Investing in Cyclical Businesses

And Braemar Shipping PLC

Economic cycle, courtesy Wikipedia

All businesses are influenced by the economic/business/stock-market cycle. Consider Dignity PLC, the UK quoted funeral service company. In its 2004 Annual Report, Dignity predicted its market for 2005:

"Historically, fluctuations in recorded deaths have tended to be self-correcting and the Board’s view on death rates continues to rely on government forecasts. Based on these forecasts, we expect 579,700 deaths in 2005."

The actual number of deaths in the UK in 2005 was 582,639. No other business I know can forecast demand a year in advance with 99.5% accuracy. And, from one year to the next, the number of deaths never varies by more than about 5%. Yet Dignity's share price (in blue) has fluctuated with the movements in the FTSE 250 (in green).

Graph courtesy of Yahoo, click to enlarge

Opposed to industries like Dignity's, what are normally considered cyclical industries - property, house building, engineering, mining, banking, shipping etcetera - present a difficulty for the long-term investor. Their irregular earnings, coupled with the threat of bankruptcies, ruinous 'schemes of arrangement' or desperately priced rights issues at the cycle's bottom, make them hard to value. The FTSE All-Engineer Index (in blue) compared to the Gas and Water Utility index (in green) illustrates the opportunity of investing in cyclical businesses:

Courtesy Yahoo, click to enlarge

And the FTSE Banks Index (in blue) compared to the same Gas and Water Utility Index (in green) illustrates the risks:

Courtesy Yahoo, click to enlarge

Long-term investors will prefer the steadier income streams from non-cyclical industries - utilities, food, personal care, healthcare etcetera (see companies valued in previous posts). And from those companies that have established a private market among consumers and/or professionals; these include the online and catalogue clothing retailer N Brown, the accounting software provider Sage, the education materials provider and financial publisher Pearson and British Sky Broadcasting, all valued in previous articles on this blog.

But there are times, and now is one, when many non-cyclical industries are valued too highly by the stock market. For instance, the funeral services company Dignity, at 1500p a share, is priced on a multiple of 22 times earnings and yields a scanty 1.1%. The long-term investor can sit on his or her cash or venture into cyclical companies. 

The cautious investor will want to:

1. Assess whether the cyclical industry is growing or not from one cycle to the next.

2. Understand what the causes of the cycle are. It helps to quantify the most relevant factors. Cyclical companies often refer to industry standard statistics when presenting their results.

3. Know at what point of the cycle the industry is in now. Timing is very important. Industry sources (trade journals, company news and reports) help.

4. Be prepared to sell when there is evidence the cycle has entered the boom phase. Here a target price and a stop loss are most useful.

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Braemar Shipping Services PLC

Unloading at port of Mumbai, India, courtesy Wikipedia

Shipping volumes depend on international trade, and international trade grows - and falls - at about twice the rate of world GDP. Since 2000, merchandise exports have grown at a cumulative 5% per annum. This includes the 19% fall that occurred during the financial crisis. Since then, merchandise exports have been growing at over 9% p.a.

Graph courtesy of Wikipedia, click to enlarge

While trade and shipping volumes have recovered, shipping rates have not. The standard measure for shipping rates that exclude oil and containers, the Baltic Dry Index*, recently shows the most alarming volatility:

Graph courtesy of Wikipedia, click to enlarge

*The Baltic Dry Index provides an assessment of the price of moving the major raw materials by sea. Taking in 23 shipping routes measured on a time-charter basis, the index covers dry bulk carriers carrying a range of commodities including coal, iron ore and grain.

The Harper-Peterson Index for transporting containers and the Baltic Dirty Tanker Index for transporting oil also boomed in the years preceding the financial crisis. Prices have yet to recover. Ship owners ordered too many ships in the boom years preceding 2009 and, as two years pass between order and delivery, ships were still coming onto the market when international trade had crashed. Fleets are young and it will take years for shipping rates to recover.

However, shipping volumes continue to increase and shipbrokers that provide services for shipping have benefited. Braemar Shipping Services (BMS) is one. Braemar's share price (in blue) is more volatile than the FTSE Small Cap Index (in green) to which it pertains:

Graph courtesy Yahoo, click to enlarge

But Braemar's earnings and dividends are more stable than one would expect from the above chart or from the volatility in shipping prices:

Braemar	2004	2005	2006	2007	2008	2009	2010	2011	2012	2013
Earnings Per share pence	14	29	36	32	49	56	47	47	33	32
Dividend Per share pence	13	16	18	19	23	24	25	26	26	26

 The relative stability in Braemar's results is thanks to management's role in reducing its dependency on ship broking. In 2007, 84% of the company's operating profits came from ship broking and only 16% from its other activities - technical support, logistics and environmental services. In 2013, ship broking accounted for only 40% while technical (25%), logistics (15%) and environmental services (20%) contributed 60% to operating profits. Ship broking profits fell by 39% from 2007 while the contribution from shipping services increased by almost 5 times. Braemar operates in all parts of the world.

Braemar is in good financial health. Consider:

1. The company has held net cash for every one of the last 10 years. At February 2013, net cash, at 23 million pounds, was almost a quarter of Braemar's market capitalization of 95 million pounds.

2. The balance sheet is clean of pension scheme liabilities. Braemar only offers a defined contribution pension scheme to its employees.

3.  Operating cash flow (after deducting capital expenditure) of 40 million pounds these last 5 years covered the dividend 1.6 times. Braemar has built up its newer businesses through acquisition.

4. Return on equity for the last 3 years has averaged 12%.

In Braemar's 2013 Annual Report, management expect continued decline from ship broking, an improvement in the technical and logistics business and a decline in environmental during 2103/14. There are no broker forecasts for this small company.

Braemar's nearest London-quoted competitor in ship broking and services is Clarkson PLC, a constituent of the FTSE 250 Midcap. As such, Clarkson attracts the interest of analysts. Braemar and Clarkson have a similar recent trading history, but Clarkson's shares (at 1900p) are rated much more highly than Braemar's (at 458p):

	P/E Ratio	Dividend yield	Price:Book ratio	Net cash as % market value
Braemar	14	5.8%	1.35	24%
Clarkson	22	2.7%	2.84	32%

Compared to Clarkson, Braemar looks to be good value at its current price of 455p. But the investor will want to consider the following:

1. Braemar's main business continues to be ship broking, which is still in recession.

2. While shipping volumes are increasing, there is still an excess of ships of all kinds and there is no sign that rates are recovering.

3. When it comes, the increase in shipping rates, as measured by the Baltic Dry Index, is likely to be sudden. And this will be reflected in Braemar's share price.

4. As the stock market anticipates cyclical recoveries, the investor is seemingly left with the option of buying in early, in the hope of anticipating the market anticipating the recovery. The risk is that the cycle has not reached bottom.