It’s a slender strip of water that separates the island of Sumatra from the Malay Peninsula. It also connects the Indian and Pacific Oceans and — more importantly — Europe and Asia. At its widest spot, however, the Straight of Malacca stretches only 1.5 miles (7000+ feet). A simple tanker crash can prevent other ships from sailing through.

This Singapore-controlled shipping lane serves as arguably the most important link in the vital chain of global trade.

It’s long, narrow, and essential for moving the major staples of trade — things like coal, oil, cars, and clothes. In other words, it’s essential for moving basic commodities and finished goods — from producer to consumer.

The Strait of Malacca connects American consumers with Asian producers. It opens the oil rich countries of Africa and the Middle East to the newest class of energy-thirsty nations of Southeast Asia.

More than 60,000 vessels carry over half of the world’s petroleum and a quarter of all maritime trade through this narrow divide each year. Approximately 400 shipping lines and 700 ports worldwide depend on its access.  Tanker traffic on these particular waters is three times greater than the Suez Canal, and more than five times greater than the Panama Canal.

Bypassing this waterway would force a ship to travel an extra 994 miles to reach most destinations. In the words of the Department of Energy, “If the Strait were closed, nearly half of the world’s fleet would be required to sail further, generating a substantial increase in the requirement for vessel capacity.”

One might think, with lightning-fast courier services, airplanes, FedEx, UPS — a whole slew of modern transport services — that using ships to transport cargo would be antiquated.

That assumption couldn’t be further from the truth.

Shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports are still transported by ship.

The point is this: Shipping is, and will remain, irreplaceable on the world stage. We can’t live without it. It won’t be replaced. It’s been around for centuries. Until we reach a stage of technological innovation in which the major staples of trade — things like coal, oil, cars, the finished products that fill Wal-Mart stores — can be disassembled, one molecule at a time, and instantaneously beamed to another location, our current means for commerce will remain the most efficient.

What does this all mean? Well, there’s a Greek shipping company that deserves a serious look.

Shipping can be broken down into three distinct categories: Tankers, containers, and dry bulk. Tankers are best known for moving the world’s oil supplies. They also carry chemicals and liquefied natural gas. Containers are used for finished products. Most everything we import from China falls under this category. And dry bulk vessels deliver the raw materials used in industrial production. Most everything China imports falls under this category.

We’re focusing on dry bulk. Dry bulk shippers deliver basic raw commodities such as iron ore, coal and grains. Iron ore and coal alone dominate over 50% of dry bulk demand.  Unless we miraculously find other raw materials to power our cities, feed our people, and build our buildings, the demand for these raw commodities will be around for quite some time.

The dry bulk markets are driven by the economic growth in emerging markets, specifically China and India. As long as these economies continue to grow, the demand for ships to transport these goods will continue to grow as well.

The company I recommend you check out is called Excel Maritime Carriers (NYSE: EXM):

Right now, you can buy the stock for 90 cents on the dollar and less than four-times cash flow. With an earnings yield of 26.3% on a company that produces operating margins well above 60%, it’s hard to believe the shares are so cheap.

The first and most inhibiting reason that stocks become so cheap is too much debt.  Now Excel’s management has taken a 70% debt to equity ratio to ramp up it’s fleet. But I’m cautiously optimistic considering the company’s balance sheet contains 13% more cash than total current liabilities. Furthermore, total assets less intangibles are twice as great as total liabilities.

So what gives?

I believe investors avoid this sector for a couple of reasons.

First, most old economies are cyclical industries. Shipping is no different. Shipping is a very cyclical industry. You have to get in at or near the bottom.

It’s an industry that reacts solely to supply and demand. So regardless of the fact that China imports roughly one-third of the world’s iron ore production, if there are too many ships sailing the seas, freight rates plummet and profitability suffers.

Now it’s become common knowledge that Asian economies (specifically China) have produced unprecedented demand growth for shippers in recent years. At the end of 2004, shipping rates were at an all-time high. Consequently, this has led to a slew of shipbuilding activity.

But it’s important to note that the dry bulk fleet is aging very rapidly. There has been no major reduction in the number of seaworthy vessels over the past few years. Shipping companies have been stretching a ship’s useful life to take advantage of very favorable market conditions. But the ships currently in use are getting old. Eleven percent of the existing fleet is 25 years or greater. Next year, that percentage jumps to 14%. They can’t keep pushing these older boats forever.

The greatest threat to supply looks to stem from the possibility of new shipyard capacity coming online. Even if this were to occur, I don’t think the impact on the dry bulk sector will be all that great. Here’s why… Producing dry bulk ships is a low margin business. Shipyards would rather build tankers.

The second factor affecting investor confidence appears to be lack of historical record of dry bulk shippers. Granted, shipping has been around since the dawn of trade, but shipping stocks are something of a nouveau asset class.

Now I’m hesitant to say this stock provides an adequate margin of safety for long-term investors (I want to stress long-term, especially in such a cyclical industry!). But I will give you this…

The risk here lies in the assumption that the company can maintain steady revenues for years to come.

Well, if you believe globalization isn’t a fad… If you’re convinced BRIC (Brazil, Russia, India, and China) countries will continue to grow, there will be ships on the open seas to service their needs.

You can be sure there will be hiccups from time to time…some driven by excess capacity…some will be driven by nothing more than market exuberance. But as long as the fundamentals supporting your investment are still there, I believe pullbacks to be excellent opportunities to add to your position.

Good Investing,

Chris Hancock
December 1, 2006

Small-Cap Shipping Companies was originally featured in the Penny Sleuth.