Divestment of FSL Trust

I guess this was an action which should have been taken some time back, but trust me to allow inertia and false hope to dull my thought processes, rationality and objectivity; thus causing me to delay my decision to completely divest First Ship Lease Trust (“FSL Trust”). For the record, I have completely divested my position in FSL Trust on August 3, 2010 at an average price of S$0.41125, crystallizing a realized loss of about S$14,000 (or about -64%). If dividends of S$6,300 are taken into account over the years, the actual loss from this investment stands at S$7,700 or about -35%, still nothing to sneeze about. Since I had recognized realized gains from dividends under realized gains/losses in my portfolio review, I shall now take in the full S$14,000 loss there to offset the $6,300 recognized over the years (as per proper accounting procedures).

Let me categorically state right now that even as early back as mid-2008, I was “warned” about the structure of Shipping Trusts and of FSL Trust in particular as being vulnerable and unsustainable. An expert and very detailed forum poster by the nickname of d.o.g. (Disciple of Graham, no doubt) pointed out that a shipping trust could be evaluated and valued based on a DCF (Discounted Cash Flow) basis, since its cash flows were “supposed” to be predictable, stable and consistent. When he ran the model through using an appropriate discount rate, it was discovered that the discounted cash flow value of FSL Trust was less than the share price at the time (above S$1.00). I chose to ignore that pertinent piece of advice at the time as I was indignant and obstinate and wanted to prove that the Shipping Trust model was sustainable and that the value of the cash flows would grow (through M&A of vessels) over time to render the original DCF analysis invalid. All I can say was that it was a very expensive piece of advice to ignore, and if you count in the opportunity costs of having the capital invested in FSL Trust, then the mistake is sadly compounded many times!

In some ways however, the decision to divest has been long overdue and it is actually a big relief for me to be finally rid of this investment, which has been providing perennial headaches and problems for the past 1.5 years (since the global financial crisis hit the shipping industry hard). The point here is that there is no logic or sense in holding on to a sinking ship (mind the pun) while letting your capital languish; hence I saw the opportunity to free up this capital and reinvest it into a more worthwhile company. Considering my investment in FSL Trust was made in January 2008, a time when I was in transit with regards to my investment philosophy and a “virgin” learner in the value investing field, I guess I probably made some “classic” mistakes and committed several easily avoidable cardinal sins. These mistakes have been thought-out by me and will be detailed below for future reference in order for me to learn and avoid making the same errors again.

1) Not understanding the risks fully (e.g. LTV Covenants Clauses) - One of the basic rules in investing is that you should fully understand the investment you are making, or at least the important aspects of it so that you are not caught by surprise. Apparently, I had read up on shipping trusts in a cursory way and did not delve deeply into the details of LTV clauses and interest reset clauses, which conveniently kicked in when ship values plummeted along with the crisis. There were other risks such as counter-party risk which was perceived to be low at the time because “times were good”; but which came back with a vengeance to “haunt” the Trust recently (when Groda Shipping defaulted on payment for NIKA I and VERONA I). Some investors mention that of the three shipping trusts, only FSL Trust has a full-time risk officer; but then again a risk officer is quite useless when the risks cannot be foreseen or properly mitigated! At the time the Trust was constituted, no one could have predicted the kind of severe fallout in the industry which would severely depress values of ships.

2) Under-estimating the downside, over-anticipating the upside - A classic case of investor myopia. When times are good, people (including myself) can only see clear skies and a nice breeze ahead; and no one even imagines there will be storm clouds, thunder and a lot of lightning! I recall very clearly that during the AGM for FSL Trust held in April 2008, investors were talking about “yield compression”, which essentially implied that the share price would move up to reduce the yield which was then a high 9-10%. Of course, no one could foresee that instead of the share price moving up, the yield went down instead…..

3) Overly aggressive payout (initial was 100% payout) - Warning bells should have rung loud and clear when it was declared that FSL Trust would have a 100% cash payout and not retain any cash for paying down loans at all. Back then, the loan was structured as a “bullet” repayment in 2012 and was not treated as an amortizing loan (which required regular repayments similar to a mortgage loan). This overly aggressive payout ratio meant that Management was more focused on the short-term rather than the long-term viability of the Trust, as they did not create a buffer for the Trust in case something went wrong (and true to Murphy’s Law, something DID go wrong, as we can all see from hindsight). I even recall a shareholder questioning the rationale for Management to pay out 100% while passing a resolution to raise funds through issuance of new units; and the reply given by Philip Clausius (if I recall correctly) was that Management wanted to maximize returns to shareholders. In the end, Management were forced to reduce payout ratio from 100% to 70%, then to 50% and to the current 33%. With no end in sight to the crisis, bank loans being due in 1 to 2 years time and having two vessels on the spot market instead of long-term charters, it would seem that payout ratios may dip even further in future.

4) Ships as depreciating assets; unsustainable business model which requires either fund raising or debt issuance - It has been argued on many forums that shipping trusts are inherently inferior to property trusts (known as REITS) as ships are depreciating assets whose values MUST go down over time, while properties will retain a significant portion of their value even through the passage of time. The opponents of shipping trusts feel that this makes shipping trusts unsustainable as investment vehicles as the Trust must continually raise funds to acquire new vessels which are accretive to DPU in order to sustain the payout. In time to come, this can only mean more debt to buy vessels, or else a secondary offering of securities to raise funds (which dilutes existing shareholders). A rights issue would totally defeat the purpose as a Trust is supposed to pay out cash, and not suck it back from unit-holders!

5) Loan bullet repayment in FY 2012 - On hindsight, I would conclude that the Trust was setting itself up for trouble when it agreed to a “bullet” one-off repayment of its loan by 2012. This was on the assumption that it was either able to raise enough funds to pay off the loan by then, or it could roll over the debt by posting up more vessels as collateral. Both options did not materialize and I can safely say that the Trust will now have a major headache come 2012 as it mulls over how to settle its debt obligations. They should have structured it as an amortizing loan in which they pay down the debt progressively, while reducing their payout ratio to say 80%.

6) Risk mitigation is close to impossible - Despite having a stringent screening process, a risk officer and many levels of review before selecting a lessee for their vessels, FSL Trust still experienced a client default by Groda Shipping. Its ships were arrested and had to be put up in the spot market for spot charter. Risks are very tough to mitigate in the shipping industry as the industry itself is cyclical by nature, which means that companies may seem healthy and fine during good times, but will struggle to survive during bad times. It is a known fact now that the global crisis caused several shipping companies to go bust; while NOL reported a whopping US$700 million loss in the previous financial year (at the nadir of the crisis).

7) No visibility in terms of cash flows, more costs may be incurred for lawsuit and other associated costs relating to VERONA I and NIKA I - The default by Groda Shipping was the tipping point in terms of my decision to finally divest, as this meant that there was no more reliability in the cash flows for the Trust and it should be noted that the Trust has stopped providing forward guidance on DPU. Up until 1Q 2010, they were still guiding for US 1.5 cents per unit DPU; and it was only recently that this dropped to US 0.95 cents due to the default. Other future costs may be incurred for lawsuits and guarantees to be posted on the two vessels, and this clouds the visibility for future payouts. The point of a Shipping Trust is to have predictable and stable cash flows for the unit-holder. Once cash flows become unpredictable and inherently unstable, I do not see the point for staying vested.

8) Go for sustainable yield even if it is moderate, rather than for high yield which may not be sustainable in the medium-term - Another classic mistake made by me was the constant chase for high yield, so much so that the risks are blindly ignored in the process. The key is to look for sustainable yield rather than high yield; thus I am willing to accept a dividend yield which is higher than inflation but I have to be assured it can be sustained.

9) Yield is about 4.5%, but risks are high due to leveraged balance sheet and consistent pressure from bankers (at the mercy of bankers) - The yield for me for FSL Trust has fallen to about 4.5% (using US 0.95 cents as a gauge), but with the highly leveraged Balance Sheet and the fact that the Trust is subject to the whims and fancies of bankers (for LTV Covenants, advance payments to “appease” the banks, and stuff like market disruption clauses), this makes investing in FSL Trust particularly unsettling and worrisome. In short, it does NOT give me a good night’s sleep and I can find assets which yield a similar level of dividend yield which would probably allow me to sleep much better. Hence, I can safely conclude that it was the sharp decrease in yield which has contributed to my decision to divest too.

10) Risk of DPU becoming lower in future periods due to LTV covenants, debt repayment issues and vessels on spot charter - There is a further risk of DPU further declining in the face of many uncertainties, such as LTV ratio, vessels on spot charter, and legal wrangles for NIKA I and VERONA I. Not to mention the fact that the bankers also need to be paid their interest; and the impending bullet repayment in FY 2012, all this comes together to make up a “perfect storm”.

11) Unable to raise financing during Dubai Crisis indicates lack of attractiveness - The fact that the Trust was unable to issue bonds as a result of the Dubai Crisis also indicated that they did not have much bargaining power and clout. Of course, some may argue that it turned out to be a blessing in disguise as the bonds were to have an 11%-12% yield, so how in the world could you have accretive acquisitions when you are paying through your nose for interest expenses (yes, to the same bankers, no doubt)?

12) Recent attempts to acquire a vessel have also fallen through (no potential accretive DPU acquisitions) - FSL Trust’s recent attempt to conclude the purchase of a vessel had fallen through (as per the audiocast session Q&A). This further puts a spanner in the works and reaffirms my belief that the business model is inherently flawed.

13) Relatively new business model (shipping trust), IPO was too recent and no track record or stability of performance - In fact, the only comparables were to the two (also newly listed) shipping trusts Pacific Shipping Trust and Rickmers Maritime Trust. The more established Shipping Trusts were Seaspan listed in the USA, but even then this was not a proxy for stable performance as the Trusts had all yet to undergo “hell and high water” conditions. Only if they had survived through downturns and recessions and emerged unscathed (or even stronger) can we conclude that the business model is sound and can stand the test of time.

14) Weakening USD:SGD rate also does not boost dividends once converted into SGD as dividends are declared in USD - This may sound like a minor point but it also contributed to the frustrations and resulted in lower dividends for me.

In conclusion, the above points were the culmination of much rumination, analysis and critical thinking on my part over the course of many weeks (and even months actually). I certainly will keep the above lessons in view and judiciously avoid repeating them again for my future and current investments. The capital released from the sale of FSL Trust will be deployed once a suitable investment opportunity is found.