Value in the oil majors?

Benjamin Graham, often considered the father of value investing said that in the short term the stock market acts like a voting machine but in the long term it acts like a weighing machine.  This means that share prices are swayed by short term noise but eventually revert to fair value.

One sector where the stock market is currently voting “no” is the large oil companies which are very much out of favour after years of disappointing production growth and rising capital expenditures.  Royal Dutch Shell is a typical example of this with the shares having broadly gone nowhere in the last 2-3 years and investors demanding a dividend yield of 4.8%1,2, some 40% above the average yield in the stockmarket1.  Shell has paid a flat or rising dividend for many years so the yield is a good measure of how popular the shares are (higher yield is less popular).

One of the key issues for oil companies has been disappointments about their cash flow generation.  Morgan Stanley have shown, in the chart below, a very close link between Shell’s cash flow cover of the dividend (a measure of how safe the dividend is) and Shell’s dividend yield compared to the average yield in the stock market.  When the cash flow has been going down and there has been lower dividend cover, the market has demanded a higher yield (inverted scale).  The market has effectively “voted” against the company.

Shell dy

At one level this makes intuitive sense, lower cashflow makes dividends less secure or reduces dividend growth rates.  However at another level it is quite troubling.  Shell is a business that invests with a time-frame measured in decades, one year’s cash-flow is not a good measure of the true worth of the business.  The company’s value appears to fluctuate wildly based upon short term considerations.  This could present a great opportunity for an investor with a long term perspective.  But how should an investor “weigh” up the value of Shell.

I do not believe there is an easy answer to this question and many valuation measures should be considered, but let’s consider one simple one – investment spending.  Over the last decade Shell has invested £142bn in the business, which is slightly more than the current £135bn value of the company.  I am not suggesting that all the investments they have made in the last decade have been good deployments of cash, far from it, but this an interesting statistic nonetheless.

Were Shell a 10 year old company it might make sense that it’s current value is close to or below it’s investment spending over the last decade, but it has a far longer history.  10 years ago Shell was already an enormous business with vast oil and gas reserves, valuable producing assets, refineries, petrol stations etc, many of which are still producing profits today.  By way of comparison, the world’s largest retailer, Wal-Mart, is valued at close to twice its last decade’s investment spending.

This one simple measure suggests the business could be worth considerably more than today’s market value.  On January 1st 2014, Ben Van Beurden will take on the top job as the new Chief Executive Officer of this company.  The cash flows of the business should improve over time as past investments start to deliver profits growth and there is scope for improvements in the capital allocation process to deliver material benefits as well.  Any short term cash flow improvement could lead to a significant re-valuation of the shares if the stock market extrapolates an improving trend and starts to vote “yes” to Shell.

Simon Gergel

1. Financial times, 22nd Nov 2013
2. This is no recommendation to buy or sell any particular security.


Author - Simon Gergel

Simon Gergel

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