After climbing more than 1,000% in five years, Rolls-Royce (LSE:RR) shares reversed course in March. So what should investors do? They shouldn’t expect any stock to go up in a straight line indefinitely, but Rolls-Royce is more cyclical than most.
When to sell
When is the right time to sell and move on? At the Fundsmith Annual Meeting, Terry Smith raised this question about funds. His answer is… when things have been going well. Given Fundsmith’s recent results, that’s probably no surprise.
The underlying rationale is that investing styles go in and out of fashion. That’s true whether it’s growth, value, or anything else. In the case of funds, I’m not convinced. But I do think this makes a lot more sense in the case of shares in individual companies.
Lloyds Banking Group isn’t going to start making missile systems because of rising defence spending. And nobody thinks it should.
Things are different with funds. Portfolio managers have the opportunity to see opportunities and shift their portfolios accordingly.
Sell high
Selling high to buy low makes a lot of sense as a strategy. But it’s much easier said than done on both sides of the equation. A year ago, Rolls-Royce shares were very clearly at highs. The stock had posted an 805% return across the previous five years.
Anyone who sold at that point though, missed out on another 47% in the last 12 months. And that’s only part of it. Twelve months ago, Diageo shares were trading at their lowest prices in a decade. That presumably counts as buying low, if anything does.
Unfortunately, that stock’s down another 30% in the last year. So the cost of selling Rolls-Royce to buy Diageo a year ago has been huge.
Selling high and buying low is a good idea. But it’s no easier to work out when a stock’s going to fall than it is to predict a recovery.
Valuation
The decline in the Rolls-Royce share price has happened in the last month. Unsurprisingly, it’s coincided with the conflict in Iran. Higher oil prices threaten increased flying costs and this weighs on demand. And that’s bad for the firm’s commercial aerospace division. This has been the biggest driving force behind the company’s recent success. So investors need to pay attention to what’s going on.
The stock’s still trading at some unusually high valuation multiples. On a price-to-book (P/B) basis, it’s close to a 10-year high. In terms of the price-to-earnings (P/E) ratio, things look more reasonable. But a lot of that is due to a one-off tax consideration.
High multiples make the stock more vulnerable to exogenous shocks. That’s what’s happened and it’s still the case.
Hold?
A lot of the time in the stock market, the best thing to do is nothing. And I think that’s the case with Rolls-Royce shares right now. The current valuation multiples make it hard to buy the stock right now. But selling comes with the risk of missing future returns.
Geopolitical uncertainty makes it almost impossible to know what to do. And that probably makes it best to do consider doing nothing at all.
