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Surfing high amidst falling skies

Mitul Dave, a board member at Golden Sands Capital and managing director of AlphaSeas Management, on how the investor tides have turned so dramatically between aviation and its erstwhile ugly cousin, shipping.

“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money”, Warren Buffett once famously said in a 2002 interview. Earlier this week he exited all his aviation positions at a staggering loss of $2bn on an investment of about $7bn-$8bn. Why is that so unique in an era where Boeing stock can yo-yo from $348 to $88, back to $183, only to lose another 35% in a couple of weeks? It is unique because Buffett rarely sells entire holdings in an industry. He likes value buying, for the very, very long term. For him to reach a point where he made that decision, it must’ve taken an armageddon-style apocalyptic view of the aviation industry for many years to come.

Having seen the shipping industry remain the step child in the transportation investment space for far too long, it was a bitter sweet moment. Bitter because it meant that many friends that I’ve made in the aviation industry during my previous avatars in transportation banking will undoubtedly be facing an extremely uncertain future. Furthermore, the supply chains that keep the planes flying are also going to be hit, leading to an inevitable negative spiral sucking in any aviation industry optimism that dare rear its head.

Sweet, because of the whole debate between shipping versus aviation that has panned out over the major course of the last 20 years and perhaps earlier, where aviation was consistently seen as a superior investment category. Aviation investment professionals would often talk down the shipping guys, like they were some sort of cowboys in the city. Now that very same lot have themselves been found wanting, due to a misplaced bout of hubris. Aviation was almost akin to investment grade, if anything of that sort ever existed in transportation finance. Regulations post-2008 reaffirmed that belief with central banks demanding obscene amounts of pounds of flesh (read Tier 1 capital) from any financial institution that even remotely dabbled in financing the world’s second oldest industry. As a result, it was only a few months ago that lending to aviation was attracting margins of 2-3% (fixed) for around 70-75% LTVs while vessels were finding it difficult to even lever up to 50% at low double digits on floating rates.

For a while now, the only type of financing available for vessels are ‘loans to own’ shelled out by a handful of unreasonable equity funds with little understanding of how a vessel generates its lifeblood – cash, in the long run. Meanwhile, the banking space is being occupied by a new breed of captive financiers who are certainly not asset-based risk takers. As a result, the space has started resembling Chinatown more than Manhattan or Bankenviertel.

To their credit, aviation did have a few things going for it. First, there are a handful of lessors that control an overwhelming majority of the world fleet of around 16,000 aircraft. This ensured that lease rates were relatively stable for the foreseeable future, all things remaining equal. It is something banks love – predictable capital costs. Secondly, aviation has a pretty robust inspection regime in place for every aircraft that is to be deemed airworthy. This reduces technical risk to a certain extent. Thirdly, there are just a handful of manufacturers – both for engines and fuselages, leading to massive homogenisation of aircraft types across the fleet. They have strong labour unions and most airlines have decent, transparent corporate structures in place. Rating agencies, in their infinite wisdom, also fed the gluttony by issuing high ratings to airlines ordering new aircraft and this led to a staggering orderbook.

Shipping on the other hand is highly fragmented in most sectors. There is very little homogenisation, simply as a function of the number of vessel types, shipyards and equipment manufacturers that service this industry. An overwhelming majority of the fleet is privately owned with an average shipowner owning between no more than five vessels in an ocean-going fleet of around 50,000. To make matters worse from an investment standpoint, some ownership structures look more like jenga blocks of cross-holdings. Bankers tolerated these oddities until 2008, but have since retrenched in their traditional centres, in big part due to central bank policies, which encouraged them to look at shipping’s better behaved cousins in aviation.

But like all good parties they must come to an end at some point. It seems Covid-19 abruptly pulled the plug on the music and is now going to leave a terrible hangover for those flying high.

ISTAT, a respected aviation organisation, estimates that around 6,000+ aircraft may have to remain grounded, even after the reopening of economies, until a safe vaccine is found and distributed to a sizeable chunk of the global population. That’s 40% of the entire fleet.

My conversation with a respected aviation guru, who previously worked for one of the world’s largest lessors, revealed that the reduction in demand during the worst period ever, before Covid-19, was a demand drop of 5-7% in the 1980s and early 2000s. We are now staring at a demand drop of 50%. That has never happened before in the short 100+ year history of this industry.

Meanwhile, the humble sailor has continued to do his duty at sea, so that us landlubbers can get our share of sanitiser and toilet paper. This crisis has clearly shown that it will take much more than a little molecule of RNA with a regal name to put the brakes on the global movement of goods. If two world wars couldn’t stop these beauties at sea, a bug is unlikely to win this war. Shipping’s diversification of cargo streams is its strength in this crisis. Sure, some commodity flows will get negatively affected but there are others that are benefitting from this disruption. Aviation, particularly of the passenger variety, suffers from the curse of the homogenised commodity – passengers. The shipping industry has the benefit of nearly 10 major sectors and 64 unique sub-sectors, each with its own set of variables that define its non-concurrent cargo cycles. Falling or rising oil prices affect sectors differently, as will changes in global supply chains in a post-Covid-19 world driven by increased protectionism, distrust and a rebalancing of global power centers. Nonetheless, the flow of goods and commodities will continue as producers and consumers remain disparate, despite increased distrust.

Diversification combined with volatility puts shipping in a very unique position. If handled properly, it can provide outsized returns to investors while its prim and proper cousin takes at least half a decade to recover, or in the best case make do with sub-standard returns, provided lessors themselves start taking huge haircuts, the fleet gets optimised for a new normal and business models that are unsuitable for a post-Covid19 world are allowed to go bust instead of taxpayer money being deployed to bail them out. A prolonged near-zero revenue environment would kill nearly any industry. Now combine that with huge fixed costs, strong labour unions and a declining commoditised pricing and you get the picture. I believe many upstream and downstream aviation stakeholders such as lessors, OEMs and infrastructure providers will also go six feet under.

At AlphaSeas, we tried to put our money where our mouth is, and ran a little experiment that we dubbed ‘Resilience of the Waves’. Earlier in the first quarter this year, when the outbreak was still restricted to Asia, we went long on shipping via the options market – buying calls / shorting puts on certain shipping stocks by conducting a commodity-based sectoral analysis. At the same time we went long on puts / shorted calls on a select group of airlines that we believe are likely to go bust within the next two to three months. As of April 30, our little experiment has yielded a net return of 20.53% with a Sharpe Ratio (daily movement) of 3.06 and a standard deviation of less than 1%.

It’s only when the tide goes out that you discover who’s been swimming naked. Looking at aviation versus shipping in a Covid-19 world, we can only concur with the Oracle of Omaha.

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  1. Not sure that an exodus of aviation financiers will mean that capital providers will reconsider/rediscover shipping. Shipping’s ‘jenga block’ ownership schemes still teeter precariously for wannabe investors, and the industry’s stubborn resistance to modernisation and social responsibility remains for an impatient to see.

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