Image source: Rolls-Royce plc
Between 2020 and 2022, shareholders in Rolls-Royce (LSE: RR) saw the share price seesaw dramatically. Since then, though, there has been a turnaround in the share price that is the stuff of investor dreams. Today (3 June), Rolls-Royce shares hit a new all-time high. The price has grown 1,159% since October 2022.
That sort of growth can immediately raise a red flag and send investors scurrying to reconsider valuation. But, as the FTSE 100 engineer’s incredible momentum shows no signs of slowing (the share is up 51% so far this year), might there still be value. So, should I buy some Rolls-Royce shares for my portfolio?
There’s potentially more value to be unlocked
The answer to that question, in my opinion, is that indeed there could be more value here.
I am wary of momentum-based investing. I prefer to buy shares based on what are known as fundamentals: the underlying financial performance of the business.
But the share’s strong momentum over the past couple of years has been driven at least in part by a number of positive commercial developments.
One has been improving financial performance. Another is growth in demand from customers in areas like civil aviation and defence. This is key to the company’s business model and look set to remain in place for the foreseeable future. On top of that, the firm set ambitious medium-term targets and later raised them.
If it can deliver on those targets, let alone potentially raising them again in coming years, I think the share price could potentially go even higher from here.
Pricing in risks can be challenging, but it matters
So far that all sounds promising. Current management deserves credit for turning the business around over the past couple of years.
However, taking a step back can help to add the sort of perspective I aim for as a believer in long-term investing.
Rolls has long been an unpredictable business from one decade to the next. Long development timelines, uncertain future demand, and sudden wild swings in the civil aviation market have wreaked havoc with its performance on multiple past occasions. The most recent example was the pandemic and associated travel restrictions, which decimated demand for civil aviation.
Such risks have been exacerbated in the past by management decisions that may have seemed better at the time than they did in hindsight. But this was not just about how Rolls-Royce was run: it was about the dynamics of its key end markets.
That has not changed, in my view — and is largely or totally outside of management control. That is what concerns me.
Sooner or later, I expect we will see another sudden drop in civil aviation demand. This tends to happen from time to time for reasons from terrorist attacks to a recession. That poses a risk to revenues and profits for Rolls-Royce.
At the current price, I do not think I would have sufficient margin of safety for such risks. So I will not be adding Rolls-Royce shares to my portfolio.
