Those interested in finding undervalued stocks among shipping companies, a beaten-down industry (with good reason, as discussed here) will have come across the Baltic Dry Index (BDI), an important measure with which many shipping stocks are somewhat correlated. However, this index operates completely differently than most indexes with which investors are used to working, and therefore an understanding of how it works is imperative in applying its usefulness to making investment decisions.
The BDI has recovered well of late, as shown in the 5-yr chart below:
Though well off its highs of the last couple of years, the BDI has recovered to 2006 levels, suggesting shipping companies should be able to make money, right? For now, perhaps, but the future does not look great. You see, unlike most indexes we're used to working with, the price of the BDI is not set by the supply and demand of investors, which would make it a forward looking index. Instead, the price is based on the spot (current) supply and demand to ship dry raw materials. There is no element of speculation; the index price represents a composite of what it costs to ship these goods right now over a number of important routes.
Why is this distinction important? Because of the nature of the shipping industry. There are long lead times (in the range of several years) for building ships, and so when the economy was strong, the industry appears to have overreacted to the number of new ships that would be required in the coming years. Consider the number of new ships to be delivered in the near future:
As those ships continue to add to the supply of existing ships (and they will until 2012), they will put downward pressure on the BDI.
The BDI can be a very useful tool for analyzing the state of affairs for dry bulk shipping companies. Care must be taken, however, in understanding how the index works so that investors make informed decisions when it comes to purchasing shipping stocks.
Of course, this is only the supply side of the equation. We'll leave the discussion of dry-bulk demand for a future post.