One of the big stories of the London stock market over the past few years has been the performance of FTSE 100 aeronautical engineer Rolls-Royce (LSE: RR). After falling to pennies during the pandemic and still selling for pennies as late as 2022, Rolls-Royce shares have come back with a vengeance.
Over the past five years, for example, the Rolls-Royce share price has increased by 1,134%.
Taking a long-term approach
Such a gain helps to illustrate why I am a believer in taking a long-term approach to investing.
But even on a shorter timeframe, Rolls-Royce shares have performed well.
Over the past year, for example, the share price has gone up by 119%. This month it hit an all-time high.
That means someone who invested £20k into Rolls-Royce shares a year ago would now be sitting on a shareholding worth around £43,800.
As well as that, thanks to the cheaper purchase price a year ago than now, they would also have earned around £245 in dividends even though the current dividend yield is a fairly measly 0.6%.
A classic turnaround story
Despite the company’s aeronautical prowess, the reason behind the surge in Rolls-Royce shares is not rocket science.
It has three main businesses: civil aviation, power systems, and defence. During the pandemic, reduced civil aviation flying hours meant that business was bleeding red ink. Power systems also faced an uncertain demand outlook though the longer-term picture was less concerning.
Since then, civil aviation demand has come storming back. Power systems has been doing well, while the past few years have also seen surging demand for the company’s defence offering.
In other words, after several years when the company was struggling with its sales, demand has come roaring back.
This sector has high barriers to entry
Why did that affect Rolls so much?
The businesses it operates in have high barriers to entry. Research and development costs are high, timelines are long, and projects often require substantial cost outlays that can only be recouped if they achieve a certain number of orders.
That adds up to a business model with high fixed costs. When a business has high fixed costs but variable customer demand, it can mean that profitability evaporates if orders suddenly decline, as happened during the pandemic.
Rolls-Royce shares have soared in recent years because the company has experienced a classic turnaround. That has also been helped by current management taking an aggressive approach to managing costs and consistently delivering on ambitious financial targets.
I’m not investing at this price
But while that helps explain why Rolls-Royce shares have soared, what is my move now?
At 19 times earnings, the share price does not appeal to me.
Rolls’ brand, a large installed base of engines, and high demand are all factors in the company’s favour right now.
But if demand suddenly collapses overnight again, whether due to a pandemic, terrorist attack, or even a recession, that high fixed cost base remains a risk to profitability.
Today’s share price does not offer me sufficient margin of safety to accommodate that risk, I feel. I will not be investing.
