There are some strange things happening in financial markets today. Interest rates are negative across much of Europe and Japan. The German government can borrow for 15 years at negative interest rates1. Some shares, seen as consistent cash generators, are on high valuations, whilst others, like Royal Dutch Shell, languish on a 7% dividend yield1. In theory, the German government could buy Shell with borrowed money and pay off the entire cost from Shell’s dividend payments over the next 15 years, without paying any interest. They would be left with the whole company, for free, in 15 year’s time!
Clearly, this doesn’t make much sense. At the very least, it suggests one (or more) of the following three things: German bunds are expensive; Royal Dutch Shell is cheap; or Shell’s dividend is not sustainable2.
I happen to think that, under most realistic scenarios of the oil price outlook, Shell should be able to continue paying its dividend. Sure I can see certain scenarios where that may become more challenging. However, the real point I am trying to illustrate, is that certain financial assets, like German bunds or many defensive shares, are priced as if they have almost no risk. Others, like Shell’s equity, are priced as if they carry extreme risk. Even if Shell were to cut its dividend at some point, that would not be the end of the world. The value of a company is not defined (solely) by the dividends it pays. Shell has tremendous assets, oil reserves, chemical plants, distribution networks, infrastructure, technology, people etc. The business is managed with a view stretching into decades.
Low, or negative, interest rates and quantitative easing by central banks, have driven bond yields down to extreme levels. It has been a clear objective of authorities to try to stimulate the wider economy. But cheap money is also affecting equity markets. What is surprising though, is how narrowly this distortion is taking place. Not all equities are being affected equally. There is a massive premium being placed on perceived safety.
In my recent blog What price quality? I talked about the high valuation of certain quality shares, and in Matthew Tillett’s blog Beware the bond proxies he discussed a similar theme. However, what is remarkable is how little effect this cheap money driver has had on many other, less defensive shares, such as Shell. Admittedly, Shell shares have performed very well this year, helped by a recovery in the oil price and the recent devaluation of sterling, post the Brexit referendum. However, this follows a prolonged period of poor performance. The shares remain extremely cheap based upon longer term measures, such as looking at the value of the company’s assets, its revenues or, as discussed above, its dividends.
It is a strange environment when many commentators extol the virtues of certain types of companies, like high quality stocks, whilst many other shares, such as oil producers, banks and consumer cyclicals, languish at low valuations. It reminds me of the “TMT” bubble in the late 1990’s. At that time, technology, media and telecommunications stocks were on extreme valuations. Whereas “old economy” stocks like tobacco producers and beverage companies were deeply out of favour. How times have changed. History was kind to those laggards over the following decade, as the TMT stocks fell from grace and were heavily de-rated.
I see many parallels today, with clear risks amongst the “safe” defensive stocks, and great value in many other “risky” sectors of the stock market.
1. Source Bloomberg @31 July 2016
2. This is no recommendation to buy or sell any particular security