The bull and the bear part two – breaking down our clients' top share holdings

We encourage investors to take a long-term view on the shares they buy, but a periodic review of what's in your portfolio is no bad thing. It's often more difficult to sell shares than it is to buy them, but sometimes the story changes for a particular stock and it might no longer fit with your investment goals.

This is the second in a four-part series in which we look at some of HL clients' most popular shares to outline both sides of the investment case.

Read part one

Investing in individual companies isn't right for everyone – it's higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you're investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This article isn't personal advice. If you're not sure whether an investment is right for you, seek advice. Investments will rise and fall in value, so you could get back less than you invest.

International Consolidated Airlines Group – turbulence ahead?

With post-pandemic travel restrictions easing further every day, airline stocks are making a comeback. Short-haul traffic is forecast to recover faster than long-haul, with some markets potentially returning to pre-pandemic levels as early as this year.

IAG operates short-haul flights throughout Europe, but also has a large long-haul business. At last check, the group was flying less than a quarter of its usual capacity, with passenger numbers expected to be below 50% of normal levels by the end of September.

IAG's benefited from strong cargo operations which have played a role in getting the group through the darkest days of the pandemic. This was a welcome crutch, and has become a much larger proportion of the group's revenue with passenger revenues severely depressed. However, in normal times, it makes up only a small fraction of the group's overall business and isn't a long-term attraction.

Chart showing IAG 2020 revenue breakdown

Chart showing IAG 2021 revenue breakdown

Source: Refinitiv, 07/10/21. Figures may not add up to 100% due to impact of rounding.

The case for IAG is recovery. The group's been hampered by the pandemic and its long-haul and business travel arms are acting as a millstone around the group's neck. It's in a worse position than most of its budget, short-haul competitors – but for long-term investors that could be part of the investment case. A return to business as usual has been somewhat priced in for some competitors – but IAG is still trading well below pre-pandemic levels.

But a fully-fledged recovery could take time. Analysts don't see profits recovering to pre-pandemic levels within the next two years, unsurprising considering IAG itself doesn't expect passenger traffic to hit 2019 levels until 2023 at the earliest. IAG has also loaded up on debt and sold off over £1bn in assets. This helps build the case that there's a real possibility it could come out the other side as a totally different, and far smaller, company.

The bottom line

The case for IAG relies on believing that the group will make a full recovery, faster than expected. With the public more conscious of hygiene and personal space, there's a chance that IAG's upper-tier services and business class seating could see a surge in demand.

We think IAG is in a tough spot with a lot of debt to service and limited income to do it. We're optimistic about the approaching end to pandemic-related travel restrictions, but we can't rule out another round of tightening over the winter. That would be a crushing blow for IAG.

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Rolls Royce – a recovery play

Like IAG, the investment case for Rolls Royce is all about recovery. The group's bread and butter is making and servicing aircraft engines. It will be slow to enjoy the fruits of a return to the air because it needs airlines to be flying enough to need servicing and want to buy new planes.

It's going to take years for this part of the business to get back to where it was in 2019 – management forecast that Engine Flying Hours would reach 80% of pre-pandemic levels in 2022. Judging by IAG's forecast for passenger traffic, it would be reasonable to assume 2023 won't yield a full recovery either.

The bright side for Rolls is its defence arm, which has been largely immune to the pandemic's impact. Defence spending isn't expected to slow down anytime soon and Rolls' position as a supplier to some of the world's biggest spenders is a positive. This part of the business makes up about a quarter of overall revenue, though, so even a stellar performance won't be enough to offset the weakness in Civil Aerospace.

Chart showing Rolls Royce revenue breakdown

Scroll across to see the full chart.

Source: Refinitiv, 07/10/21. Figures may not add up to 100% due to impact of rounding.

A recovery in air travel isn't the only turnaround Rolls investors are interested in. The group's also in the process of a major restructuring that's on the cusp of being complete. With the majority of promised job cuts complete and disposals in motion, the leaner organisation should have more flexibility moving forward.

Should is doing a lot of work here, though. While operations might be looking trim, the group's debt pile certainly isn't. Net debt more than tripled in 2020, and is expected to rise further this year. Adding to the issue, Rolls has been struggling with cash flow, with £1.9bn expected to leak out the door this year.

The bottom line

Rolls does have its fundamental attractions – making this kind of equipment takes huge capital investments and specialised skill. That means new competitors rarely enter the market. But there are a lot of storm clouds out there, with the group's defence business being one of few beacons of light. This isn't enough to hang our hat on, though. And as Rolls isn't able to pay a dividend to make the investment case more palatable, we think investors should be cautious.

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Royal Dutch Shell – green is the new black

The first question that Royal Dutch Shell investors must ask themselves is whether we are at the start of a long-term decline in global oil demand. With many of the world's largest consumers vowing to wean themselves off fossil fuels and population growth starting to stall, it's sensible to think we are.

This doesn't mean oil and gas stocks belong in the sell pile, the shift to greener energy will be a slow one. But it does mean investors need to determine whether their chosen company can change with the times.

For Shell, the approach to this brave new world is measured. The group's planning to clean up its own carbon emissions and shift its focus to natural gas. Meanwhile investment in oil production is expected to decline by 1-2% per year.

On top of that, the group will look to grow its presence in alternative energy. Investment in things like electric vehicle charging points and biofuels is expected to rise to more than a third of total capital expenditure by 2025.

This plan isn't as radical as some might have hoped. But we think it makes sense given the slow transition away from Shell's major revenue driver, oil. The uplift in oil prices this year has been a bonus for cashflow, putting the group in a much healthier position. Management's continued to keep a lid on capital investment despite the surge. This is a wise move in our view considering it's still unclear how long these good times will last.

Chart showing Royal Dutch Shell revenue breakdown

Source: Refinitiv, 07/10/21. Figures may not add up to 100% due to impact of rounding.

A big draw for oil and gas investors is the dividend – the segment's historically been a good place to go searching for reliable pay-outs. Volatility over the past 18 months meant Shell pared down its dividend significantly. But management's taken steps towards restoring it on top of a buyback programme. As it stands shares offer a respectable 3.8% prospective dividend yield, though it could be on the chopping block once again if oil prices tank and it should be remembered that yields are not a reliable indicator of future income.

The bottom line

We think Shell's in a strong position to deliver to shareholders while revamping its business to succeed in the green energy transition.

In the medium-term, Shell should be able to maintain its current level of shareholder returns, while executing on its pivot toward greener energy. Though this largely depends on oil prices, a factor that's out of Shell's control.

Looking further out, we can't say whether the returns on greener operations will rival that of the current business, which muddies the long-term outlook. However, a little-by-little approach to the transition means Shell's well positioned to make changes as needed.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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