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Why Royal Dutch Shell Plc Shrugged Off Its Profit Warning

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If you were a nervous sort of shareholder in Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US) then you probably would have done better to avoid the newspapers last week.

“Shell shock as oil giant posts profit warning,” gasped The Mirror.

“Higher costs to erode Shell profits,” lamented The Times.

“Shell shares plunge on profit warning – Wipes £6.5bn off FTSE,” calculated the International Business Times.

And the share price of Royal Dutch Shell did indeed fall 4% on the Friday morning the announcement was made. Not anything that would frighten an investor in a racy internet stock, but quite a big drop for this £140bn oil major.

A bad day at the office…

So were the headline writers doing a sterling service by getting shareholders to man the panic stations, then?

Did the numerous column inches analysing Shell’s woes in newspapers ranging from the Financial Times to the Wall Street Journal represent a good investment in paper, ink and journalistic employment?

Not really — at least not if you read the news and decided to dump your holding of Shell shares in a panic on Friday morning.

You see by the end of the day’s trading, the price had recovered to £22.75 — a mere 1.3% lower than the price they’d closed at the evening before the profit warning!

This was a classic example of a phenomenon that reliably befuddles new investors. Shell’s profit warning really was bad news — the headline writers were quite correct. Like a disappointed headmaster, its new chief executive Ben van Beurden said that the company’s performance in 2013 was “not what I expect from Shell”. Fourth-quarter earnings are set to be “significantly lower” than investors had grown to expect, with exploration costs rising and Shell’s refining business still weak. Figures for the year as a whole are set be well down on those posted in 2012.

And yet in grand scheme of things a 1.3% decline is nothing. It’s almost as if van Beurden hadn’t opened his mouth at all.

…but just another day for shareholders

So how do we square the panicky headlines and the doomy substance of Shell’s message with what turned out to be a resilient share price?

The key point is to remember that the stock market looks forward, not backwards. And the collective wisdom of the tens of thousands of analysts and money managers out there was already that Shell faced problems going forward — a conclusion reached long before it admitted them with the profit warning.

Such pessimism is evident in the various valuation metrics we can calculate based on Shell’s current share price. The P/E ratio, for example, has bounced between 9 and 12 for the past few years – a pretty lowly rating considering the pick-up in the global economy we’ve seen that you might expect to drive higher demand for Shell’s products.

The dividend yield, meanwhile, is just over 5%. That’s significantly above the UK market average, and shows that investors either fear for its sustainability or else are demanding a high cash payout on the grounds that earnings at the company won’t grow much in the foreseeable future.

The point is that expectations weren’t high for Shell in the first place. Savvy investors know that the company will need to curb its capital expenditure plans and likely take some restructuring measures if it is to get growing again. Others don’t expect it to ever get much bigger than it is — it is already a giant, after all — but believe they’ll be rewarded by the steady dividend for many years to come.

Priced for imperfection

Shell shares show the virtue of value investing, which essentially boils down to not paying too much for future hopes and expectations about a company. Instead, by looking for cheap companies, you try to get at least a bird (and maybe a bird and a half!) in the hand now, instead of reach for the two in the bush.

Yet the great thing about this method is you can still get good gains from it.

Imagine if Shell’s new chief exec manages to get the supertanker’s earnings moving in the right direction again (I already suspect he is being gloomier than he needs to be to make this task easier in the future). Or what if we enter a new period of panic in the wider stock market, say, that could see investors flock to safer havens like Shell?

Either way, the price could go up with nothing much changing in the fundamentals of the company. Canny investors who buy shares cheap get the downside protected and any upside as a bonus. I therefore think they can be pretty sure of Shell. 

Of course, there are plenty of other oil and gas companies listed in London, and many of them have seen their share prices beaten down over the past couple of years due to similar issues to those that bedevil Shell. As such, they could make rich pickings for value investors prepared to do their homework.

Download our free special report on unearthing hidden value in oil and gas companies to get started!

> Owain owns shares in Shell.