When I looked at Rolls-Royce Holding (LSE: RR) just before Christmas, I saw a company I liked. Based on my belief that the aerospace engine maker will get over its recent troubles and faces a return to earnings growth, I certainly haven’t changed my mind.
High value?
One thing I can’t help noticing, though, is the apparently high current value of the shares. The company is forecast to be back to a rising earnings trend this year, but even with that the shares are on a toppy-looking P/E multiple of around 22.5 even as far out as December 2020.
The reduced dividend is expected to be still low too, with a 2020 yield of a very modest 2% on the cards. On that score, we’re not looking at an obvious bargain. But I think there’s very much a quality effect happening here — in terms both of the general feel of Rolls-Royce as a quality company and a ‘flight to quality’ that’s been spurred by market fears and Brexit uncertainty.
What’s so good?
Do you fly on holiday? If you do, take a look at who made the engines for your plane. The chances are it will be Rolls-Royce or General Electric. Almost every time I fly, that’s what I see. There are a couple of others, with Pratt & Whitney making up the last of the ‘big three’, but it’s a tight market with not much competition and with massive barriers to entry.
Another key is the safety aspect of modern aviation. Jet engines are complex beasts and require regular inspection and service, and providing that is where Rolls makes its profits — once an engine is sold, it has a monopoly on being able to do that job.
Specialist
I think Rolls is a great long-term investment, but what’s the FTSE 250 stock that I think could beat it in 2019 and the medium term? It’s much smaller engineer Ricardo (LSE: RCDO).
It is big in a number of specialised engineering fields, including high-performance road and rail engines, marine products, and the emerging clean power generation field. While not as exclusive a market as Rolls’ big aero engines, it still needs the expertise that Ricardo has built up since its founding in 1915.
The six months to December 2018 has brought Ricardo a total order intake of just over £200m, ending with an order book valued at £300m. The company reached the end of December with net debt of £27.5m, which is significantly below its previous underlying full-year pre-tax profit of £39m. Absolutely nothing to be concerned about there.
Quality again
Again, I’m seeing the same combination of quality coupled with a relatively safe haven for times of stock market upheaval. But this time it’s a smaller company on a significantly lower valuation.
Earnings per share progress is going at modest single-digit rates at the moment, and in the current climate I think that’s petty respectable. But bearish sentiment has helped push Ricardo shares down 37% in the past 12 months, giving us forward P/E ratios of only around 10.
The shares are also offering predicted dividend yields of 3.5% this year and 3.8% next, covered around 2.8 times by earnings and rising steadily year-on-year.
I think Ricardo shares are simply too cheap.
