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As one of our top 10 holdings, Royal Dutch Shell comprises 2.38% of our Templeton Global Growth Fund. We’ve held the stock for a long time. However, we significantly increased the position when the oil price was weak in 2015/16.
There are a lot of good reasons to like Shell, including its acquisition of BG, which has made it a global leader in Liquefied Natural Gas. Shell has an enticing 5.5% dividend yield, making it attractive to income investors. The company raised its free cash flow (FCF) targets by 20% in early 2018, and is on track to lower its gearing to the desired 20%. Its FCF target for 2021, at US$65 per barrel, should deliver a 10% FCF yield.
We don’t believe it is completely necessary for Shell to be better than its competitors, given that it is a commodity business. We own a number of names in the integrated oils space.
We found Shell’s valuation to be more attractive than others at the time of purchasing; the market was very pessimistic on the BG deal and LNG at the time, as well as Shell’s ability to cover its dividend and divest the targeted $30 billion in assets (and thus expected the dividend to be cut).
At its peak, the anticipated yield was almost 10% in early 2016, when the oil price was in the $20s. The yield is now around 5.5% (as the share price has risen). Shell has successfully divested approximately US$30 billion in assets, and has been benefitting from strong cash flows, as oil and gas prices have moved higher.
We like Shell’s commitment to value over volume, continued capital discipline and strong focus on cost and efficiency.
We don’t have a target price per se, rather as a value manager, our approach to investing is to look for unloved and unappreciated quality businesses, which we believe will be rewarded over time. In our experience, the winners are the stocks that are heavily discounting on future growth, and P/E is a good valuation metric. We also look at various other qualitative metrics, such as FCF yield and balance sheet strength.
Shell has added 0.81% to the portfolio in absolute performance to 30 June, with a 47% return in Australian Dollars.
One of the reasons for Shell’s discounted valuation may be the market’s scepticism about the long-term future for oil as an energy source because of the rise of electric vehicles. Even if electric vehicle volumes were to grow by 50% per year for the next five years, this would mean that only 2% of the global car fleet would be electrical vehicles and the underlying impact on oil demand would be less than 1% (as truck and aviation, plus industrial demand for oil would be relatively unaffected).
Shell’s costs and capital expenditures are declining, and oil prices have significantly recovered. In the current environment, Shell generates significant FCF, more than they did when oil was trading at US$100/barrel before 2014. If Shell delivers a 10% FCF yield, we expect the stock to re-rate further. Shell has also committed to buying back US$25 billion in shares over the next few years and is continuing to return excess cash flow to shareholders, while maintaining discipline on capex.