SIF Folio: value rotation continues with Shell
My decision to add British American Tobacco (LON:BATS) to SIF last week generated an unprecedented number of comments on ethical issues. Given this strength of feeling among subscribers, I thought I should clarify the process I use to select stocks for SIF.
SIF (Stock in Focus) is a rules-based model portfolio I’ve run here at Stockopedia since 2016. I use a screen to select shares to add to the portfolio, with a manual overlay of diversification. My screening criteria are purely financial, targeting a mix of affordable growth, quality and momentum.
At present there is no ESG component to this strategy. Even if I wished to, I could not rule out individual sectors on ethical grounds without breaking the rules of my system.
My personal view is that we’re currently seeing a rotation from highly-rated ESG/tech stocks into value shares. BAT scores highly on traditional value metrics despite its ethical baggage. I think that this week’s stock - the recently renamed Shell (LON:SHEL) - has a similar profile.
Shell (LON:SHEL) is back on top
I have not contrived to choose Shell to follow on from BAT. What’s happened is that Shell’s bumper financial results last week have lifted the company to the top of my screening results. Rival BP makes the screen for similar reasons, albeit lower down the list:
Like tobacco, the oil industry attracts justified criticism for its efforts to suppress science through marketing and legislative capture. Even so, Shell is the largest company in the FTSE 100. The products it produces are part of the fabric of life for all of us. Like it or not, I think we may need to rely on the infrastructure and resources of companies like this to help us navigate the energy transition.
Of course, that transition isn’t really happening yet. Instead, Shell and its peers are delivering near-record profits from fossil fuels, thanks to high energy prices and newly-optimised production portfolios.
Last week’s results were on an epic scale. Shell’s free cash flow hit $40bn in 2021, or $27bn excluding asset sales. Net debt fell by $23bn. Adjusted net earnings quadrupled to $19.3bn. An $8.5bn share buyback is underway. Even the dividend received a blockbuster 37% increase (although the payout remains less than half pre-pandemic levels).
After a tough start to the pandemic, Shell is fighting fit again. The shares are trading close to pre-pandemic levels and the panic of 2020 – which saw the stock drop below 1,000p – appears to have been forgotten by the market.
However, commodity producers tend to look cheap when commodity prices are high. With oil and gas prices at their highest level since 2014, are investors looking at Shell through the market equivalent of beer goggles? Or is there real value on offer here?
Let’s take a closer look.
Value: strong numbers?
ValueRank: 81/100
My value screening criteria are backward looking, in line with traditional value investing practice. The ValueRank score uses the same approach. As a result, Shell shares score well on some key value metrics:
- Earnings yield (EBIT/EV) of 11.3% - significantly above my 8% threshold
- A trailing P/E ratio of 11.3 and a dividend yield of 3.2%
These metrics suggest the shares may not be expensive if current profitability can be maintained. However, the trailing 12-month valuation graphic on the StockReport suggests a slightly different view, in my opinion:
Shell looks cheap against the wider market, but more typically priced against sector peers. This reflects my own view. This business is a mature, cyclical and capital-intensive commodity producer.
In my opinion, a price/book ratio of 1.2x is probably fair value for Shell, on a cyclically-adjusted basis. As we’ll see shortly, Shell isn’t especially profitable, even with energy prices at current levels.
My view: Oil and gas prices are high enough to be making headlines and causing pain for consumers. I think this needs to be factored in in any assessment of Shell’s valuation. I’m comfortable with the valuation here, but I don’t think the shares are overly cheap.
Quality: ordinary but improving
QualityRank: 81/100
Shell’s strong performance last year saw profitability and cash generation rise, while debt fell sharply. As a result, the shares have earned a perfect F-Score of 9/9:
The F-score is heavily weighted in the QualityRank calculation. But some of the other factors in the mix aren’t so impressive, in my view. Even with tailwinds from high oil and gas prices, Shell’s overall profitability was not that spectacular last year:
These metrics use statutory figures, but even Shell’s own preferred measure of adjusted ROCE only comes out at 8.8%. This isn’t an especially profitable business.
My view: I don’t have any concerns about Shell’s quality score; the business is in good shape. But it’s not inherently a high-quality business, in my view.
Momentum: more to come?
MomentumRank: 99/100
Shell’s StockRank of 99 is all about momentum. Rising earnings estimates and strong price action have created a strong setup for further gains.
Price momentum: Shell’s share price has risen by 50% over the last year. Last week’s results have added further support. I have not often seen such a strong technical setup on a £150bn stock.
Earnings estimates: Remarkably, consensus forecasts suggest Shell’s earnings will rise a further 35% in 2022, before levelling out in 2023.
This leaves the stock trading on a modest forward multiple of 8.3 times forecast earnings, with a 3.6% dividend yield:
My view: Shell’s momentum setup appears very strong to me. If the company delivers results in line with forecasts, I suspect the shares will rise further.
The caveat is that in my experience, earnings forecasts for natural resources stocks tend to be more volatile than for other businesses. Analysts must continually readjust their calculations as commodity prices move. I would not place much faith in consensus forecasts for 2023.
My decision
Shell appears to have strong momentum, backed by solid fundamentals. Although I think the shares may be close to fair value on a medium-term view, I also think this cyclical rally may have further to run.
I must also recognise that Shell passes all of my screening tests very comfortably.
For these reasons, I will be adding Shell to SIF this week, and to my own holdings. As usual, I’ll make these trades after this article has been published.
Disclosure: At the time of publication, Roland owned shares in British American Tobacco.
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13 comments
Excellent analysis which can be used as a template for my own analysis. Just one question - you mention Earnings Yield (EBIT/EV) of 11.3. Where is that ratio shown on the Stock report?
Thanks again for reminding us of what the Stocko metrics mean. Sometimes its right in front of your face and you chose to ignore it.
Big oil hasn't had it's day yet. Surprised to read recently that Japan and South Korea, two of the most advanced countries, how reliant they are for carbon energy, including coal. Maybe wind dosn't blow so much in that part of the World
I don't smoke and I can't imagine I would buy tobacco stocks, even if I felt that the investment case was good.
But how do I feel about an investing writer assessing tocacco stocks? I have no issue here, while I would prefer not to buy tobacco stocks, that is my choice, if other investors feel happy to buy them, then that is their choice and I would not criticise them for doing so. And no, I don't feel uneasy about Roland covering tobacco stocks. At the end of the day, tobacco is not forced upon people, they have a choice and that is the key point here I think.
duplicate
I note the comments about short term rise in earnings arising from the spike in oil and gas prices. However, I see BP & Shell as a long term play as well. Energy consumption is not going to go down and it's likely that the same companies producing electricity from oil and gas today will be the ones producing it in more ESG friendly ways in future. Just look at who is snapping up the licenses for off shore windfarms at present.
I think there are some interesting responses here. I loved that aflash believes everyone owns this stock, when it has underperformed the market (since the Covid plunge), and ESG has been the key thematic - I would disagree, I think that many PMs have done well out of avoiding the oils and have been scrambling back in. I do however agree that this is not a doubler - but with 3-4% yield, and great cashflow does it need to be? I agree with the many of the replies - the European oil majors are critical players and can be beneficiaries in the great energy transition, and should not be excluded by ill-informed ESG hardliners. What is most important to understand though is the total lack of accessible spare production capacity worldwide, as is finally being understood by the International Energy Agency - the key concern for all investors should be that rising energy prices will likely push us into the next recession. Oil, Copper and Gold should be part of your portfolio here.
I think Shell still looks very cheap. Trailing PE may be around 11, but at current oil prices PE is more like 7. Worth noting that share price is still well below its pre Covid level. As well as being cheap, also provides an very good inflation hedge.
Hi Roland,
Think you are being a little unfair in suggesting that Shell (LON:SHEL), and I guess by implication Bp (LON:BP.) too, are not addressing climate change and the need to shift to renewables. Yes they are be benefiting hugely from the high current prices of oil & gas and as a consequence their Stocko & your SIF metrics look very positive. The cynics and the green community might say they would say that wouldn’t they but if you look at the Strategy update from Bp (LON:BP.) last week you will see that they recognise a transition has to happen and they intend to be a big part of it. I expect Shell (LON:SHEL) will go down the same path. I’m not a great fan of ESG and think there is a lot of ‘throwing the baby out with the bath water’. The future revenues & profitability of these big oil companies may not be tied so closely to fossil fuel in the future. Add to that the fact that during any transition we still need oil & gas in virtually all areas of our economy and that cannot change overnight. I am more than happy to hold Bp (LON:BP.) & £SHEL for the excellent short term dividend yield and their longer term role in the energy transition.
However, not for ESG reasons but because their product is addictive and kills people I would never invest in British American Tobacco (LON:BATS) but that is a personnel decision rather than one based on rational analysis!
Good article. Personally, I think we could see another 10-15% at least out of shell. What I think is not considered here is that Shell is relatively well priced in a generally overvalued market. Also, as such a big company the share is relatively a safe haven for money in tumultuous times. Whilst it's not popular in these ESG times the shares fundamentals speak volumes
Thank you for a very well balanced article. Personally, I never invest in commodity businesses because it is impossible to predict the price that they will be able to sell their product for. It's also a cyclical business. Who knows what will happen to the economic cycle? Although many claim to know, they are at best making an educated guess. However, both these factors, and also the ESG factors, have to be weighed up against the fact that the shares are currently cheap with a value rank of 82. But, if Putin decides to take his tanks home, and a whole host of other factors cause energy prices to fall significantly from their present high levels, then the current price of Shell shares would be looking rather expensive. It's all far too unpredictable for me.
Very similar to my own assessment - except I have taken the opposite decision, using the I suspect temporarily high share price to reduce my position size by about half (to a still chunky 5%). Probably there are a few more months of high prices but then......more gas from anywhere that can make, another nudge towards renewables powered electricity. It certainly seems unlikely that Shell can double for very long ie upside is limited
I quite like that Shell seem to be staying ahead of theenergy transition by selling out of weak assets and building up electricicity / trading services but I doubt this is will leave such a big company in 10 years time.
At the same, there seem to be better options elsewhere in the market. But good luck, I have been very wrong before!
I.C. says Sell.
I.C. may mean Investors' Chronicle but some invert the letters to make Contrarian Indicator.
Everybody holds this stock, even if not directly. Pensions, trackers, dividend funds.