Braemar Shipping Services PLC joined my model portfolio way back in early 2011, just a couple of months after the portfolio’s inception.
Although substantially different in detail, my investment strategy in 2011 was based on the same basic principles that I use today. In other words, I was looking for high quality dividend growth stocks which are available to buy at attractive prices.
On that basis Braemar Shipping Services certainly fit the bill, with its consistent record of dividend growth, historic growth rate of more than 16% and dividend yield of 5.4%.
Unfortunately, that attractive combination of high yield plus high growth did not turn into high returns for the model portfolio. Instead, Braemar’s financial results began to decline almost immediately.
There was a brief recovery in 2015/2016 but more recently things have taken a turn for the worse. The full-year dividend has now been cut by almost 50% and the share price responded accordingly, as the chart below shows:
Selling on bad news is something I generally try to avoid. In this case, I was reluctant to sell Braemar as its main shipbroking and oil and gas services businesses are probably somewhere near the bottom of their respective cycles.
However, I think Braemar could struggle to generate attractive long-term growth even when the oil and gas industry does recover, largely because the commodity super cycle seems to be well and truly over.
Overall then, this was not a great investment; but it wasn’t a complete disaster either. And more importantly, learning lessons from the occasional poor investment is the best way to improve an investment strategy.
But before I start talking about lessons learned, here are the bare bones results from my investment in Braemar Shipping Services:
- Purchase price: 479p on 13th May 2011
- Sale price: 300p on 7th September 2017
- Holding period: 6 years 4 months
- Capital gain: – 38.0%
- Dividend income: 33.3%
- Annualised return: – 0.9%
Buying a cyclical company at the top of its cycle (this is generally a bad idea)
In 2011, Braemar had a fantastic track record of consistent growth across revenues, profits and dividends, with a growth rate of more than 15% per year over the previous decade:
The company’s results had stalled somewhat after the financial crisis of 2008/2009, but even there things didn’t look too bad. As the chart shows, revenues had quickly bounced back to an all-time high and the dividend continued to go up.
Investors were cautious, as implied by the 5.4% dividend yield, but the dividend cover was over two and so I wasn’t desperately worried about a dividend cut.
This combination of high growth plus high yield made Braemar look far more attractive than an investment in the FTSE 100 (at least on paper and ignoring the risk of investing in a single company rather than a diverse index).
The table below shows how Braemar beat the FTSE 100 across all of the key metrics which I use today, so even though I didn’t use these metrics in 2011, if I did I would still have been very interested in the company.
Those are the raw numbers, but what about Braemar as a business?
In short, it’s a shipbroker which generates revenues by bringing together those who want tankers and other large cargo vessels, and those who have them.
During the commodity super-cycle, which lasted from around 2000 to 2014, Braemar did exceptionally well as demand outstripped supply for tankers and other ships and their cargoes.
The volume of transactions and the profit per transaction were at record highs, but Braemar’s management were sensible enough to realise that this wouldn’t last forever. To counteract the potentially enormous cyclicality of its core business (which I did not fully appreciate in 2011), the company diversified into the related areas of technical and logistics services.
The company also had no debt and no defined benefit pension scheme, which is exactly what I’d want to see in a highly cyclical business.
Overall then, Braemar appeared to be a high quality, high growth and high yield stock, so I added the company to my model portfolio and my personal portfolio as well, with a weighting of around 4%.
Holding on as the commodity super-cycle came to an end
There was only one significant event in this investment’s history, and that was the ending of the commodity super-cycle around 2014. But even before that Braemar’s performance had begun to suffer.
The first major problems came in 2012.
As is typical in capital intensive industries, there can be a long delay between an increase in demand and an increase in supply. Oil tankers, for example, do not simply materialise out of thin air. This delay also works in the other direction. Once there is a sufficient amount of supply, there may still be much more supply in the pipeline which is impossible to turn off. Again, you can’t easily stop building an oil tanker just because you realise that the world already has enough of them.
This imbalance between supply and demand can lead to massive price and profit volatility for companies within the affected sector, and that’s essentially what happened to Braemar in 2012 when its shipbroking profits (which at the time made up more than 80% of the company’s total profits) fell by 50% in a single year.
Following years of construction and a slowing global economy after the financial crisis, there were too many tankers in the world. That led to depressed tanker values and chartering rates and therefore depressed profits for Braemar’s shipbroking business.
Today, more than six years later, those shipbroking profits have yet to fully recover.
Fortunately the company’s policy of diversifying away from shipbroking worked. It’s non-shipbroking profits increased from £2.7m in 2011 to £5.6m in 2012, somewhat softening the £7.2m decline in profits from shipbroking.
Investors were far from convinced though and the share price fell to 300p, giving the company a 9% dividend yield. That was a nice entry point for those who were brave enough to buy, because the dividend was sustained and the share price recovered massively.
For a while, the company’s fortunes recovered too. Although the shipbroking business never seriously recovered, the technical services business had a fantastic run from 2014 to 2016, eventually becoming the largest profit generator for the company. But it didn’t last.
Many of the company’s technical services are provided to the oil and gas industry, and when the oil price collapsed in 2014/2015 Braemar’s customer’s were hit. The reaction wasn’t immediate, but eventually companies across the sector started to cut back and Braemar’s technical services were one of the things that got cut. In 2017 the technical division made a £3m loss.
So with the shipbroking profits on the ropes and no technical services profits to take their place, Braemar’s overall profits collapsed. The dividend became unsustainable and was sensibly cut.
Of course, this is not a happy story, but I think Braemar did a reasonable job of keeping its dividend going for several years, despite the cyclicality of its end markets.
But in the end the cyclicality of its end-markets determined the company’s fate, and as the chart below shows, the company’s track record is no longer one of impressive success:
Reluctantly selling because the risk/reward trade-off is no longer attractive
In an ideal world I would like to hold on to Braemar just to see how the company fairs once the cycles for its shipbroking and oil & gas technical services businesses turn upwards.
Will it be able to generate record profits and dividends once again, as it did at the top of the previous cycle? Or was that a once-in-a-generation commodity boom, the like of which we or Braemar may never see again?
Who knows? I certainly don’t, and from where I’m sitting today it isn’t obvious why an investment in Braemar should beat the market over the next five or ten years.
I don’t think it’s obviously likely that Braemar will grow its revenues, earnings and dividends faster than the market average, and I don’t think it’s obvious why the share price should outperform the market either (although of course, it could).
At its current price of 300p, Braemar’s valuation ratios are slightly attractive relative to the market average, as is its post-cut dividend yield of 4.5%. But the company’s low rank on my stock screen implies that the combination of very weak financial results and only slightly attractive valuation are no longer worthy of a place in the portfolio.
Overall, I think there are better places to invest the model portfolio’s capital.
Having removed Braemar from the model portfolio and my personal portfolio yesterday, I’ll be looking to redeploy that cash into a hopefully better investment at the start of next month.
Lessons learned from investing in a highly cyclical business at the top of the cycle
The subtitle above is a less than subtle hint at the main lesson from this investment. Braemar had an impressive track record of steady growth, it had good profitability, no debt and no defined benefit pension scheme.
But none of that mattered because at the end of the day Braemar was like a rudderless ship, almost entirely at the mercy of two key industry winds:
- Tanker supply/demand: When tanker supply exceeded demand, tanker values and charter rates fell and so did Braemar’s shipbroking fee and profits
- Oil & gas supply/demand: When oil & gas supply exceeded demand, Braemar’s oil & gas technical services revenues collapsed and the business unit made a loss
There are two separate issues here.
The first is the capital investment cycle (or capital cycle for short), the second is the commodity cycle. The is often some overlap between the two, but they’re not the same thing.
I’ve already described the capital cycle, which is caused by the extended time it takes to increase or reduce the supply of many types of capital asset.
In this case, the supply of tankers (a capital asset) can only be increased through massive capital investment over many years, and once that supply is brought to market, it can remain in place for years even if supply eventually exceeds demand.
Following bad investments in other companies affected by the capital cycle (such as Balfour Beatty), I came up with the following rule:
- INVESTMENT RULE: Don’t invest in a company if its 10yr capex/profit ratio is above 100% and its 10yr capex/depreciation ratio is above 200%
This rule is designed to pick up companies that 1) have to invest heavily in new capital assets (capex/profit ratio) just to stay in business and 2) have recently gone through the expansion phase of the capital cycle (capex/depreciation ratio).
Regardless of price I will avoid these companies. There’s a good chance they’re either at the peak of their capital cycle or are climbing up towards it, and beyond the peak it can be downhill all the way (or at least, downhill for a very long time).
However, Braemar does not have to invest heavily in capital assets. As a shipbroker all it needed was some desks, some telephones and some brokers with excellent contacts, and none of those are capital assets.
But capital assets (those tankers) were still a key part of its shipbroker business. It’s just that they were on another company’s balance sheet.
The lesson here is to think about the capital cycle not only in terms of the company’s own capital expenses, but those of the markets and sectors it serves and is affected by.
As for the commodity cycle, I already have a rule:
- INVESTMENT RULE: Be wary of a company if it is sensitive to commodity prices
I didn’t have this rule back in 2011, but if I did then it would have flagged Braemar up as a high risk cyclical stock because both its shipbroking and technical services businesses are affected by commodity prices.
But the rule doesn’t suggest avoiding these companies. It just says “be wary”, which means being extra careful with debt levels and similar risk factors, none of which were a problem with Braemar.
Given these issues with how I look at commodity and capital cycle-sensitive companies, I think now is a good time to introduce a specific rule to limit any purchases of highly cyclical companies to somewhere near the bottom of the cycle.
Before I tell you the rule, here’s some context:
Currently I have another rule (as you can tell, I love rules) which says that I shouldn’t invest in a company if its PE10 ratio (ratio of price to 10yr average earnings) is more than 30.
From experience I’ve found that this is a reasonable cut off, beyond which almost all companies will be just too expensive (except for the Amazon’s of this world, but they’re so rare that they’re not worth considering).
Of course, investors don’t really want to buy companies cheap relative to past earnings, they want to buy companies cheap relative to future earnings, so looking at 10yr average earnings is simply a way to estimate future earnings.
In other words, if a company is priced at more than 30-times its average earnings of the last ten years (which is a pretty high PE multiple) then today’s price is probably going to be high relative to the company’s average earnings over the next ten years.
The only exception to this would be companies that are highly likely to more than double their earnings over the next decade, in which case the future earnings might be high enough to justify the current price.
A typical example of this sort of stock would be Reckitt Benckiser (RB), which currently has a PE10 ratio of 32.5. Investors think RB can keep doubling in size every ten years, so they’re happy to pay a premium price which may (or may not) be justified.
The problem with this rule of PE10 being below 30 is that I apply it to all companies, including cycle-sensitive companies like Braemar, BP, BHP Billiton or Rio Tinto, all of which are in my portfolio.
During the upwards phase of the commodity or capital cycles these companies can generate very impressive multi-year growth rates, such as 15% in the case of Braemar, 18% for BHP and 14% for Rio Tinto. This can make it seem like a high PE or high PE10 ratio is justifiable.
But can highly cyclical companies generate sustainable growth in the same way that Reckitt Benckiser probably can?
I think not.
Most cycle-sensitive companies can only produce high growth rates for relatively short periods of time, by which I mean not much more than a decade, and usually less.
When the cycle turns, their profits collapse, or at the very least decline for several years.
This means that above average PE10 ratios are unlikely to be justified because future earnings are unlikely to keep going up in a straight line.
Perhaps more importantly, when the cycle turns downwards these cycle-sensitive companies can fall to incredibly low valuations.
As a defensive value investor, if I’m going to buy highly cyclical companies I want to buy at the bottom of the cycle, not at the top.
In the case of the cycle-sensitive companies that I currently own, they all fell substantially from my purchase price.
In every case their PE10 ratios fell well below 10 at the point of maximum market pessimism in 2016, and most of them have since recovered strongly.
Having lived through these ups and downs, I think it would be a good idea to have a far more cautious PE10 rule for highly cyclical companies. Something like this:
- INVESTMENT RULE: Only invest in a company that is sensitive to capital or commodity cycles if its PE10 ratio is below 10
This is a much stricter rule than the one I currently use. It would have forced me to buy companies like BP or BHP Billiton at much lower prices and much closer towards the bottom of their cycles.
And if it means that I miss out on investing in some highly cyclical companies, then so be it.
In addition to the PE10 rule, I also use a PD10 ratio rule (price to 10yr average dividend rule). The rule is not to buy a company if its PD10 ratio is above 60 (i.e. double the PE10 ratio limit, implying a typical dividend cover of about 2).
Because highly cyclical companies often cut their dividends it’s important not to get too excited about high dividend payouts, especially close to the top of the cycle as they may not be sustained.
In order to be extra cautious with highly cyclical companies, I’m going to use a bespoke PD10 ratio rule to go alone with the bespoke PE10 ratio rule:
- INVESTMENT RULE: Only invest in a company that is sensitive to capital or commodity cycles if its PD10 ratio is below 20
Again, this is double the related PE10 ratio limit. This rule would have resulted in me investing in BP, BHP Billiton and other highly cyclical companies at much lower prices than my actual purchase prices.
Overall then, I’m happy to have invested in Braemar, despite the weak results.
I’ve learned a lot about investing in highly cyclical companies and hopefully these lessons will help to improve returns and reduce risk for my portfolio in the years ahead.
If you only remember one this from this article, remember this:
Try to avoid buying highly cyclical companies near the top of their industry cycles. Instead, try to buy them near the bottom of the cycle or don’t buy them at all.