The ascent of the Rolls-Royce (LSE: RR) share price in the last few years is the sort of thing that most stock pickers dream about. We’re talking a near tenfold gain in the last five years.
As someone who never bought into this stratospheric rise, I take my hat off to anyone who had the courage to invest for the long term when few would. But not being directly involved arguably makes it a bit easier to question whether this momentum is 1) justified and 2) sustainable.
Terrific turnaround
On the first point, it would be a harsh critic to say that the incredible positive momentum we’ve witnessed isn’t deserved.
Thanks to the no-nonsense approach of CEO Tufan Erginbilgiç, Rolls-Royce is a far different beast to a few years ago. Costs have been slashed along with the number of employees, helping to improve cash generation and margins. Non-core assets have been sold off, leaving a once-creaking balance sheet in far better health.
There have been other supportive factors, of course. Travel demand understandably soared as the Covid-19 pandemic began to pass. This was clearly a good thing for battered and bruised airlines. But it was also a welcome relief for Rolls, which supplies the engines that ultimately get people to their destinations. Not only this, it also gets paid for maintaining them. This is both essential and highly lucrative work.
The rise in geopolitical tensions and armed conflict has also played a role, providing a boost to the £83bn cap’s Defence division.
Big price tag
The issue for me is that it’s become progressively more challenging to deny that Rolls-Royce’s valuation isn’t looking frothy.
The shares now change hands for the equivalent of 41 times expected earnings. This is (very) high given that the average price-to-earnings (P/E) ratio across the FTSE 100 is somewhere in the mid-teens.
True, Rolls is now posting the sort of results and statements some of its index peers would kill for. And yes, there are things for investors to get excited about. These include the firm’s foray into small modular reactors (SMRs) that could eventually generate low-carbon electricity for millions of people.
But this is the future. In the meantime, the huge number of variables that can potentially impact global travel — including terrorism, adverse weather, another pandemic, and a high oil price — leave me wondering whether the market has now got ahead of itself. Any concerns over the reliability of its engines could also hit sentiment.
Even if there is nothing on the horizon to make investors panic, Rolls could still see some volatility in its share price as traders reduce their positions, take profits, and move on.
Momentum is a powerful beast in investing. Until it isn’t.
Not for the faint-hearted
Taking all this into account, it’s probably no surprise that I’m (still) not considering adding Rolls-Royce to my portfolio. In my view, there’s now a far higher risk that expectations won’t be met. There’s also better value elsewhere in the index and UK shares in general.
Half-year numbers drop at the end of July. If I were invested, I’d be watching the market’s reaction like a hawk.
