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Contrarian indicator says steel companies support dry bulk ships

Xun Yao Chen, Industrials Analyst

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)

Steel Producers in Developed Asian Countries 2013-08-15


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) stood at 10.12x, based on 2014 EBITDA estimates made by analysts in Asia. The equal-weighted price index rose to a record 90.92 since 2012. 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 positive economic data out of China had driven overall share prices higher.

(Read more: Dry bulk capacity growth slows further, encouraging sign for later half of 2013)

Analysts versus the market

High valuation multiples often point to higher future earnings for cyclical industries, like steel and shipping. Analysts as a whole are either extremely bullish (positive) or bearish (negative) 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. This implied that analysts were constantly revising their earnings higher. For a growing company that has limited competition, higher earnings often translate 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: Supramax price rises first time since mid 2010, signs of shipping recovery)

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

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