Must-know: Steel producers’ valuation at record, positive for dry bulk shipping

Market Realist

Valuations and outlook

Valuations can often tell investors the outlook of equities in the near future. Although value investors often look for valuations that are low, high valuations can often signal better times ahead. This is especially true for cyclical companies, such as steel producers and shipping companies, as Peter Lynch mentioned in his famous book Beating the Streets. 

(Read more: Diana Shipping: the most undervalued dry bulk shipping company)

Record EV/EBITDA

On July 12, the EV/EBITDA (Enterprise Value/Earnings Before Interest, Tax, Depreciation and Amortization Expense) valuation multiple for steel producers in developed Asia (including Korea, Japan, Singapore, Taiwan, and Hong Kong) rose to a record 10.31x, based on 2014 EBITDA estimates made by analysts in Asia. The equal weighted price index rose slightly to 87.55 from 86.72 the prior week. Stock prices were under pressure in June, as China’s financial woes hit the news and the market was spooked by the central bank’s plan to taper off the current asset purchase program. But a decline in interbank repo rates, followed by rebound in steel prices and relief this week that China’s economic growth wasn’t as bad as estimated, drove overall share prices higher.

(Read more: Shipping recovery continues with additional purchases, long-term opportunity)

Analysts versus the market

Although value investors often look for low valuations, high valuation multiples often point to higher future earnings for cyclical industries, like steel and shipping. Analysts as a whole are either extremely bullish or bearish when fundamentals are about to change. For example, from 2007 to 2008 and in 2011, EV/EBITDA (next year estimated) kept falling while share prices rose higher, implying that analysts were constantly revising their earnings higher. For a growing company that has limited competition, higher earnings often translates to higher share prices. But in a competitive industry with little product differentiation, fundamentals often revert to the mean. As long as EV/EBITDA holds at current levels, steel companies should perform well over the medium to long term.

(Read more: Dry bulk shipping rates rise due to restocking, but likely downside looming)

Medium term: positive outlook

Positive outlook for steel companies generally translates to a similar outlook for dry bulk shipping companies, such as DryShips Inc. (DRYS), Knightsbridge Tankers Ltd. (VLCCF), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), and Safe Bulkers Inc. (SB). This is because when steel companies expect to generate more profits, they use more iron ore and coking coal, which drives shipping rates higher.

To read why the market may expect steel companies to generate higher profits and how that will affect shipping, see Why May industrial profits support dry bulk imports, positive for shipping.

To see other key drivers that affect the marine shipping industry, visit our driver page, Marine Shipping.

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