Stockwatch: This "quality cyclical" could be a helpful sterling hedge

Shares in shipping services group Clarkson have advanced 60p to 2,700p in response to interims that appear "in line", albeit with the story hinting at medium-term potential to beat expectations.

Ship-broking is the main contributor, about 75% of annual revenue/profit, then finance at 13%, research 7% and support services 5%. I last drew attention to the FTSE Mid 250 stock exactly two years ago at 2,280p as a tuck-away, given what seemed an over-reaction on the downside to a 20% drop in European freight shipping rates in the second week of August.

My sense was it paying to buy into the shares of industry leaders when near-term conditions go against: Clarkson traded volatile-sideways for the next 16 months but has risen over 40% from January to March this year and its latest results imply further to go.

Signs of recovery in major shipping markets

Clarkson has delivered genuinely strong performance despite "difficult shipping and offshore markets": underlying pre-tax profit up 12% to £24.5 million on revenue edging 6.5% higher at £156.8 million.

This makes forecasts for lower earnings per share (EPS), shown in the Company REFS table below, look odd, albeit based apparently on Canaccord Genuity numbers back in March; with upgrades looking likely.

Low activity in new-build and a lack of customer commitment to long-term business continue to limit revenue visibility, however "we see signs of a rebalancing" and "are optimistic in our ability to capitalise on the upturn when it occurs (with) very early signs of recovery in some of the major shipping markets".

In anticipation, the stock trades on a forward price/earnings (PE) ratio over 20 times, priced for only a modest 2.6% yield, but if shipping markets are firming up then technically this stock is at the top of a three-year volatile sideways trend; a more definite break-out looking likely, beyond the anticipatory rise to 3,010p last March.

Fundamentally attractive financial ratios

Better industry conditions would boost revenues and quite easily drop through to earnings. See from the table how the operating margin has improved materially from 10.8% in 2012 to 17.9% in 2016, with 15.4% achieved in the first half of 2017 2017 versus 14.5% in H1 2016.

Indeed, the market has remained respectful of Clarkson over recent years, its annual average historic PE in a 20s range implying perception as a "quality cyclical" and the stock being a choice 'buy' as and when industry conditions improve.

Note, also, the strong cash flow profile relative both to earnings and capital expenditure needs (most years), enabling near half of earnings to be distributed. This contributes to a positive risk/reward profile despite the yield at the current share price being unlikely to attract income buyers.

Likewise, a strong balance sheet with all debt now repaid: at end-June, year-on-year cash was up 10.4% to £117.4 million thus a comfortable current ratio (of assets to liabilities) of 1.8 times despite trade payables being 1.7 times receivables.

Intangibles represent 72% of net assets hence net tangible assets being a less appealing 380p per share, albeit which is at least rising.

Hints at a Goldilocks scenario for equities

These results are also notable in a wider context of how shipping tends to be a forward indicator, although care is needed. In the not-too-distant past, scaremongers seized on drops in the Baltic Dry Index (prices of moving raw materials by sea) as heralding a wider downturn although cargo ship supply is intrinsically tight hence marginal changes in demand can cause dramatic changes in the index.

For H1 2017 the average Baltic Dry rating has doubled on H1 2016 despite another shipping index rising only 2% and both as yet well below the average since 2009. Shipping indicators are, therefore, tricky to interpret if relevant to holding equities generally.

As a principal operator, Clarkson's message is robust performance with prospects tilting upside, i.e. affirming a "Goldilocks" scenario where growth is neither too hot nor cold, hence interest rate policy remains accommodative.

Moreover, it counters a bearish claim the present cycle must soon turn down after eight years of upturn which is historically very exposed.

At the risk of "this time it's different", bulls contend a fundamental macro shift has occurred - to a sluggish growth, low interest rate environment - which blunts the conventional sense of cycle. This helps explain why "buy the dips" continues to apply, just lately over the North Korean weapon crisis.

Chief executive/finance director, reduce holdings

So, if Clarkson merits backing, why are bosses selling? On 14 June the chief executive sold 243,512 shares at 2,475p, cashing in over £6 million, and the finance director 37,674 shares i.e. just shy of £1 million.

They retain 500,000 shares and 75,000 shares respectively, also 51,281/10,995 restricted shares and 103,164/58,967 performance related options - and therein lies a clue. Modern bosses are indeed prone to cash in equity along the way, the various bonus schemes helping replenish it.

I've seen this happen before and it's not necessarily a reflection of their judging risk/reward, if certainly frustrating how shareholders are in different boats as a result of such schemes. If bears are correct and the economic cycle does turn down the directors have assured some protection.

We can't tell, the global economy being largely unpredictable. But they don't have a crystal ball as regards macro/industry prospects which are key for this stock; so I wouldn't be perturbed by these sales which represented 27.1% and 20.6% of their equity at the time.

Hedge against sterling during the Brexit years

The 2016 annual report showed 78% of revenue deriving from Europe, the Middle East and Africa; 13% Asia Pacific and 8% Americas; Clarkson having 46 different offices across its four divisions.

So the group ought to benefit from a very material exposure to overseas earnings, despite this being hard to specify in terms of currency factor.

Most economists expect sterling to continue gradually weakening during Brexit, and presently a generally weaker US dollar is not looking a great hedge, thus an international shipping group offers useful diversification of currency exposure.

Admittedly Clarkson is not rich in terms of news flow to enliven its story, the next item likely to be a pre-close update next January. Thus, buying on the expectation of a more vigorous industry upturn requires some faith. On present signs, though, the balance tips to medium-term upside.