For investors in Shell (LSE: RDSB) (NYSE: RDS-B.US), the last year has been particularly tough. The declining oil price has hit its profitability and investor sentiment very hard, with Shell’s share price falling by 24% during the period, while the outlook for ‘black gold’ remains highly uncertain.
Certainly, looking ahead, Shell remains a hugely appealing investment. For example, it offers excellent value for money via a price to earnings (P/E) ratio of 14.5 and a price to book (P/B) ratio of only 1, as well as supremely strong cash flow, a sound strategy of offloading non-core assets and a yield of 6.5%. However, I’d buy British American Tobacco (LSE: BATS) before it. Here’s why.
While Shell’s financial performance is significantly dependent upon the price of oil, which it cannot control, British American Tobacco’s bottom line is exceptionally stable. That’s simply because demand for cigarettes is relatively consistent, with any volume falls in recent years being more than made up for by price rises and also by the emergence of e-cigarettes. As such, British American Tobacco is very likely to deliver high single-digit earnings growth in each year in the long run, which provides its investors with stability and means that the effects of compounding should deliver a very upbeat long term growth profile.
Shell, on the other hand, has financial performance that is extremely volatile. That’s despite it being one of the most stable oil companies in the world and, looking ahead, it appears as though its bottom line will remain very uncertain during the next two years. For example, Shell is expected to post a fall in earnings in the current year of 33%, followed by growth next year of 29%. This up and down performance has the potential to cause investor sentiment in Shell to remain rather downbeat, while British American Tobacco’s growth forecast of 8% next year is likely to inspire confidence among investors.
While Shell’s longer-term growth prospects are largely dependent upon an external factor (i.e. the price of oil) in which it has no say, British American Tobacco has far more control over its future. For example, it is a price maker (rather than price taker) and has the financial standing to make acquisitions in the e-cigarette space, invest more heavily in key brands and expand into new territories.
And, while Shell’s programme of simplifying and rationalising its asset base will raise cash and provide it with greater scope to make additional acquisitions (such as that of BG), British American Tobacco appears to have more power to change investor sentiment by its own actions. In other words, British American has a greater economic moat than Shell, and it seems to be worth paying a premium for this, with the former’s P/E ratio being 12.5% higher than that of the latter.
Although there are concerns among many investors regarding the future of the tobacco market with, for example, increased regulation and greater counterfeit cigarettes on offer, it remains one of the most lucrative industries in the world. And, while the oil sector does offer huge upside, with Shell’s valuation, income prospects and growth potential being strong, British American Tobacco’s greater competitive advantage, via its brands, stable demand and pricing power, mean that it offers more appeal than Shell at the present time.
Peter Stephens owns shares of British American Tobacco and Royal Dutch Shell. 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.