards’ and laughed all the way to the bank for the next decade or so by riding the ‘Wintel’ infrastructure of the PC market. (Different times, different gadgets!)
It’s amazing how vested people become in a situation, whether job or company or industry. As long as one is on the ‘inside’, the never-ending cyclical path around the water well seems to be a purpose by itself. It takes often some stepping-back in order for one to get a better perspective of the right priorities, like Grove’s insightful question what would a new team with a clean slate and mandate do to solve a problem. Apparently both Grove and Moore had intimate knowledge of the company, the industry and the engineering behind them and the answer become obvious instantly; a new team may have to spend time on consulting reports, take more time, do their own analysis and possibly could never see the ‘light’.
Shipping and maritime are integral industries in our every day lives, and no doubt they will remain important going forward. However, the dramatic drop in asset prices (compared to 2008 peak pricing levels) has induced a tremendous wave of newbuildings. It almost seems like a race to the shipyards (at least the ones that provide competitive pricing and lenient payment terms) to build more and more vessels in the mainstream markets; bit more fuel efficient than older vessels, bit bigger in cargo capacity within same asset class, bit better standards of workmanship than the ones from fresh yards a few short years ago. However, in our opinion, the amount in newbuildings is not justified by the market economics and demand for cargo.
We run two basic scenarios evaluating historic returns on major asset classes in shipping: under the first, long-term scenario (TABLE 1), the vessels were bought and paid for at the beginning of 2001 and were held till present; purchase price and residual price are real (nominal) prices and freight rates have been the average freight for the whole period; operating expenses (inclusive drydock) are shown in the table herebelow for each category; also, it is assumed 60% mortgage on the vessels at 6% interest rate. The IRR is calculated for each asset class, and the returns have been ranging from single digit rates (MR tankers with 8%) to highly respectable 37% for capesize vessels. It needs to be noted that historically, 2001 has been a good year for one to enter the market and the almost twelve years of this scenario include the best shipping cycle known to man.
Under the second scenario (TABLE 2), since the beginning of 2006 till present, the same assumptions have been maintained. Returns however under this scenario range from negative returns to barely adequate of 14% again for capesize vessels. In 2006 asset prices had already moved significantly higher than 2001 and since then, there has been ‘the best of times and worst of times’ in terms of freight rates with extreme example in early 2008 capesize and VLCC freight rates at $150,000 pd spot market and negative freight rates in 2009 and 2010 (‘back haul’ to reposition vessels).
We acknowledge that our scenarios are rather simplistic by presuming average rates and average financing terms and holding onto the assets, thus excluding any ‘asset play’ (capital gain from asset appreciation) when sometimes where most of the opportunity lies in a highly volatile industry like shipping.
Shipping and maritime are rather risky business and the cost of capital (discount rate) has to be rather high. The achieved historic returns really do not justify an investor being aggressive on acquisition pricing or one orderbook.
Going back to the newbuilding race, are investors are losing the trees for the forest? The vessels for the ocean? Revisiting Grove’s question, if one was not vested in a company or an asset class or the industry, what would have been the ‘right’ thing to do?
© 2013 Basil M Karatzas & Karatzas Marine Advisors & Co.
No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders.