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One Wrong Reason to Buy Royal Dutch Shell's Shares

By Alex Dumortier, CFA – Sep 9, 2015 at 1:51PM

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Royal Dutch Shell shares may be good value, but a high dividend yield may be signaling that the dividend is at risk.

U.S. stocks are showing small gains on Wednesday afternoon, with the Dow Jones Industrial Average (^DJI) and the benchmark S&P 500 (^GSPC 1.46%) down 0.33% and 0.25%, respectively, at 1:30 p.m. EDT. 

Source: Ben Lunsford.

I'm convinced that the slump in energy companies' shares resulting from the sharp drop in the price of oil has created opportunity for patient, value-driven stockpickers. Among the oil and gas supermajors, Royal Dutch Shell plc looks like it could be just such an opportunity. Nevertheless, there is one reason that isn't adequate justification for buying shares: the current dividend yield, which stands at an alluring 4.7%. 

My Fool U.K. colleague Rupert Hargreaves recently pointed to Shell's dividend history in support of the future dividend's sustainability, writing that "Shell has paid and increased its dividend every year since the end of the Second World War, and that's an illustrious record management won't want to break anytime soon." 

However, "wants" must sometimes cede to "needs" when a company (or, indeed, an entire industry) is under duress. For example, on Feb. 27, 2009, industrial conglomerate General Electric cuts its dividend for the first time since 1938 (by more than a third, from $0.31 to $0.10 per share). 

The next day, the stock fell 10.6% taking GE's dividend yield from 14.6% to 5.3%. (Nevertheless, this turned out to be an outstanding opportunity to buy GE: The current dividend represents a 12.1% yield on that trough price.) 

Shell considers its dividend is "core," recognizing that the shares are a mainstay of income-oriented U.K. investment funds. Furthermore, Shell acquired a reputation for conducting itself with a pronounced conservatism. However, I wonder if this reputation, which reflects a distinguished corporate history, is still representative of its present position. 

In a blog post (click-through free with registration) on the Financial Times website, which ought to be required reading for Shell investors, Nick Butler argues the two are inconsistent: 

There is nothing wrong in principle with taking big bets. What is puzzling, though, is when a company with a record of deep caution stretching back to the second world war makes a series of bets that all run contrary to the conventional wisdom. The company concerned is Shell, which, in the past few months, has placed three huge bets.

Those three bets are: First, the acquisition of BG Group. Second, Arctic drilling of the north-west coast of Alaska. Third, a proposed strategic alliance with Russia's Gazprom. All three of which Butler finds out of character for Shell: 

The assumptions behind these bets run contrary to current market sentiment. If this approach was followed by any other company, I would think it had been bewitched by some clever presentation into believing energy prices were set to rise in the next few years -- to $150 or $200 a barrel for oil, say. Or that they were trapped by judgments made when the outlook was different, and cannot now retreat without embarrassment. 

In most companies, such mistakes are perfectly possible. [...] But Shell is such a serious company that such irrational behaviour seems incredible. That means they must know or believe something that the rest of us have missed. 

I believe Shell's dividend is safe for at least the next couple of quarters. However, were the price of oil to remain depressed lower and longer than most people now expect (the next couple of years, say), the dividend would be in real jeopardy.

At least some investors (or speculators) share this view: At today's close, Shell's December 2017 dividend futures is priced at nearly a 30% discount to the dividend futures expiring this coming December.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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