Back in April 2022, I was talking to another Fool writer about Rolls-Royce (LSE:RR) shares and we had pretty much opposite views on the stock. She thought it had potential, I thought it was done for.
Well, I was wrong there – the stock is up around 250% since we had that conversation. And while I wasn’t entirely unjustified in my thinking, there are some important lessons to learn from it.
For and against
So what did the case for and against Rolls-Royce shares look like in 2022? For me, it was mostly to do with the effects of the pandemic on the business.
While the worst was probably over, travel restrictions had left the company huge debt, a rising share count, and issues with one of its engines. All of that looked like a long-term problem to me.
On the other hand, my colleague pointed out that all wasn’t lost. The company had a good base of technical know-how, limited competition, and the macroeconomic picture was going to improve.
Realistically, there wasn’t much argument about any of these points. The only question was whether a share price of around £1 was underestimating the risks or the rewards.
In hindsight it’s pretty clear it was the rewards. Not just because the stock went up, but because the cash the company now generates makes the stock look like a ridiculous bargain at that price.
Learning lessons
I’m not saying I plan on buying things in future just because other people (even other Fools) tell me they think it’s a good idea. That’s almost certainly a bad plan.
There are however, a couple of lessons to learn from this one. The first is that the stock market has a tendency to overreact to news, whether good or bad.
This is clearly what happened with Rolls-Royce. The company was in a difficult position, but its long-term prospects were not nearly as bad as the share price implied.
The second is the importance of having the right management. While Warren East arguably had things going in the right direction, the company has kicked on under new CEO Tufan Erginbilgic.
Cutting costs as well as increasing prices has caused free cash flow to grow sharply. And while this would have been hard to foresee in 2022, it’s an important part of the Rolls-Royce story since then.
Investment ideas
I think there are a couple of ways to apply this kind of thinking to the stock market at the moment. One example is FTSE 100 drinks company Diageo (LSE:DGE).
With virtually zero switching costs, there’s always a risk of consumers trading down in a recession. And weak sales in the US, as well as Latin America, have been weighing on the stock.
The shift towards premium beverages looks like a durable one to me. And the prominence of Diageo’s brands means the business is well-positioned to benefit from this over time.
It’s also worth noting that the company views the current headwinds as temporary. Despite the decline in sales, maanagement maintained its guidance for 5-7% growth going forward.
I think there might be an opportunity here for investors willing to be patient. So having missed out on Rolls-Royce shares in 2022 by being too cautious, I’m going to take a close look at this one.
