Why Royal Dutch Shell Plc Is Going On My Watch List

royal dutch shellThere are no points for original ideas in investing. It only matters if your ideas are any good or not. The proof of that shows in your returns.

It isn’t any secret — backed by many academic studies — that dividend stocks outperform the market over the long term. When stock prices fail to reward — as they have done this year, with the FTSE 100 declining 2% — dividends give investors a regular income stream and, most importantly, a reason to stay invested.

Day to day the market has a 50% chance of moving up or down, but a smart investor — with a time horizon of 20 years or more — will at worst see low single-digit upside on a diversified share portfolio.

All the more reason to hug your income shares.   

Shares of the oil giant Shell (LSE: RDSB) (NYSE: RDS-B.US) have risen by a hefty 9% in 2014. Risk averse investors have piled into big, solid dividend stocks, some of which now look a bit pricey.

Shell trades on a trailing P/E of 12, whereas the FTSE 100 is on a P/E of 13. That valuation is hardly demanding, but for an income investor a better starting point might be to look at the firm’s cash position. We’ll soon get to that. Let’s first delve a little into the business, so we better understand what we’re buying.

After a disappointing 2013, Shell has decided that the best course of action is to taper its growth expectations. It’s difficult for a company of Shell’s size — with a market cap of nearly $250bn — to keep expanding. A disposal programme is under way, and Shell is making quick work of selling its non-core assets. It sold its its Australian downstream business for $2.6bn and has so far delivered around $12bn of its $15bn divestment programme for 2014/15.

Longer term, Shell expects to sell around $5bn of its assets on an annual basis. The pace of Shell’s transformation helped lift the shares to a five-year high at the beginning of September. Free cash flow, which is the cash generated from operations less capital expenditure, rose to $8bn in the second quarter, compared to an aggregate of around $7bn in the last 12 months.

Shell’s free cash flow comfortably paid for the dividend in the each of the first two quarters this year. Does Shell’s underwhelming valuation fail to appreciate its well-covered 4.5% dividend yield and dominant market position?

It’s very possible, but producing a full-blown valuation is time consuming. While I can’t off the bat say I love Shell’s business, it’s one I might revisit at a later date once I’ve considered a few other ideas.

There's also room in a portfolio for faster moving, perhaps more volatile growth companies. While small cap investments are considered risky, as long as you do your research, you can make sure you aren't putting your capital at gratuitous risk.

A quality business is a quality business no matter what size it is.

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Mark Stones has no position in any 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.