Waves in Ship Prices & Investment
What the shipping industry can teach us about cycles
I spent my sophomore summer in college working for a dry bulk shipping company in Athens on an internship sponsored by Harvard’s Center for Hellenic Studies. I sat with the Greek ship captains and accountants that ran the fleet and listened as they negotiated with customers, ports, and repair shops across the continents and monitored each ship’s voyage across the oceans.
Dry bulk shipping is a commoditized, competitive, and brutally cyclical industry. The industry’s greatest challenge is that it takes 18–36 months to build a new ship, meaning that, in the short term, supply is fixed, while the demand for shipping cargo fluctuates widely month to month. This makes shipping prone to amplified boom-bust cycles that create great fortunes and grind others to dust.
These dynamics also make the industry a perfect place to study business cycles and the human psychology that drives booms and busts. In one of the most fascinating academic finance papers of the last few years, Harvard’s Robin Greenwood and Samuel Hanson studied 35 years of dry bulk ship prices and ship earnings to try to understand this ancient and Byzantine industry and the excessive volatility in prices and investments.
In their study, Greenwood and Hanson find that ship prices are extremely responsive to current ship earnings. Ship owners seem to be buying ships based on DCF models that assume current earnings are highly persistent into the future, far more persistent than the volatility experienced by the shipping industry.
Figure 1: Used Ship Prices vs. Current Ship Earnings
Source: Greenwood and Hanson
Moreover, they find that shipping companies tend to commission new ships when net earnings are highest and used ship prices are highest, leading to a phenomenon whereby significant numbers of new ships are delivered 18–36 months after big booms in ship earnings. The shipping companies don’t seem to be incorporating the likely influx of new supply from competitors and the predictable effect that will have on prices when they make their orders.
Figure 2: Ship Deliveries and Ship Earnings
Source: Greenwood and Hanson
These increases in supply tend to bring down ship earnings, meaning that used ships bought at peak prices and new ships commissioned during peak pricing periods both tend to exhibit negative future returns.
Figure 3: Current Ship Earnings and Future Returns on Ships
Source: Greenwood and Hanson
Like stock prices and fund flows, ship prices and investment in ships exhibit what academics call “excess volatility,” by which they mean much higher volatility than classical economic models can explain. But despite this volatility, there is a distinct pattern to the data: higher current ship earnings are associated with higher prices for ships and higher investment in ships, but lower returns on that capital. Greenwood and Hanson show that ship owners who buy ships at cycle peaks historically earned returns as low as -36%, while those who bought them at cycle bottoms earned returns as high as 24%.
Shipping companies make two mistakes, Greenwood and Hanson argue. First, they tend to commission new ships when ship lease rates are high, when the modeled economics of the ships are attractive, assuming that those high earnings levels will persist into the future. They over-extrapolate current demand into the future. Second, they fail to realize that competitors are making the same decisions based on the same data, thus neglecting the impact that future increases in supply will have on prices. Greenwood and Hanson show that a model incorporating these two expectation errors explains a significant portion of the historic volatility in ship prices and in ship building.
Like stock investors during boom markets, ship owners have a strong tendency to extrapolate good fundamentals into the future and to fail to take into account that other investors are reacting in the exact same way to those fundamentals. This excess extrapolation and competitor neglect drives overinvestment and the creation of excessive new supply that almost inevitably lead to falling prices and low returns on capital.
IPOs and SPACs might be the equity market’s new ship orders, and valuation multiples for big tech companies are used ship prices. And, perhaps, equity investors suffer from the same extrapolation bias and competitor neglect as ship owners. Like them, equity investors might, in the future, suffer the same low return on capital when they buy at the top.