While I always invest with the expectation of holding the shares for a number of years, it doesn’t always work out that way.
The stock market is a volatile and unpredictable place and sometimes what was attractively valued one day may look significantly less attractive just a few months later, and that’s pretty much what happened with this investment in Royal Dutch Shell PLC (RDSB).
The shares were added to my model portfolio in December and from that point onwards they were up and away, registering gains of more than 16% in just 8 months.
2,151p on 09/12/2013
2,531p on 07/08/2014
|Capital gain (net of fees)|
|Annualised rate of return|
Of course I would love to claim that I had some special insight which allowed me to see that Shell’s shares were about to advance so quickly, but I can’t. The reality is that these short-term gains are almost entirely down to luck, with perhaps a small amount of help from an attractive purchase price.
The decision to buy
Shell is a relatively obvious purchase for an income-focused, defensive portfolio; it’s a big company with global operations and it has a long history of paying a progressively growing dividend.
It had managed to grow the dividend at 9% a year through the previous decade and that dividend growth appeared sustainable too, with revenues and profits increasing at a similar rate.
At the tail end of 2013 the shares had a very attractive historic dividend yield of 5.1%, well above the FTSE 100’s yield at that time of 3.5% and so in some sense it was almost a “no-brainer”:
Fast growth + high yield = an attractive valuation
But things are rarely that simple and the market won’t usually offer this combination of features without a very good reason. In most cases the reason is uncertainty, which is effectively a hidden negative factor in that equation above. So the actual situation is something like this:
Fast growth + high yield + lots of uncertainty = fair valuation
Shell had run into problems in recent years, not least of which were the financial crisis and the popping of the oil price bubble.
From 2009 dividend growth has been slow and recent quarterly updates have disappointed the market. As investors became more uncertain about the company’s future a higher yield was required before investors would buy.
However, if you are generally less concerned about uncertainty than other investors, or if you believe that there is always uncertainty regardless of what other investors think, then what appears to be fairly valued to the market can instead look decidedly under-priced and perhaps even worth investing in, and that’s exactly what Shell’s high rank on my stock screen suggested.
The decision to hold
Usually I like to write something about how the decision to hold on through the ups and downs of a particular investment have resulted in solid gains over time, but here the holding period has been so short that almost nothing in the real world (i.e. outside the world of daily share price gyrations) has happened to Shell.
The “almost” bit of the almost nothing that happed was the announcement of the 2013 results and the 2014 Q1 results.
With the 2013 annual results came a change to the company’s fundamentals, i.e. its long-term growth rate, growth quality and cyclically adjusted earnings, all of which form the basis of my approach to valuation.
When the shares were bought the company’s 10-year growth rate was 8.1%, its growth quality (i.e. consistency) was 83%, its cyclically adjusted earnings were 211p per share and the previous year’s dividend had been 109.6p.
After the 2013 results were announced in January the 10-year growth rate dropped to 6.9%, growth quality fell to 63%, cyclically adjusted earnings increased by 4% and the dividend increased by 3%. So the company had continued to grow, but its long-term growth rate and quality had declined.
The overall effect was to reduce the implied “fair value” estimate for Shell, so in effect the company had a rising share price and a falling fair value price, which of course reduces its attractiveness as an investment.
As for the Q1 results, they were better than the market had anticipated and caused a pronounced spike in the share price, but it was a short-term effect and in general I pay little attention to quarterly results anyway.
The decision to sell
Looking purely at the numbers again, here’s what Shell offered in December:
- A long-term growth rate of 8.1%
- A dividend yield of 5.1%
- Long-term growth “quality” of 83%
- A PE10 ratio of 10.1
Just using the enormously over-simplified dividend yield plus growth rate approach the projected returns at that point were 13.2% a year (a 5.1% yield projected to grow at 8.1%).
Today things are different. Shell now has:
- A 6.9% 10-year growth rate (down 15%)
- A 4.4% dividend yield (down 14%), which together give a simplistically projected return of 11.3%
- Growth quality of 63% (down 24%) and
- A PE10 ratio of 11.6 (up 15%)
All of the quantitative factors have deteriorated, but they’re still better than the market averages. For example, the FTSE 100’s yield is only 3.5% and the growth rate of its fundamentals such as profits and dividends is closer to 3% than Shell’s 7% growth rate.
So why am I selling Shell even though it still seems to be a good investment?
First of all I would agree; I do think Shell is still a good investment, with an above average yield and perhaps an above average chance of growing that dividend faster than average.
But my investment strategy is not just to own stocks with a “good” combination of growth, income, quality and value, but to hold the stocks with the “best” combination. When a company’s shares can no longer be classed as the “best” they are replaced, but not so often that transaction fees become a drag on performance.
While Shell’s fundamentals decreased in attractiveness as its share price increased, many other shares were doing the opposite, pulled lower along with much of the UK market which has struggled to go anywhere in recent months.
The supermarket’s have fallen off a cliff, while many other companies with successful track records have been beaten down at the slightest sign of weak results. As Shell has gone up other shares have gone down, which creates an opportunity to sell high(er) and buy low(er).
This is one of the main reasons why diversification is so important. It not only lowers risk but also increase the odds that something in the portfolio will be going up while something else in the market is going down. If a portfolio was tightly focused on one sector then I think this opportunity to buy low and sell high would be diminished.
And so on that basis I have recently sold the entire Shell holding from both the model portfolio and my personal portfolio, and I will be looking to reinvest the resulting cash into a new holding next month.