Revelation from Shipbuilding: The Power of Cycles
The study of cyclical sectors is an important topic in investing. By understanding the drivers behind cycles, and determining where we are in the cycle, we can better predict the next wave of the cycle and strategically position our portfolio for it. Naturally, our effectiveness in this will be reflected in our investment performance.
Everything is cyclical.
The significance of studying the cyclical sectors is not only in the sector itself, but also in further understanding the world we live in. From the rise and fall of companies to the ups and downs of industries, from economic growth to social changes, all are driven by the power of cycles. Howard Marks summarized the three laws of cycles in his book “The Most Important Things”:
1.The development of things is a curve, not a straight line.
2.History doesn’t repeat itself, but it does rhyme.
3.Market cycles fluctuate around the basic trend line, not walking in the middle but often walking to the extremes.
Only after experiencing several cycles ourselves can we realize our own insignificance and lack of power. Investing is like trying to surf a wave - you cannot control the ocean, but you can ride the waves with the right knowledge and approach to investing.
Discovering Cyclical Opportunities
A cyclical upswing is often accompanied by strong demand and limited supply. When a sector shows the potential for increased demand, but supply is unable to catch up quickly, that often signals the arrival of a cyclical opportunity. Then, how do we identify a potential demand pickup? Observing the capital expenditure along the supply chain is not a bad place to start.
Taking the shipbuilding industry as an example, its cyclical opportunity stems from the repair of the balance sheet of its clients - shipping companies. When COVID broke out in 2020, large-scale stimulus in the US led to a rapid increase in consumer demand and export orders. The demand for container shipping also rose sharply. At the same time, the pandemic negatively impacted supply chain efficiency, resulting in unmet shipping demand which in-turn led to record-high shipping prices. From a level of 1000 at the start to 2020, the Shanghai Containerized Freight Index soared to 5000 by the end of 2021, representing a 400% increase. This helped with the rapid recovery of cash flow for shipping companies. Against this backdrop of improved balance sheet and ESG push, shipping companies were putting in a record number of new orders for ships.
The supply side presents a very different story. Over the past decade, global shipbuilding industry went through continuous consolidation. The number of active shipyards decreased from 700 at its peak in 2007 to 300 currently. Delivery volume also declined from 160 million tons to roughly 80 million tons. As shipping companies’ ability and willingness to expand their fleet continue to increase, shipyards are receiving more and more orders. Amid significant supply-demand imbalance, ship prices have been rising steadily. From 773 at the start of 2020, the China Newbuilding Price Index (CNPI) has risen to 1048, a 36% increase. There is also a backlog of shipbuilding orders extending all the way to 2027.
Understanding the Magnitude of the Cycle
The magnitude of the cycle demands on the sustainability of demand and the time needed for supply to catch up. A large cycle implies sustained growth and prosperity over a longer period, which typically brings more attractive investment opportunities.
Since World War I, shipbuilding cycles have lasted 20-30 years, driven by the replacement cycle of ships which usually have a lifespan of the same length. The last peak in global ship deliveries occurred in 2011, resulting in more and more ships nearing retirement age now. Currently, roughly 53% of ships in operation are over 20 years old. By 2030, this number is expected to reach 70%. This trend will continue to drive the demand for fleet renewal. On the other hand, the International Maritime Organization’s (IMO) 2030 carbon emission reduction target has further accelerated the replacement of older, less energy efficient ships. Leading shipping companies are aware of the tightness in shipyard capacity and have started to place orders for clean energy ships in advance to meet the environmental requirements by 2030.
After the financial crisis, the global shipbuilding industry entered a downturn, and several large shipyards closed. From its peak, the industry lost roughly 40% of its capacity. However, China’s shipbuilding industry continued to reform and expand globally. It’s market share rose to the top in the world after 2010.
Currently, China and Korea are the top two players with the largest number of orders. Due to coastline limitations, environmental protection, and labor costs, Japan and Korea have limited room for capacity expansion. China as the biggest manufacturing country in the world still has an advantage in labor costs, but its capacity is also unlikely to expand in the short term. From acquiring the land, it takes roughly two years for a shipyard to go into production. Most of the shipyards eliminated in the previous cycle have been abandoned or repurposed, and shipping companies are generally cautious about placing orders with re-started shipyards. On a policy level, major shipbuilding countries including Korea, Japan and China, have taken strict measures to limit shipyard expansion due to environmental considerations and desire for orderly growth. Against this backdrop, new entrants face relatively high barriers.
Currently, China and Korea are the top two players with the largest number of orders. Due to coastline limitations, environmental protection, and labor costs, Japan and Korea have limited room for capacity expansion. China as the biggest manufacturing country in the world still has an advantage in labor costs, but its capacity is also unlikely to expand in the short term. From acquiring the land, it takes roughly two years for a shipyard to go into production. Most of the shipyards eliminated in the previous cycle have been abandoned or repurposed, and shipping companies are generally cautious about placing orders with re-started shipyards. On a policy level, major shipbuilding countries including Korea, Japan and China, have taken strict measures to limit shipyard expansion due to environmental considerations and desire for orderly growth. Against this backdrop, new entrants face relatively high barriers.
In addition, emerging markets such as Vietnam and other ASEAN countries are not conducive to the development of shipbuilding industry due to their climates. Even with support from their governments, they will face significant initial investments, longer construction periods, and time to build trust and loyalty with clients.
Timing the Opportunity
Once we have identified the cyclical opportunity and its scale, we need to conduct deeper analysis to accurately forecast the earnings changes in the next 1-2 years. This is important for the timing of our investment.
Ship prices have risen steadily since 2021, reaching an overall increase of 36% so far. The construction cycle of a ship is typically 2 years. This means that these high-priced ships will be delivered over the course of 2023 to 2025, and the shipbuilder’s revenue growth is therefore highly certain over the next two years.
In the shipbuilding process, steel is one of the main costs. Steel plate prices started to rise in 2020 and peaked in mid-2021. Since then, we have seen a 20% decline from 2021 average. Typically, shipyards would order steel plates 3 months to half a year ahead. This means that the cost of raw materials for ships being delivered from 2023 onwards are lower. As time passes, the trend of lower production cost will become more apparent.
Considering the above factors, we expect shipbuilding revenue to continue to rise from 2023, while its core costs gradually decline. This environment is highly favorable for the profitability of shipbuilders, especially as higher-priced ships get delivered. We expect this trend to continue.
