It’s been a tough week for Rolls-Royce (LSE:RR) shares. Despite this, the stock has still returned 1,017.14% since April 2021.
A £1,000 investment in the stock from April 2021 is now worth £11,122.25. But what do investors need to look for in the next big thing?
A transformation
It’s no surprise Rolls-Royce shares have done well. The company’s situation now compared to where it was five years ago is night and day.
It’s making more money and has a balance sheet with more cash than debt. But this is only part of the story.
The business gaining momentum has caused the stock market to view it differently. In 2021, it traded at a price-to-sales (P/S) multiple of 0.8.
That ratio has now expanded to 4.55. And that’s a big part of why 84.55% sales growth has translated into a 1,017% increase in the share price.
Obviously, the end of the Covid-19 pandemic has been a big boost. But investors shouldn’t think this has been the only driving force.
Right place, right time?
Not every business that faced problems during the pandemic has recovered so well. An example of one that hasn’t is easyJet.
Despite the return in demand for air travel, the stock is still down 55% from where it was five years ago. And this tells investors something.
Rolls-Royce’s outstanding returns haven’t just been the result of being in the right place at the right time. There’s a lot more to it than this.
More generally, a cyclical downturn can be an opportunity to be brave. But it’s not a chance to buy beaten-down shares indiscriminately.
Downturns affect some companies more than others. So why has Rolls-Royce fared so much better than other Covid-19 casualties?
Structural improvements
Attributing all of Rolls-Royce’s success to recovering travel demand is a mistake. It ignores the work of the new CEO.
Under Tufan Erginbilgiç, the firm has made big changes. As a result, its civil aerospace division is much more profitable.
Rolls-Royce previously sold its engines at big discounts. It’s now focusing on maintaining stronger margins on these.
On top of this, it’s renegotiated its service agreements to bring them in line with cost increases. They’re now much more profitable.
The key to both of these is better engine reliability. So there’s a lot more than just the end of the pandemic.
Did I miss it?
I wasn’t buying Rolls-Royce shares in 2021. And I obviously missed a big opportunity in not doing this.
Despite this, I’m not too concerned. Seeing the potential return from the company was about more than just a cyclical downturn.
Tufan Erginbilgiç has done more than steer Rolls-Royce through a recovery. The firm has made big internal improvements.
That wasn’t easy to foresee. And it’s very hard to see how the stock would have generated anything like the same return without this.
Sometimes it’s better to miss a Rolls-Royce than to land on an easyJet. So I’m ok with the fact I never bought the stock.
The next Rolls-Royce?
My sense is that the time to buy the stock has passed – for now. Today’s prices don’t offer much protection from the risk of another exogenous shock.
The question is where to find the next Rolls-Royce. And I think there are a number of worthy candidates at the moment.
