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Why Royal Dutch Shell Plc Is Undervalued

The good news for value investors is that Shell (LSE: RDSB) (NYSE: RDS-B.US) is undervalued.

But it’s going to stay that way. That’s not-so-good news, but it’s not bad news. Shell’s share price is unlikely to grow dramatically but the company will keep on pumping out a large dividend, and that can make for a highly rewarding investment.

Mis-match

There are two fundamental reasons that explain why the market will never fully value Shell. First is a mis-match between Shell’s planning horizon and the City’s well-known short-termism.

Nothing highlights that better than the reaction to the company’s proposed acquisition of BG Group (LSE: BG). The response of the City’s teenage scribblers was to plug the numbers into their models and take issue with the economics of the deal based on the somewhat optimistic-looking outlook for oil prices predicated by Shell. Consequently, Shell’s stock dropped by 8% on the day the bid was announced, though it has recovered half that ground since.

From the perspective of a company like Shell, which works on planning horizons from exploration to production of decades rather than quarters, the deal makes strategic sense, and the timing was perfect. BG was a darling of those same teenage scribblers when it made some remarkably successful oil and gas discoveries. But it stumbled in bringing resources into production, its management got into a tail-spin, it suffered some unfortunate external hits in Brazil and Egypt, and the oil price fall hammered an already vulnerable stock price. Already with complementary businesses and assets, BG’s woes provided the ideal opportunity to fix a problem at Shell: its failure to replenish resources as fast as production.

But it’s difficult to put common-sense into corporate-speak. I’m not convinced by Shell’s oil price outlook or its expectation that the acquisition will be earnings-enhancing in 2017, but if it looks like a good deal, sounds like a good deal and smells like a good deal then I’m on board.

The tension between long-term planning and City short-termism plays out across the resource sector, but it most punishes companies when they are out of favour with analysts.

Overweight

There’s another, technical, issue that will hold back demand for Shell’s shares. The company is just too big. It’s already the largest constituent of the FTSE 100, making up 6.9% of the index. After consolidating BG, it will be around 9%. Even if institutions’ mandates allow then to concentrate more than 10% of their funds in just one stock, it’s hard to imagine many going much overweight. So there’s a natural cap on demand that will in turn put a damper on Shell’s stock price, however much it may be a screaming buy.

But that’s good news if you’re a dividend investor. Shell’s cash machine should keep on delivering a payout that hasn’t been cut since the Second World War. If the shares remain undervalued, then reinvested dividends buy you more shares.

Based on Shell’s intention to pay a $1.88 dividend this year and current exchange rate, then the shares are currently yielding 5.5%. Reinvesting those dividends would see the value of your holding double in 13 years, and treble in just over 20, assuming no rise or fall in the share price or payout.

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Tony Reading owns shares in Royal Dutch Shell and BG Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.