I have made no secret of the fact that I am a big fan of the U.K.-Netherlands energy giant Royal Dutch Shell (RDS.B). The company was the subject of my first blog post ever at The Conservative Income Investor, and I came to like it even more after reading parts of the four-volume set “The History of Royal Dutch Shell.” Since 1911, the returns have been over 14% annualized, with about two thirds of the total returns come from collecting dividends and reinvesting them.
During the 1957 through 2006 period, Royal Dutch Shell delivered 12.5% annual returns (suggesting that the law of large numbers only had the effect of diminishing Royal Dutch Shell’s long-term returns by a percentage point and a half as it transitioned from large-cap to mega-cap status).
With most investment decisions, there is a trade-off between income and market-beating returns. If you want high income now, you usually have to tolerate a lower growth rate. And many of the stocks that beat the S&P 500 over time tend to have starting dividend yields of 2.5% or below.
In the case of Royal Dutch Shell, you tend to get a dividend yield that is much higher than what you can get from other large high-yielders with a similarly distinguished history, plus you get three additional benefits: (1) a dividend that is close to being supported by earnings even with the price of oil at a much lower point than recent norms; (2) the ability to reinvest in a stock that consistently trades with a P/E ratio under 10, meaning that shareholders get the “Altria effect” when a high dividend is perpetually reinvested at attractive prices; and (3) the likelihood that the EPS growth rate for Shell will be higher than what you’d get from a similarly situated high yielder.
Let’s say you set aside $10,000 to purchase shares of Shell at a price of $37 and picked up 270 shares after brokerage fees. You “locked in” $1,012 in annual dividend income if Shell managed to maintain the payout. Even with a frozen dividend, you would stand to collect more than 100% of your purchase price within the next ten years. Even if the dividend remained static for a decade, you would collect $10,120. If it got reinvested at an average price of $60 per share over a ten-year time horizon, you would be collecting an additional 168 shares. Those 270 shares would become 438 shares pumping out $1,644 in annual dividend income.
Those estimates may even prove conservative because it assumes that Shell keeps its dividend frozen for a decade, and it also neglects to include the build-up of new shares created each quarter which provides an accelerant effect (i.e. the shares don’t just arrive at the end of the ten-year measuring period but instead arrive forty-sliced up increments).
Now, you might be wondering–isn’t that hindsight bias to incorporate the recent rise of oil prices into the analysis of what seemed likely when Shell was trading at $37? In other words, didn’t Shell incorporate a greater likelihood of a dividend cut back when the price was trading at $37 compared to what it’s at now?
The answer to the first question is mostly no, and the answer to the second-follow up is yes with a “but.”
When we analyze a cyclical company that is going through a period in which earnings have fallen, the price has fallen, and the dividend payout has come into question, the possibility of a dividend cut speaks to the short-term dividend merits of the company but not the ultimate dividend merits of the company.
For instance, the reason I have high confidence that oil prices will shoot up and get much higher in the next two or three years is because the active rig count has been decimated since 2014. We’ve gone from having almost 2,000 active rigs at the end of 2000 to 372 active rigs during the middle of March 2016. The response to the fall of oil has been “Oil still low? Let’s shut down some rigs. Still low? Let’s shut down some more. Still low? Let’s shut even more down.” Since the rise of Rockefeller himself, there have only been two, maybe three, loosely analogous periods of rig count reductions.
With active rig counts this low, if I had to guess what will happen next–you’ll see a rapid rise of another $1 or so in gas prices happening over a short time interval, and then take a year or two for the re-activation of the idle rigs to provide relief at the pump. Though not perfect, there’s something to be said about studying the supply-demand curve for oil prices in three-year cycles.
Now, just because you recognize that oil prices stand a good chance of rising does not naturally follow that it’s easy to figure out which oil stocks are the best ones to buy right now. What’s Exxon at these days, low $80s or thereabouts? With oil currently below $40 per barrel, it seems that some of the rise of oil is already priced in. That is to say, if oil stayed at $39 for a while, you probably wouldn’t want to pay much more than $60 per share for Exxon. This is not the same as saying that Exxon is currently overvalued. It’s just saying that the future cash flows for Exxon already incorporate the expectancy of higher oil prices into the current valuation.
That leaves the question: What’s the best risk adjusted trade-off out there in big oil right now?
I find myself once again coming back to Royal Dutch Shell, which has fallen to $47 per share at the close of Thursday’s after hours trading session. That $3.76 dividend payment, if maintained, stands to be an absolute compounding monster over the next ten years.
That brings me to my second question from earlier: How do you know that Royal Dutch Shell’s dividend will be maintained? The short answer: I don’t. However, I do believe that it is a well-compensated risk to take on.
I reach this conclusion by always keeping in mind the true nature of corporate ownership. When you buy one share of Royal Dutch Shell, you are becoming the owner of 1/3,850,000,000 of an oil giant that produces 1.5 million barrels of oil every single day. That ownership lasts from now until kingdom come.
The dividend policy, set by Charles Holliday, Hans Wijers, Ben van Beurden, Simon Henry, Guy Elliott, Euleen Goh, Gerard Kleisterlee, Sir Nigel Sheinwald GCMG, Linda Stuntz, Patricia Woertz, Gerrit Zalm, and Michiel Brandjes in their capacities as the Royal Dutch Shell Board of Directors, will determine the immediate sequence of dividend payments but the earnings power of Royal Dutch Shell will determine the cumulative amount of dividends that you collect.
Analysts expect Shell to make $8 per share in profits in 2021. Right now, the dividend is at $3.76. Let’s stipulate that Shell can pay out $4.30 in dividends per share five years from now. If the dividend is maintained, the shareholders should expect a dividend growth rate of 2.72% annualized. Let’s say that the alternative is a 50% dividend cut that takes the payment down to $1.88. In that case, you would have a 17.99% annual dividend growth through 2021. In a more realistic version of the second scenario, the Board would more likely give shareholders dividend hikes in the 7-9% range each year until the dividend payment caught up–a more moderate version akin to how General Electric has grown its dividend by 12.64% annualized since the dividend cut of 2009.
If you’re going to be around for a long time as a Shell holder, the options are this: (1) collect a high $3.76 per share dividend which will grow glacially in the 1-4% range for the medium term, or (2) experience a dividend cut and then experience a high dividend growth rate thereafter when oil prices rebound but the company’s payout at that time would be artificially low and set for many years of high dividend growth.
The advantage of Option #1 is that, in addition to collecting high current income, you receive the opportunity to reinvest those unusually high dividends at an unusually low valuation. Someone with 100 shares paying out $376 and reinvesting them at $40 is going to have nearly 10 additional shares of stock by the end of the year. The downside is that Shell would have to add leverage to its balance sheet to pay out the dividend and make acquisitions/capital expenditures, and this would lower the valuation of the stock.
While Option #2 wouldn’t give you that accelerant effect of picking up freshly minted shares in a hurry, it would relax the burdens on the balance sheet and give the stock a higher justified valuation. It also allows the company to have higher retained earnings during the period when the payout ratio transitions from artificially low to the fair amount, and this would allow Shell to grow its payout in a way that it wouldn’t if it maintained the $3.76 dividend.
The theory underlying a Shell investment isn’t driven entirely by trying to secure a high yield now. Instead, it’s driven by recognizing that it remains the most attractively valued oil major, and has a “more likely than not” chance of maintaining the high dividend payout. If the “not” turns out to prevail and there is a cut, then you will have a higher dividend growth rate over the long term. Either way, whether you purchase shares of Shell at $37 or $47, you stand to collect a large chunk of cumulative income over the next 10+ years.
For the investors that got in at $37, they will probably clear 100% in dividends over the next ten years without any dividend reinvestment. For the people considering the stock at $47, there’s a good chance of collecting at least 80% of your capital amount without factoring in the effects of dividend reinvestment. Absorbing the volatility of the share price, and if need be the dividend payment, and instead focusing on cumulative income, will give you a very high chance of collecting both significant income and significant capital gains over the long haul. The short-term volatility is the reason the opportunity exists to collect high income without sacrificing long-term returns.