In it for the Long Haul: Core-plus transport investing for resilience during turbulent times
David Lebovitz: The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode on transportation has been recorded for institutional and professional investors. I'm David Lebovitz, global market strategist and host of the Center for Investment Excellence. With me today is Andy Dacy, chief investment officer for our global transportation group. Welcome to the Center for Investment Excellence.
Andy Dacy: Thanks for having me.
David Lebovitz: So let's go ahead and jump right in. We recently released our second annual global alternatives outlook where we challenge the CEOs, CIOs, and strategists from our $146 billion alternatives platform to provide a 12 to 18 months outlook for their respective markets and explore their most promising investment ideas over that time horizon. You can access the outlook by going to www.JP Morgan.com/altoutlook.
Today we're going to focus on transport. We know that global transportation investments have grown in size and in relevance over the course of this business cycle, but for a lot of people this asset class is still relatively new even in the institutional space. I would add that the diversity of what constitutes a transportation asset has increased dramatically. You've got shipping, you've got aircraft, you've got rail, you've got trucking.
All of this is so integral to global trade - which has obviously been front of mind for investors over the past 18 months as trade tensions between the US and China have escalated. Andy, maybe to kick things off here, can you help set the stage for us in terms of how you think about the opportunity set across the transportation landscape? And then secondly, where you're finding some of the most interesting opportunities at the current juncture?
Andy Dacy: Thanks, David. That's a good series of questions. And I think one of the ways to understand transportation today is maybe to go back in time over the course of history and look back to as far back as the 1960s. And really at that point in time we saw the beginnings of what became really a capital optimization strategy that has really started then and gone over the next few decades -- or five or six decades -- to today.
And when I say that, what I mean by that is that back in the 60s you had the companies that are actual operators owning the assets that were involved with transportation. So for example you'd have an oil company owning oil tanker assets. You would have airlines for the most part owning their own aircraft. You had rail companies owning all the rolling stock. And to a lesser extent the trucking industry has matured more in the past 20 or 30 years than it was back then.
But for those other asset classes that was the beginning of the transition that really began to occur as these large companies began to realize that, well, maybe it wasn't the best thing to own a shipping asset when in fact you were an oil company involved in moving cargo around the world and delivering it to your end customers, and that your core competency wasn't necessarily the shipping or the cargo component of what you did.
And so what we saw beginning back then was the emergence of a whole leasing industry to provide leased capital to the transportation world. That's true of the aircraft industry. It's true of the shipping industry - very much true of the rail industry.
If you scroll ahead to today, you've seen the percentage of assets that are owned by lessors increase dramatically over that period of time to the extent that today about 50% of all aircraft are owned by lessors, whereas back in the 60s it was almost 100% that was owned by the actual airlines. Same with the shipping industry - whether it's a mining company, a utility, an oil or energy major or commodity trader.
In many cases those entities own even less assets than we'll see in the airline space, where it's perhaps today maybe 20% or 30% are still owned by those companies. So with that we saw the emergence of a leasing space as I mentioned. And initially that leasing space was pretty much dominated by the leasing arms of banks. And that was very much the case up until the global financial crisis back in 2008, as we all know.
And with or subsequent to that we saw the emergence of a whole series of regulations that began to impact how banks and their subsidiaries that were involved in leasing space treated the equity that they're putting into the assets that were being leased to these companies. The banks liked the business. The end users were often investment grade companies, large multinationals.
But at the same time as regulations changed and the way that banks took risks were being further curtailed by the regulators in different jurisdictions around the world, that business became increasingly less profitable from an equity return perspective. So we saw the movement of banks out of the industry and new writers of capital moving in.
And what I would also say is that the banks focused on -- and to a large extent we think this is for the best space is in this industry -- the longer duration higher quality counterparty types of transactions.
Now there are other parts of the industry that are more opportunistic I would say. For example you can have in the aircraft space sort of middle-aged aircraft that have gone through the first or second lease cycles. They go on to perhaps secondary or tertiary airlines. And that whole market becomes maybe more private equity-like in nature.
But for the first part of the leasing or operational cycle for an asset, the high quality counterparties really like those younger assets and focus on leasing those. And we think from an income generation perspective that's where the best risk-reward return parameters exist.
True in the shipping space too. There's a complete opportunistic part of shipping which typically involves smaller-ticket assets that trade on much shorter durations. There's a lot more volatility there, a lot more asset price risk.
But as you get into the bigger ticket assets that get leased for five to fifteen years in length, that's where we see the duration, the predictability, the stability that we like from an income generation perspective. So it's this transition that's happened over the last 40 to 50 years as I mentioned that has brought us to today, whereas we see alternative capital coming into the space we think there's a tremendous opportunity to replace the capital that was being provided more traditionally by these bank-sponsored lessors.
And also just your second question, where do we find the most opportunity? Maybe I'll level set a little further in answering that. And so when you think about the market itself, we see about $400 to $500 billion of investable capacity per year in the global transportation sector. One of the interesting things about transportation is that transportation assets get old.
Now, some people may think, well, that's not great because the asset's going to ultimately disappear and not be around after its useful life is over. But one can account for that. One can underwrite for that. And one can depreciate the asset in one's investment rationale and certainly the kind of returns that we think are attractive are achievable by taking that approach.
But the benefit of that is that if you think - let's say on average your plane, ship, train, et cetera has a useful life of about 25 years -- which is generally the number of years that is applied to these types of assets -- in any given year we're seeing about 4% of the total installed base of transportation assets being eliminated from the global fleet. Now, with that you have to replace that.
Now, demand varies from sector to sector. The aviation industry's been growing a little bit more quickly than other parts of transportation. But when we boil the demand we see at about 3% growth globally across all transport modalities. So if you take that 4% replacement requirement and you add the growth of 3%, $400 to $500 billion.
So it's a very capital-intensive industry. With the right approach, it's an income-generating industry. And on top of that for the most part -- for US investors in particular -- it's a very dollar-denominated industry. And for aviation and for shipping, we don't see any taxation either. So you don't have to pay any sort of jurisdictional body. It's all done pretty much offshore because ships and planes than most of their time flying over oceans or trading through oceans. So we like the tax aspects of the transportation space.
So that gives a little bit of a backdrop on how we think about it on a macro level.
David Lebovitz: That was fantastic, and I think important one to kind of walk through the history of this asset class so that investors understand how we've gotten to the juncture that we currently stand at today - but also great to get some of your thoughts around from a sector standpoint where you're finding opportunity and kind of that natural source of demand that exists as these assets approach their useful life. You have a certain amount rolling off every single year.
So if we think about this market broadly, it's always important from where I sit and think about some of the things that could impact the asset class the most. I think that that leads most people to think about the risks. We just went through an eighteen month period -- again -- characterized by escalating tensions between the United States and China on trade. We're making some forward progress there, but I think it's probably premature to sound the all clear.
So would love to know kind of from where you sit, what are the biggest risks that investors should consider? And if I may, perhaps you could give one example of a macro risk that is front of mind for you, and then an example of a micro risk as well, because this asset class really does seem to capture both those aspects.
Andy Dacy: Sure. Well, let's dig into that. I think that as I mentioned, there's two ways of approaching investing in this particular industry. And one as I said is more opportunistic. There's more fluctuation in that particular part of the market. You'll see much shorter lease durations.
And one way we like to highlight the differentiation that exists between a longer duration bigger-ticket strategy and a shorter duration smaller-ticket strategy is that if you think about that shorter-duration strategy, the asset often is leased up to four times a year. And if it has that 25-year useful life that I mentioned, you multiply that times four, the asset will face the market up to 100 times during its operating life.
So clearly every time the market is out there for the asset to contend with on a re-leasing type of situation, then that asset has to deal with whatever the extant situation is. So for opportunistic strategies, things like trade wars, regulatory changes, differentials that exist between regions in terms of supply and demand of commodities and retail goods and energy products - that all becomes very critical to thinking about the opportunistic strategy.
We perhaps lend ourselves a little bit more or veer ourselves a little bit more towards the longer duration strategy. And there if you have a lease let's say that's anywhere from five to ten years - let's take the five-year lease for example. That particular asset -- unlike the opportunistic asset -- will only really face the market up to five times. So we see a significant reduction in risk in that longer-duration strategy.
And on top of that, the companies that lease those bigger-ticket assets over longer periods of time are often very high quality -- as I mentioned earlier -- multinational entities, whether they're energy majors or utilities. In some cases you have companies like a Siemens for example that's sort of a multifaceted multinational that's involved in a range of different activities that might need a transportation asset.
So high-quality companies - and they will focus on the bigger-ticket assets because they need those as critical components or building blocks for their supply chain. So we like the differentiation that exists. You may not get the same up and down opportunities that you'll see in the opportunistic space, but you'll get a more consistent predictable return, we believe.
So that's one area. And how that factors back into dealing with extant issues like trade wars - so for example, take a longer term leasing strategy, where let's say we have an investment-grade counterparty that's leased an asset for seven years. We really look at that counterparty's balance sheet as the first point of departure when it comes to mitigating risk.
So we may see ups and downs, but it's going to be that counterparty that has leased the asset that has to deal with the market, and we're relying on the strength of that balance sheet to ensure that during that seven years we're going to get what we bargained for from a lease rate perspective.
Now when we come to the end of that seven years we'll have to re-confront the market. At that time -- if there is a trade war for example -- that may impact rates that we'll have to deal with. But we solve for that by ultimately thinking about how do you create a diversified strategy? And a lot of the diversification comes through staggering lease durations. It's really hard to say today what's going to happen in 5, 10, or 15 years.
But if you don't have the majority of your portfolio maturing from a lease duration perspective in any one given time frame, you're able to mitigate that risk and make sure that you don't have too much concentration from a market perspective. So that's one way of approaching it. The other thing too is also looking at different asset types. Clearly diversifying across counterparties as well as sectors.
So at any given time you may have some sectors that are more in favor from an investment perspective, others that are less so. And for example today, as one thinks about putting capital to work in this space, oddly enough the shipping industry -- which has gone through some ups and downs on the opportunistic side -- has seen the departure not just of leasing capital for the regulatory reasons I mentioned but of bank capital to the more opportunistic strategies.
So we're seeing less capital available, which is actually stabilizing the market because you're not seeing uncoordinated supply additions being made by many actors that had access to cheap capital historically. The actors that are acquiring new capacity are doing it on a much more balanced structure and manner that is reflecting what the demand expectations are on the market going forward. So we like that prudent approach.
We're seeing more consolidation in the space. And the counter parties in the shipping space -- oddly enough -- can be some of the highest quality counterparties. Like I mentioned the miners, the utility companies, the oil majors or energy majors. So I think really thinking about the vagaries that may exist at any point in time with the asset class - I mean if you look at the rail market for example in the United States.
We're not too keen on that space today. You can get probably a 5% to 6% return. We like to get higher returns than that. One of the reasons for that is that we had a significant overbuilding of capacity in the United States -- particularly in tank cars -- as some of the logistical requirements of what was happening with shale oil production were getting worked out over the last four to five years and the market essentially overbuilt the tank car fleet in expectation of more over-ground transportation.
So it's important to keep in mind some of those things when you think about entering a particular asset - because also when you enter the asset you are dealing with the market at that point in time. The aviation market, I can highlight some of the issues there. I think we've seen a period of very strong growth in aviation over the past four to five years. As we get into the late cycle - there been a few bankruptcies last year.
You have to be very careful in terms of counterparty risk. You'll see more variation in credit quality in the airline market. So clearly when you're looking at low-cost carriers in emerging markets I think you have to be more focused on the asset, and making sure that it's a commoditized asset that if there is a difficulty with that lessee, you can take that asset and redeployed it.
By the same token there are high quality airlines out there, and certainly the level of risk and perhaps the return will be lower in both cases. But there'll be more predictability to it. So thinking about how each individual counterparty's credit will affect the long term expectations of your investment strategy is very important.
And you asked about micro and macro risks. I touched a little bit about some of the rail activities that happened in the US. I think generally speaking - the trade war for example was a concern last year. In shipping we saw some interesting unexpected developments that actually were beneficial to shipping as a result of the trade war. Some of these perhaps have been spoken about in the industry.
But for example with the restrictions that existed and the increasing terrace between the US and China, we saw logistics of certain products -- particularly agricultural products -- moving greater distances from the US getting shipped to China. So that actually resulted in more time at sea for cargoes, which constrained capacity, because if the ship is at sea for longer than it was previously then that that vessel can't be turned around and do another voyage.
So for example we had soybeans going down to South America that were getting mixed with South American soybeans and they were being transshipped to China. And that resulted in vessels taking a much longer route to go from the US Gulf to China. We also saw on the retail side manufacturing capacity getting moved out of China into some other Southeast Asian countries.
Vietnam was a huge beneficiary. The export volumes out of Hanoi went up by about 50% last year, whereas Shanghai was down about 7%. And that was solely due to the fact that companies in China moved manufacturing capacity into Vietnam to essentially avoid the tariffs by having different origin. And Vietnam in fact is further away from the US west coast, so that resulted in container ships being at sea for a longer duration.
So there's always unexpected -- in this case beneficial -- outcomes from things that perhaps at the face of it look a little bit negative. But generally speaking I do think that the trade war was a concern. We think that's -- as you said -- blowing over to a certain extent now. And we'll see how that pans out over the next few months.
David Lebovitz: Excellent. I think it's really great to hear you kind of approach things from both a top down and bottom up standpoint, and certainly gives our listeners a lot to chew on as they think about allocating to the asset class and including this asset class within the context of their portfolios. We'll come back to the portfolio question in just a few minutes.
But before we get there - I mean we kind of started this conversation in the 1960s. We're now in 2020, so 60 years of transportation is kind of what we've been discussing here today. What are you looking at going forward? What do you think some of the big trends that shape the transportation space broadly may be over the coming 5, 10, 15 years?
I want to zoom out and think about this longer term. Where should investors be looking and how should investors be thinking about the evolution of the space going forward?
Andy Dacy: That's a great question, and I'm sure in another 60 years we'll see a different market that'll probably have some elements of the past but will have elements we don't expect sitting here today. But sitting here today looking forward I would say that there are a couple of big challenges ahead. And probably the one that comes to mind as the biggest is the whole ESG matrix when it gets applied to transportation.
Now if we just think about shipping and aviation, both of those sectors individually contribute about 2% of total greenhouse gases to the climate on an annual basis. Arguably the shipping market has more toggles to turn in terms of improving its carbon footprint. We just had a big regulatory change that happened on January 1, 2020, which is known as IMO 2020. IMO stands for the International Maritime Organization, which is a United Nations body.
And it's the one that ultimately implements the proposals that come up sort of organically through members of the United Nations and ultimately become ratified and then put into the legal jurisdictional frameworks of the underlying members of the United Nations. And so IMO 2020 basically stipulated that we have to reduce the amount of carbon being emitted by ships by a certain amount.
And as a result of that there are two ways to address that. One was to install a scrubber, which is a type of technology that's been used on power generation for many years. This would be a shipboard scrubber which essentially scrubs the carbon out of the exhaust coming out of the vessel's smokestack. The other way to address it -- and this is where most of the industry is dealing with it now -- is to burn very low sulfur fuel.
The fuel that ships burned historically was known as bonkers. It's typically the bottom of the barrel in the refining process. It's the thickest, heaviest form of fuel that was left over after the refining process. But that is a very polluting fuel that had a very high sulfur content. So sulfur oxide and nitrous oxide emissions coming out of that particular type of fuel are quite high.
But starting January 1 of this year, all ships have to comply with this new regulation and are burning very low sulfur fuel or VLSFO as it's sort of affectionately known. So that's a significant step. So we're going to see the amount of carbon being emitted by ships just dramatically reduced just by that one particular transitional element.
There are lots of other initiatives underway - lots of dual fuel solutions in terms of using for example liquid natural gas or hydrogen or ammonia in the future. Ammonia -- oddly enough -- is the least polluting fuel that a vessel can use. It has other issues in terms of handling, but I do think that the science behind it and the technology behind it in terms of containment and hazardous material handling is there, and it's just about getting it into a shipboard deployment type of strategy that will work for vessels.
So the point there is that for ships we see lots of opportunities to really improve the carbon footprint of vessels. And just in terms of from an investment perspective how does that work out? I think looking at newer vessels -- particularly if you're leasing them for long periods of time -- these companies that lease them -- the big companies that I mentioned -- they also have a very keen focus on ESG. It's important to what they do.
And so having assets that are equally compliant and equally oriented around their own strategies in the ESG realm is a critical factor for them to choose who to lease from and also obviously what type of asset to lease.
The aviation space is a little more challenging. So far there's really not that many other solutions to power an aircraft than kerosene and jet fuel. There are some interesting innovative ideas that are underway. Synthetic fuels - there was an article just this week on Bloomberg that I saw -- which is something that's been talked about an industry for quite a while -- which is a carbon neutral form of fuel that when it's produced - now, it takes a lot of energy to be produced, more than is actually available once it's created.
But synthetic fuel essentially pulls carbon out of the atmosphere, combines it in the production process, and then when the aircraft burns that synthetic fuel, that carbon's re-released. But there's no net increase in carbon that exists in the atmosphere as a result of that. Now historically and oddly enough, the Germans were building or using this type of fuel back during World War II. It was a technology they developed.
It takes a lot of energy to produce, but what we're finding now is that with some renewables -- particularly wind farms that half off-peak moments -- you can use that energy to actually produce synthetic fuel and provide that type of fuel to the aviation industry. I think it's still got some time to go before it's widely available, but as alternative sources of power become available to lower the cost of production, I'm very excited about the possibility of that going forward.
Other sort of carbon capture technologies -- and I won't spend too much time talking about that -- but there's lots of innovations I think will improve the environmental footprint of transportation going forward. So where that becomes important from an investment perspective is that you want to make sure you're obviously investing in those assets that will have those technologies, that will meet those ESG requirements, that would be attractive to the end users.
And that's often a bit of assessing clearly what's happening in the industry, also taking a little bit of a view as to what direction it's going in, and that's sort of the job of any investor is to try to navigate that future pattern. But I think 60 years from now we'll see assets that are very different from a propulsion perspective and that I think will have really addressed some of these ESG concerns that are out there.
So maybe I'll just switch over a little bit and talk about some of the other challenges. I do think that one of the things that is interesting about the oil market particularly is that if you go back 10 to 15 years we were concerned about peak oil supply, which became clearly not something that we had to worry about - certainly with shale oil, that was even further debunked. But now we're getting into peak demand concerns.
And I do think that will be a reality. Clearly it has an ESG component to it. Expectations are that we probably hit peak oil demand sometime in the 10 to 15 years. So one of the questions would be how do you manage a tanker fleet for example in an environment where demand for the cargo that that fleet is carrying is declining year in and year out.
Now you'll still need to move it around, but I do think that with consolidation in the industry the view will be that - well, there'll be more prudent decision-making around supply, there'll be fewer participants in the industry, and managing an industry that is declining will be a little bit more effective if you have fewer players in the market, which I see happening today.
Other sectors - I think aviation despite its ESG challenge is slated to grow quite dramatically. You have significant populations in emerging markets that are adopting air travel those type of mode of transportation that we're very comfortable with in the developed markets, and we see no stopping of that in the next 10, 15, 20 years. So as India, as China, as Africa continue to grow from a population perspective we'll see a lot more air travel happening there.
So the demand backdrop is strong, but ensuring that there is a connectivity between some of these ESG things that I mentioned will be really critical going forward. And I do think that as I said there are lots of technological solutions that can achieve those goals.
David Lebovitz: ESG is certainly something that's front of mind for our clients, front of mind for us here at JP Morgan. So good do to get some perspective around how that's going to integrate in the transportation space over the next not only couple of years but likely next couple of decades.
Maybe to just bring things to a close here - you know, we've talked about what does the transportation universe look like? We've talked about some of the risks. We've talked about some of the opportunities. We've taken a bit of a forward-looking perspective and tried to think about what's really going to impact the space over the foreseeable future.
To close things today, Andy, can you talk a little bit about how you think about putting a transportation strategy in a diversified portfolio? And kind of in addition to that - I think I mentioned that we're later cycle, you mentioned that we're later cycle. How can clients not only think about incorporating the strategy in their portfolio, but how should they think about the performance of the strategy as we move towards the end of the current expansion?
Andy Dacy: Sure, I'd love to share some thoughts on that. I think that as a backdrop to the answer that I'll give - and one thing to keep in mind is that transportation is critical not just for transporting people but also goods, and roughly 90% of all goods are on a ship at some point in their production and delivery cycle to consumers. So transportation forms a very critical component of global society.
And there has not been a single year except 2008 into 2009 where we saw a decrease in transportation growth. Actually, in the airline space post 9/11, there was a decrease. But with the exception of those two very significant events, transportation demand has grown consistently since the 1960s and even before that, since World War II.
So there's a very strong backdrop to the investment framework that one thinks about when putting capital to work in the space. As I mentioned, there's a lot of capital that's needed, given the requirements that are highlighted - not just from growth but also from replacement.
So when you think about how you're going to put capital to work, and assuming that there is going to be consistent -- and again we're not looking at sort of high levels of growth, but that 3% that I mentioned on aggregate across all the different sectors -- our view at least is that you look for those opportunities that will provide a consistent return over a long period of time with reduced risk by mitigating that risk through counterparty selection.
And as I've said earlier throughout the conversation we've been having, it's that more core plus approach that we find to be the most attractive. You're not going to get sort of mid-teens to 20% type returns. But you can get a very respectable return that is on par with long-term equity returns in the broader stock markets, and you'll get a regular distribution of income. So it's cash that comes on a quarterly basis.
And so we feel that approaching the market from that perspective -- getting as long a period as you can, getting as best of a counterparty as you can, and managing the asset in terms of its useful life by expecting depreciation and accounting for that in your underwriting process -- that's where the most attractive and exciting opportunities exist now.
And it's a space that -- as I said earlier -- is being left behind by banks that were very comfortable with investing in the space for a very long period of time. They've been forced out due to regulatory reasons, so investors on the institutional side now have a really great opportunity to step into a well-trodden space that has had a long time to mature over many decades.
David Lebovitz: Well, Andy, this was great. It was a lot of fun. Really good content, so I thank you for that. And importantly, thank you for joining me on the Center for Investment Excellence.
Andy Dacy: It was really great to be here. Thank you.
David Lebovitz: Thank you for joining us today on JP Morgan's Center for Investment Excellence. CFA institute members are encouraged to self-document their continuing professional development activities in their online CE tracker. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our website. Recorded on January 31, 2020.
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