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Lloyds Banking Group plc and Royal Dutch Shell plc could thrash the FTSE 100 this year

The FTSE 100 may be trading close to record highs but there are still bargains on the index, such as these two undervalued blue-chip behemoths.

Big boys

Lloyds Banking Group (LSE: LLOY) and Royal Dutch Shell (LSE: RDSB) offer massive growth and income prospects, yet both have been through a tough time lately. That is an understatement in the case of Lloyds, which would be dead and buried without taxpayer largesse during the financial crisis. Shell was hit by the oil price dip, although it managed to keep its honour, dignity and dividend intact.

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Lloyds fascinates me because it has seemed primed for lift-off for some time, yet remains stuck on the launchpad, today’s share price of 62p is barely up over five years. That is despite steady balance sheet strengthening, with its common equity tier 1 capital ratio rising from 11.6% in 2010 to 15.8% in December, then 16.2% on 31 March.

The bank’s profitability is increasing as profits grow and costs fall, with my Foolish colleague Roland Head noting that underlying costs total just 46.8% of income against 58.2% at RBS and 73% at Barclays.

LLOY, LOL

Lloyds trades at a knock-down forward valuation of just 8.6 times earnings despite its forecast yield of 5.3%, generously covered 2.1 times. By 2019, that could stand at 5.9%. Return on equity is 7.8% but management is targeting double that. City analysts reckon earnings per share (EPS) will jump 63% in calendar year 2018, so it might be worth buying now, before the official numbers are in.

Lloyds is heavily exposed to the struggling UK economy. The PPI mis-selling scandal has cost it £19bn so far and the cut-off for claims is not until 29 August 2019. It also faces competition from a swarm of challenger banks in key areas such as savings and mortgages, although it has responded impressively, by building up its digital operations. That shouldn’t overshadow its low valuation and high yield, a combination that cannot last forever.

Sure thing Shell

While Lloyds is down 10% in the last year, Shell is up 27%, powered by the strong oil price recovery. Brent crude may have pulled back to around $76 a barrel, but I think it could still climb higher, amid lengthening shadows over Iran and Venezuela, and uncertainty over Saudi Arabia’s pledge to pump more. I believe oil could just as easily overshoot on the upside as it did on the downside.

Shell also looks incredibly cheap as judged by its price/earnings ratio of just 13.5. Again, EPS forecasts are buoyant, with 62% pencilled in for calendar year 2018, followed by another 10% in 2019. The oil major’s dividend is the stuff of legend and remains juicy, despite the recent share price growth. The current yield is 5.1%, covered 1.4 times. If it could maintain that with crude at just $27, it can certainly afford that for some years to come. Also, it should reap the benefit from all its recent cost-cutting.

Buy, hold, forget

Shell’s $30bn investment programme proceeds apace and as my colleague Paul Summers reminds us, it remains competitive and resilient. I would seriously consider buying both these stocks today, then holding them forever. Maybe longer.

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harveyj has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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