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Using economics to analyze stocks. What makes your stock tick?

April 20th, 2008 · 2 Comments

Find the one or two variables that really move your stock and you will know a whole lot more. In this new series we will use a little (simple) economics in search of those basic factors. It will be demonstrated that this can really be quite effective in teasing out the most important factors that move the performance of a share.
Oftentimes, what seems like complex factors can be reduced to something manageable, something which is more easily observed and actionable. It’s like that counting cards system at blackjack, adding or subtracting numbers as new cards are shown as a short-hand for calculating statistical probabilities.

A perfect example was that DRYS graph we showed the other day. A company who manages such a monumental rise in its share price in a mere two years, what makes it tick? Something behind that rise must be very variable and increase a lot.

What are the candidates? Well, lets provide a few stylized facts from the sector this company moves in, shipping:

  • Shipping is largely a fixed cost business. This means that companies want to have them operate as much as possible, as close to full capacity as possible. A day in the docks is really very expensive for shippers.
  • Barriers to entry are not terribly high. If you have capital (or access to credit and a good business plan), you could buy a ship and start for yourself (of course, it’s not that simple, but you’ll get the idea).
  • It takes years between planning for new capacity and bringing it on-line, that is, building ships takes time.
  • The demand for shipping should grow in-line with world trade volumes (which itself grows a little faster than world economic output, but with high correlation between the two)

Just a couple of basic characteristics from the shipping sector, what can we deduce?

  • Shipping rates should be really variable because of the fixed cost aspects. If supply outstrips demand, the companies are so desperate to keep their vessels at sea, they will accept much lower prices. On the other hand, when supply of capacity is tight, these rates will zoom up.
  • Tight capacity leads very high prices and windfall profits, providing big incentives to build new capacity. Since the entry barriers are not very high, this will happen, but it will take time.

It turns out that this simple deduction actually describes almost exactly what is going on (as discussed in an article about DRYS). The world economy has been booming, since it takes time for new ships to be build, this led to tighter supply of shipping capacity and very high prices.

Will the party last? Almost certainly not. Big incentives are in place to build new ships, and that is indeed what is happening. So much so, that there are order queues at shipbuilders. So we can safely predict that there will be a wave of new capacity around the corner, and indeed, this is what is being said in industry cycles, 2010 is the year it will hit the market.

But here we might very well see the demonstration of another nice little economic mechanism, well known in agricultural economics. A cycle is likely, and here is a basic description. Farmers will notice a high price for, say, pigs, providing incentives to breed them. It takes a couple of years, but they will notice that when those new pigs are ready for slaughter, the relative scarcity will have turned into a glut.

This glut will lead to farmers cutting back in breeding pigs, and the stage will be set for a new scarcity and price rises, and the cycle will repeat. Now exchange ships for pigs, and basically we have the same cycle.

Yet we have one phenomenon that is not really explained. If we look at that Baltic Dry Index, that depicts an index of daily shipping spot rates for dry bulk (steel, coal, grain, stuff like that), we see definitely cycles, but we also see something what looks like a long-term upward trend.

Part of that is just general inflation, but that can only be a minor part. There really can be only a couple of explanations.

  • Shipbuilders have structurally underestimated the demand for shipping capacity, which is a function of world trade (which is itself closely correlated with the growth of the world economy).
  • Or they were faced by capacity constraints.

It could be both, in fact. Another candidate could be that shipbuilding capacity was tight and other types of ships were more profitable to build, but looking at that wonderful DRYS stock price graph once more, one can only conclude that if that ever was the case, it’s almost certainly not so anymore. There is just too much profit in dry bulk shipping at the moment.

All very nice, you would perhaps say if you stuck by us until here, but how can we profit from all this knowledge? Well, firstly, its always important to know the main drivers of your stocks.

Secondly, if shipbuilders did underestimate the growth of the world economy systematically, it’s very likely this happened in the first half of the decade, moving out of the recession after the crash. It’s almost unimaginable that they have not come to their senses (or worked those capacity constraints away) since.

What this means is, even if they didn’t read any newspapers, they would have noticed upwards spiraling shipping rates. In all likelihood (this is an assumption without which economics hardly functions), they responded in kind, setting off a shipbuilding boom.

And indeed, such a boom is indeed underway. Unfortunately, as we have noted before, it takes years to bring those new ships into action, setting the stage for a massive wall of new shipping capacity from 2010 onwards. Lets hope the pace of the world economy has picked up again, otherwise, what that will do to those spot prices is not hard to imagine…

So, a little economic knowledge can go a long way into explaining situations which look complex at first hand.

Tags: DRYS · Economics of stock analysis

2 responses so far ↓

  • 1 j // May 6, 2008 at 9:24 pm

    ZIM is an Israeli shipping company, that announced that will be floated in Hong Kong stock exchange. The company is held by the Israel Corporation. I am invested in ZIM through Israel Corp. (on TASE) and is slowly working. Eventually I would thank you your interesting comments.

  • 2 That Baltic Dry Index (BDI) — // Oct 28, 2008 at 5:11 pm

    […] We sort of concluded that it was driven almost entirely by the BDI index, which was so volatile and rather unpredictable that we left following the company. Above you can see why, sometimes a picture indeed does say more than a thousand words.. […]