We’ve talked recently about combining value and momentum strategies to provide high returns with less volatility.
But there’s another way to combine value and momentum. It’s when we have a value stock that’s trading at ridiculously low values relative to the amount of money the company is producing and the amount of assets they own…
And institutions are starting to discover just how big of a bargain this stock is, and money is starting to flow into the stock, giving us smooth, up-and-to-the-right price momentum.
So, we can combine these in our value portfolio and catch the “meat” of the move, so to speak, as the institutional money starts to come in and drives the stock up to multiples of our original purchase price.
One company that is doing that right now is Danaos Corporation (DAC), which leases container ships.
And we all know that shipping demand has exploded as the global reopening of the economy began in late 2020 and continued into late 2021. Virtually every container ship in the world is being used right now.
Now, Danaos is a little different in that they don’t want to compete in the spot market, which has already exploded. Instead, they like to lease their container ships on longer-term leases, and they had a stroke of incredible luck…
A significant portion of their fleet came off-lease earlier this year and was re-leased at rates several times the old rate. That cash flow is now locked up for years, and they’ve got more ships coming off lease in 2022.
Rates will still be high at that point in time, so those contracts will also be locked up at much higher rates. And that locks in a massive increase in free cash flow for the company until 2026 or 2027 at least. So, no matter what happens with container shipping rates when all of this madness subsides, they’re going to be locked in at much higher rates.
And they’re not leasing the fly-by-nights who are just going to walk away… These are global corporations with great credit ratings who are just going to suck it up and pay the bill because they really do have to.
Back in 2010, this was a very difficult business. A lot of ships were ordered just before the great financial crisis, and there were too many ships and not enough going to the scrap yard at that point. So, cash flows were tight.
But Danaos sucked it up, and management did what they were supposed to do. Every dime of free cash flow was used to pay down debt. And in 2021, with rates at all time lows, they refinanced a significant portion of the outstanding debt, which dramatically reduced their interest costs.
See what’s happening here? They’ve locked in higher rates for several years, and they’ve dramatically reduced interest expense, creating massive amounts of free cash flow. They’re really just in a fantastic situation at this point, and they’re going to be in that situation for at least four to five more years.
Wall Street is starting to recognize this. The stock was dramatically undervalued coming into 2021. But the shares have started to soar higher, although the stock is still undervalued. The shares are trading at about three times free cash flow and the earnings they’re making right now.
And honestly, the stock is trading at 75% of the book value of the ships that they own. But when I look at this conservatively, they could sell the ships almost as scrap, pay off the debt that’s left and walk away with a small profit in this stock.
So, even after the initial run-up and bump from institutional buying, there’s still upside of two to three times the current stock price and a huge margin of safety in the asset values of the ships that the company owns.
Everything is going right for these guys. The stock is dramatically undervalued, institutions are starting to pile into the stock and they’re noticing that the stock is a bargain that could at least double, if not more.
And given the value of the ships, unless we see economic catastrophe, this stock is going to double my money with little risk of actually losing money because the assets are so valuable, and they’re locked up on those long-term contracts at higher rates.
It’s perfectly well positioned, insulated from short-term fluctuations in shipping costs for four to five years at least and it is reducing debt and interest expense while controlling expenses. It’s in a great spot to be a cash flow machine.
I don’t think they’ll use it to expand the shipping fleet, but I do think we’ll see some stock buybacks and dividend increases from the current 2% level, which should help attract that institutional money coming into the stock and driving the price to multiples that we’re paying for our shares today.
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