Some quality stocks are being heavily discounted now because environmental, social and governance (ESG) investors shun them. Consider the energy giants TotalEnergies TTE, +3.19% and Shell SHEL, +3.29%.
Shares of these two Europe-based companies trade at half the valuation of their U.S. counterparts. “It’s absurd,” says Dan O’Keefe, manager of the Artisan Global Value Fund ARTGX, -0.48%. “There is no economic reason for them to trade at half the value of the U.S. integrated oil companies. They are all global integrated oil companies. You literally have essentially the same businesses.”
Yet TotalEnergies trades at a forward price earnings (p/e) ratio of 5.5 while Shell trades at 5.6 times. In contrast, Exxon Mobil XOM, +4.22% and Chevron CVX, +2.10% go for 10.75 and 11 times forward earnings, respectively. O’Keefe expects the gap between the European companies and their U.S.-based counterparts to close over time. “Something that is economically absurd can’t sustain forever,” he says, explaining one reason he owns both of these stocks.
O’Keefe may be worth listening to because his fund has posted average annual returns of 6.5% since it was launched in 2007 vs. 3.3% for the MSCI All Country World Value Index.
But what exactly explains the discount? It’s because European investors pay closer attention to ESG, so they avoid the energy giants in their backyard. “Large sections of the European asset management industry will not invest in oil and gas because of ESG restrictions,” O’Keefe says.
Closing the gap
Let’s assume O’Keefe is right. What will close the valuation gap? Simple rationality might set in. If not, some other forces might make it happen — maybe even buyouts or mergers. “If the discounts continue, the companies will not exist in their current form. They will be bought out,” O’Keefe predicts. Rival energy giants, he says, may look at the market values of Total and Shell and see “a potential opportunity to merge or acquire assets and create enormous value for both sets of shareholders.’”
Otherwise, a change of address might do the trick. “If there is a significant amount of value left on the table as a result of a European domicile, management and boards have a fiduciary duty to address it. One obvious solution is to redomicile to the U.S. or Canada where the assets will be welcomed and properly valued,” O’Keefe says.
Meanwhile, TotalEnergies and Shell both have strengths in their own right. Total has one of the lowest-cost energy portfolios, and therefore has one of the lowest breakeven points in the industry, says O’Keefe.
Both companies own substantial liquid natural gas (LNG) businesses. Shell holds the largest LNG portfolio among its peers with 70 million tons per annum (MPTA) in LNG sales in 2020, including 33 MPTA of its own production, Morningstar analyst Allen Good points out.
Total has LNG projects in Qatar, the U.S., Papua New Guinea and Mozambique, and it should increase production substantially by 2030, Good says. LNG will remain in demand around the world as a substitute for coal in power generation. “LNG is an area of energy that is clearly growing,” O’Keefe adds.
Both companies also have solid balance sheets, and they are returning nearly all of their free cash flow to shareholders via buybacks and dividends. This means you get paid to wait for the valuation gap to close. TotalEnergies recently paid a 4.4% dividend yield, and for Shell the yield is 4.2%. “I am getting a very attractive return from dividends and share buybacks, irrespective of whether that discount closes or not,” says O’Keefe.
If the idea of investing in fossil fuel companies offends you because of your concerns about climate change, consider that both companies pledge to be carbon neutral by 2050.
They operate renewables businesses, too, though Total’s seems more substantial. Total plans to lift its renewable power generation capacity to 35 gigawatts (GW) in 2025 and 100 GW in 2030, from 16 GW today, says Morningstar’s Good. Total is also investing in biofuels and plastics recycling.
In contrast, Shell emphasizes adjusting its marketing and energy trading operations “to work with customers that want to secure low-carbon solutions for their businesses,” Good says, rather than offer an explicit renewable generation capacity target.
These renewables businesses actually are one reason some investors are wary of these stocks. Hennessy Fund energy expert Ben Cook thinks these units have a long road to profitability and will weigh on returns in the interim.
“To meet investor expectations, energy companies need to deliver a return on capital that is commensurate with traditional hydrocarbon businesses,” says Cook who co-manages the Hennessy Energy Transition Fund HNRGX, +4.05% and the Hennessy Midstream Fund HMSFX, +1.46%. He doesn’t think this is the case for renewables businesses . “As long as there is this question mark about how much can they make on energy transition,” he says, “there is going to be a discount.”
Perhaps in recognition of this market reality, TotalEnergies recently announced the sale of a small portion of its renewables portfolio to Crédit Agricole Assurances. It will continue to operate the plants.
O’Keefe is more bullish on the potential profitability of renewables. He thinks Total’s renewables portfolio is just starting to turn profitable. “Clearly it has substantial value, and that value will be evident over the next few years,” he says. Total projects a return on invested capital in renewable energies of more than 10%.
Another perceived ESG-related risk weighing these two stocks (and other energy stocks) is that they will be stuck with stranded energy assets because of the transition to renewables. O’Keefe believes this transition will take a long time — if it happens at all — because of the energy production limitations of renewables.
“A thoughtful study of energy leads to the conclusion that renewables are not going to replace fossil fuels,” he says. “You could cover the entire U.S. with solar panels and it would not supply half the power the country needs. The world has spent about $4 trillion on renewables in the past 10 years and fossil fuels have only declined as part of the energy stack by about one percentage point.” Fossil fuels will be with us for a long time, he concludes. The upshot: No possibility of stranded assets at energy companies.
The all-important energy price outlook
A key factor in the mix for fossil fuel companies is the outlook for energy prices. Both O’Keefe and Cook, and many other energy analysts I talk with, believe that energy prices will stay at current levels or higher for years.
One reason is that supply growth will be limited due to chronic underinvestment in exploration and production. The other big reason is that the global economy will continue to grow — especially given China’s reopening. Says O’Keefe: “I expect oil prices over the next 10 years will be higher than the past 10.”
Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested XOM, CVX and OXY in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks
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